What could happen to global economies and investments in 2023?

Let's have a look at the bigger picture

Whilst markets still face a level of risk after a turbulent 2022, it can be said that there is optimism for markets this year. As we all adjust to higher inflation rates, Central Banks should hold off hiking up interest rates much further, meaning assets such as property, are more attractively priced. That said, the current economic environment is similar to the Financial Crisis of 2008 - it remains volatile, with the impacts of global policies also adding to uncertainty and this can make it harder for investors to stand their ground, but with risk comes reward.

The context entering the year

Last year was an incredibly difficult year for investors, with widespread inflation caused by the combination of reopening supply chains and a commodity shortage provoked by the Ukraine war. This inflation led to interest rates being raised by Central Bankers – although more on this in the ‘inflation and interest rates’ section below. However, as a result, both bonds and equities saw deeply negative returns last year. Thankfully, inflation is anticipated to fall this year in all key global markets.

The pain of last year means that this year will potentially be far more comfortable for investors across all asset classes. Inflation appears to have peaked and is moving its way back to target, while Central Banks are close to the peak of their interest rate hiking cycle.  As asset prices have been pushed down, we are starting to enter attractive valuation territory. Bonds now offer investors an attractive yield and equities are trading around or below long-term average valuations. 

The overall global economic outlook 

While the fundamental economic outlook still looks less than desirable, with much of the developed world set to enter recession, looking east we find better investment growth prospects. China has dissociated from the developed world’s economic cycle, so as the west enters recession, China is reopening its post-Covid economy which is beginning to have a positive stimulating effect. Emerging markets tend to have more intense economic links with China than the US so are set to benefit from this. In Europe, the worst of the energy crisis appears to be over, with natural gas storage restocked and economies showing surprising resilience, which should support European asset prices.  

The outlook for equities

Last year the value factor outperformed the growth factor. This is because ‘value’ companies derive their value from substantial but slowly growing present cashflows, whereas ‘growth’ companies derive their value from rapidly growing future cashflows. When interest rates rise, money today becomes more valuable relative to money in the future. Value companies also tend to be in more defensive economic sectors, like consumer staple goods that people use on a daily basis, whose necessity sustains cashflows through recessions. So long as growth prospects remain poor and Central Banks continue to tighten monetary policy – so increase interest rates - value stocks are likely to continue to outperform growth stocks. While the Fed signals it will keep interest rates high, markets are forecasting the Fed to start cutting rates in the second or third quarter of the year. If this does happen, growth stocks could rally.

Inflation and interest rates

Inflation describes the general increase in the price of goods and services and is caused by an imbalance between demand and supply in the economy. It can be caused by a rush of demand that overwhelms supply, a constriction in supply that cannot service the given demand, or a combination of the two.  

Central banks do not have control over the productive supply side of the economy – no central bank policy in and of itself can force more oil out of the ground, magic up more workers or set up additional assembly lines. But, they do have a lever over the demand side of the economy. This lever is monetary policy, more specifically the power to change interest rates. 

Central banks can increase interest rates, making it more expensive to borrow money. This affects both businesses and households – businesses may choose to put off debt funded investment as it is no longer economical at that higher interest rate, while households will begin to pay higher mortgage and car loan payments etc, Consumers may choose not to buy a new house, along with all the furniture that goes with it, and those already in their house and paying a mortgage will now have less available income for other items. All of this acts to reduce demand in the economy, hopefully to the point that it balances with supply and inflation subsides.  

Conclusion 

It would be wrong to say that the risks markets faced last year have completely subsided, but we do have a more optimistic outlook. Part of this reflects the fact that the dominant risks that have hampered asset prices, most notably high inflation and aggressive interest rate increases by Central Banks, are beginning to ease.  

The normalisation of global inflation should reduce the impetus for Central Banks to raise interest rates, while the magnitude of the drop in asset prices last year means assets are more attractively priced on valuation grounds. However, we expect continued periods of heightened volatility as investors begin to see the impact of higher interest rates on global growth prospects, weakening labour market dynamics, and pressure on corporate earnings.
 
One could draw historical parallels with the 2008 Global Financial Crisis or the energy shock of the 1970s to contextualise what we've seen, but we simply haven't seen a period in which a pandemic, a post-globalised world order, conflict between Russia and Ukraine, and unprecedented monetary and fiscal stimulus from policy markets all occurred at the same time. This, by definition, makes the period extraordinary.

However, history shows that in times of pessimism and extreme falls in asset prices, holding one's nerve during the turbulent period has been rewarded. 

Please note: This Market update is for general information only, does not constitute individual advice and should not be used to inform financial decisions. Additionally, past performance is not a guide to future returns. Investment returns are not guaranteed, and you may get back less than you originally invested.