This article is from our Outlook 2023 edition of MarketWatch.
07th February, 2023
Looking back on the events of 2022 – double-digit inflation, a spike in borrowing costs, an energy crisis, and a war in eastern Europe – it’s hard to believe that the economy and corporate earnings continued to grow. You certainly couldn’t tell from the financial markets, where stocks fell into a bear market (down 20% or more) and bonds had their worst year on reliable record.
Of course, the economy and the markets are not the same. Economic data is slow and backward-looking, while markets move rapidly in anticipation of what might happen in the future. Nobel prize winner Paul Samuelson joked that economists have predicted nine out of the last five recessions. The same could be said for markets. If we do get a recession in the United States this year, it will be the most heavily foretold recession ever.
Why are economists and investors so convinced that a recession is imminent? Mainly because we haven’t ever gotten out of such a high inflation/interest rate hiking environment in modern times without one. Are we kidding ourselves to think that this time it can be different?
To get a sense of how inflation can be brought down, and what damage that might cause, we look at what’s causing the price rises. US inflation is now mostly in services, driven by rent and wages, and here the bears have a strong case. The slowdown in wage growth required to slow down service inflation would historically have been associated with an increase in unemployment which has only been seen in a recession.
Despite almost record-low unemployment, the US workforce is still smaller than it was pre-COVID-19. Higher savings, changing life choices, slower immigration, and an ageing workforce have led to fewer workers and higher wages. The Federal Reserve (Fed) hopes that slowing demand can close the vacancies-workers gap without causing millions of lay-offs. Early evidence is positive, but wages and rents adjust slowly and we would be surprised if core US inflation gets close to the 2% target this year.
The picture is different in Europe, where energy is the dominant driver of inflation, which makes it more political and less predictable. On a positive note, even record low unemployment in the Eurozone is higher than elsewhere. There’s also more wage restraint, as seen with IG Metall, Germany’s biggest union, trading off lower wage increases for more flexible conditions. So if energy prices do settle down, inflation here should be less of a problem and require a less drastic policy.
The more difficult situation is in the UK, which suffers from both European energy prices and US-like labour tightness. Energy prices settling down will not be enough to stop inflation if the issues with wages and services cannot be solved, and judging by the widespread industrial action, this will not be easy.
A genuine concern in Europe several months ago was not the escalating price of energy, but the fear that there wouldn’t be enough energy available, at any price. Warmer-than-expected weather and alternative energy sourcing removed this tail risk, causing prices to drop. So much so that the oil cartelOPEC+ decided to reduce production to keep prices up.
However, energy prices are still well above pre-COVID-19 levels. Double-digit inflation will eat into household and corporate budgets across the Eurozone and UK, and sharply higher borrowing costs are a significant drag as the region is highly dependent on variable-rate bank lending. Consumer and business surveys indicate that recessionary declines in spending and investment may be upon us already, despite various government attempts to cushion the blow.
With its own energy resources, longer-term fixed-rate financing, and a more modern sector mix, the US economy is much less sensitive to the problems Europe faces. Although higher rates have hit the property sector, the combination of COVID-19 savings, rising wages, and low unemployment mean that the consumer is well positioned to see out a slowdown. A US recession is not at all inevitable, and if one happens it should be mild.
Higher interest rates don’t just slow down growth, they also expose unsustainable business models and economic imbalances. To paraphrase Warren Buffet, “When the tide of cheap money goes out, we see who’s swimming naked”. The good news is that apart from more speculative sectors, like new technology and crypto, the broader economy is on much firmer foundations than in 2008. This doesn’t mean that a recession can’t happen, but that it’s far less likely to become a crisis.
The natural response of market strategists is to look back at similar episodes in the past and map them into the present or near future. We fully acknowledge the weaknesses of this approach, not least due to the small number of relevant examples, but history can still be a useful guide.
So, we lay out all the times since the Second World War that the US stock market (now almost 70% of the developed world market) fell by 25% or more, and measure the real returns, i.e. after inflation, over the next 1-10 years from the point where the market reached -25%.
It’s encouraging to see that median outcomes are strong, indicating that buying the market after such drops is usually a sound investment strategy. But, there were three periods where real returns were very low, even over ten year periods. Looking more closely, we see that such ‘lost decades’ were associated with high and prolonged inflation, sky-high market valuations, or financial crisis.
The current environment does feature high inflation, which central banks are fighting hard to prevent from bedding in. However, the financial system is in much better health than in 2008, so the main worry from here is the above-average market valuations (in the US). This means that returns from here are likely to be decent, but at the more modest end of the historical range.
Despite the encouraging medium-term outlook, the problem remains that markets have moved well ahead of the economy, first by anticipating a recession, and more recently by assuming that inflation has been contained and the Fed will relent. Inflation is moving in the right direction, but is still a long way above target. Also, slowing growth and higher input costs mean that corporate earnings are vulnerable, perhaps more than analysts have baked into their forecasts.
At some point this year, we will see whether the US goes into recession or not. A recession would bring interest rate cuts, although probably smaller and slower than in recent crises, as inflation may still be a risk. Ultimately, the lower interest rate and no recession scenarios are both positive for the stock market, but we face a period of economic and earnings uncertainty first, meaning that more market mood swings are likely.
Does the prospect of more volatility mean that we should reduce our equity exposure? Now that interest rates are higher, waiting in cash seems more attractive. But waiting until the uncertainty passes – if it ever really does – means accepting a negative return (after inflation) and assuming that we can pick a better time to re-invest and catch up. Unless valuations are unusually high, or the financial system is dangerously unbalanced, we view dips as opportunities to add, not threats to avoid.
In summary, we are positive on stock markets for 2023, expecting 5-10% returns on the year, and therefore, are staying invested. We expect a bumpy first half of the year, driven by macro data and evolving expectations for central bank policy. But rather than attempt to time the market, we prefer to rely on a solid financial plan, including sufficient liquidity, to cushion our investment journey through the year, whatever it may bring.
Warning: Past performance is not a reliable guide to future performance. The value of your investment may go down as well as up. These products may be affected by changes in currency exchange rates.
Warning: Forecasts are not a reliable indicator of future performance.