Light at the end of the tunnel 

February 15, 2023

By Rupert Watson, Head of Asset Allocation, Europe

The battle with inflation continues and recession risks remain in many markets, but 2023 may be better than expected

The last 12 months have been relentless for investors, but while we enter 2023 under an economic cloud, there are grounds for cautious optimism for the year ahead.

We believe the global economy will remain soft in 2023, but the outlook for inflation is improving and with it the prospect that central banks will ease off their cycle of tightening monetary policies. What’s more, the world leading economies are not uniform. While the economic cycle has turned down in the US, Europe and other developed markets, the depth and duration of those downturns will vary. Perhaps most significant is China, which is at a fundamentally different point in the economic cycle and is now likely to enter a phase of renewed growth  on the back of a post Covid-reopening boom.

That is the optimistic dimension, but improvement is not recovery and there is good reason for continued caution.

Inflation looks to have peaked in many markets, but it has not gone away. Energy prices have returned to the levels last seen before the Russian invasion of Ukraine. However, they are still above the average over the last decade or more. This is an essential reminder that even before the tragic events in Ukraine, there was an underlying mismatch in supply and demand that was raising energy costs.

So, while inflation is in retreat, it is not defeated, and we expect it to remain above the 2% targeted by developed market central banks. As a result, those central banks can be expected to ease off their tightening, but not relax into stimulative monetary policy. Central bank rates could remain at high levels before coming down again, perhaps in 2024.

Meanwhile, the potential for a recovery in China has strengthened in just the last few weeks as strict Covid lockdowns have finally lifted. This could act as a positive counterbalance to the slowdown in other economies, but it comes with the potential risk that rising demand in China could re-ignite commodity prices and thus wider inflation in the second half of the year.

This remains a very modest risk, but one we should be alert to.

Of course, we remain alert to wider geopolitical risks too. China’s stance on Taiwan, continuing tension in Iran and the ongoing conflict in Ukraine may produce unwelcome, not to mention potentially tragic, surprises.

With those caveats firmly in mind, we nevertheless look forward to a less brutal year for economies, markets and investors.

Valuations across all asset classes look potentially more realistic than for some time. Shallower and shorter recessions in some markets than previously expected mean corporate bond risks look well-contained. We believe sovereigns and equities also look more attractive, although that too must be balanced against the danger of over-optimism in earnings, and discount rates.

In the long term, as different economies work their way through the cycle from different places and at different rates, there will be potentially be opportunities in currencies. The dollar appears over-valued and investors with a longer time horizon could consider other currencies including the euro, the yen and emerging market currencies.

Since the turn of the year our outlook has, if anything, become more positive. We are still a long way from the sunny uplands of global growth and recovery, but we believe 2023 will not be quite as weak as many feared.

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