Observations of the Global Economy 2023

The following are some observations of the global economy, and the perceived outlook for the year.  We have observed that higher inflation became more entrenched in the economy due to global supply chain disruptions.  This was exacerbated by higher levels of demand and energy uncertainties.  In reaction to this, the Federal Reserve tapered from its asset purchase programme, and aggressively tightened monetary policy.  Inflation hit a 30-year high.  These cooling measures were necessary, but lagged. 

The Federal Reserve began raising interest rates in March 2022 by 25 basis points, and then a further 50 bps in May.  Despite this, inflation continued to escalate.  This forced the Federal Reserve into further aggressive tightening of monetary policy.  Interest rates were raised a further 75 basis points over the next four FOMC meetings, to around 3.75% within 8 months.  That was unprecedented.  Because of this, risk sentiment improved in late 2022.  Data indicated inflation likely peaked.  While inflation may have softened, it is still likely to remain above what we have experienced in the past decade. 

In its final FOMC meeting for 2022, the Federal Reserve moved rates by a widely anticipated 50 basis points to around 4.25% as inflation peaked.  However, they remain hawkish.  It is anticipated that continued rate increases will be continue in 2023 before it tapers off at its terminal rate at around 5.1%.  Any lowering of rates will only occur in 2024. 

Major central banks have followed the Federal Reserve.  The exceptions have been the Bank of Japan and the People’s Bank of China.  Because of this global tightening of credit, volatility has spiked.  Both fixed income and equity have dropped in value.  This runs against conventional wisdom and correlation theory.  As of end Dec 2022, the MSCI World index lost 18.1%, and Barclays Bloomberg Global Aggregate Corporate Total Return index lost 16.7%. 

In 2023, the effects of major central banks’ tightened monetary policy tightening continue to persist.  Policies will remain restrictive to tame inflation, which is still a concern.  It is likely that US growth will stall, corporate profits will decline and the associated cost cutting measures will lead to higher unemployment.  There is a higher probability of a recession sometime near the middle of the year.  Equity valuation will likely drop before recovering in the latter half of 2023. 

The last three years have been rough.  The economic shutdown caused by the global pandemic created a huge gap between demand and supply, exacerbated by the prolonged disruptions in global supply chains.  The resulting inflation took central bankers off-guard because it is unprecedented.  This forced them to make a reverse the ultra-loose monetary policy.  In fact, as of the beginning of March 2022, the Federal Reserve was still injecting cash in the economy. 

To tame inflation, interest rates need to be maintained above the neutral policy rate.  This neutral rate reflects the potential rate of economic growth and long-term inflation expectations.  Pertaining to the case of the US, potential growth stands around 1.7% per annum.  The best market approximation of long-term inflation expectations, the 30-year inflation swap, has hovered around 2.5% at the end of 2022.  As such, the assumed US neutral policy rate lies somewhere around 4.2%.  The Federal Reserve raised rates above these levels only in December, to 4.25% to 4.50%.  As such, much more needs to be done to effectively tame domestic demand.  As mentioned, the Federal Reserve has signalled its preference for another cumulative 75 basis point rate hike, to the 5.00% to 5.25% range.  This could be achieved in the next two to three meetings.  Rates are expect to remain unchanged until the end of 2023. 

There is a correlation to the evolution of inflation and employment.  The Federal Reserve remain cautious on inflation.  The concern is that higher wages could keep inflation above the Federal Reserve’s target for an extended period.  It is implicitly assumed unemployment will remain low, because the Federal Reserve is projecting unemployment at 4.6% at the end of 2023 and 2024.  However, the rate of layoffs in the technology sector threaten that.  If unemployment spikes, particularly as a precursor to a possible recessions, the policy resolve of the Federal Reserve would be tested.  Over the last few months, US inflation has been increasingly driven by lagging items, particularly housing, which has a weightage of 33% of the CPI basket.  This could bring inflation back to a 3.0% to 4.0% range and unemployment rising to a 5.5%-6.0% range.  That is very concerning. 

Based on the above, even if a rate cut does not occur before 2024, the forward looking nature of markets will consider any change in policy bias.  The market will start betting on a policy easing in 2024, or even as early as the second half of 2023.  That anticipated market sentiment would benefit growth assets, even for an economy in recession.  Historically, equities reach their trough before the end of the recession, provided that monetary and fiscal policies are more supportive of an economic recovery.  Assuming inflation eases off, current bond yields will become attractive for long term investors.  The key market risks are inflation and the impact of monetary policy.