The global economic outlook for 2023

After a disappointing 2022, what can we expect in financial markets in 2023?

The outlook for markets will continue to be challenging in 2023, although pleasingly, most publicly traded assets are better supported from a valuation perspective than 12 months ago. The good news is we expect global inflation will be lower than the current elevated levels. However, inflation will likely remain stubbornly high relative to central banks' targets.

Inflation in developed markets, which triggered aggressive policy tightening by the main central banks, may have already peaked. Underlying inflation in the main developed economics has started to respond to higher interest rates and slowed. In addition, the surge in commodity prices (in particular energy prices) has stabilised which, in the absence of another negative supply shock, will contribute to a moderation in inflation.

However, inflation in many countries will likely turn out to be more persistent than many investors currently hope. Labour markets remain tight in a number of economies, especially in the US and UK, and central banks are keen to avoid a wage price spiral which would lead to entrenched inflation. This is especially the case in the US. Futures markets have priced in a peak Federal Fund rate of around 5.0% by March 2023, followed by a small 25 basis points reduction by September 2023. In short, investors are expecting the Federal Reserve to reverse course and reduce the interest rate at the first hint of a recession. This may turn out to be over optimistic. A more likely scenario is that the Fed will maintain the rate at its peak level until the end of 2023, with some risks of peak rate higher than 5.0%. 

Does this mean a global recession is likely in 2023?

The probability of a recession, both in Australia and in most major developed economies, has definitely increased over the past twelve months. It is the unavoidable cost of central banks trying to lower inflation by 2023. Market economists expect most developed economies to slow, in some cases sharply, in 2023 as the result of higher interest rates. The table below lists the consensus economic growth in the major economies in 2022 and 2023. 

Table 1: Forecasted Real GDP Growth (%)

Source: Factset as at 9 January 2023

Analysts expect both the UK and Germany to record negative annual GDP growth in 2023. Although the US is expected to generate modest economic growth in 2023, the annual forecast masks a shallow recession in the first half of 2023 when real GDP is expected to fall by 0.3% and 0.4% quarterly (on an annualised basis) in March and June quarters, followed by a strong recovery in second half of 2023. 

Australia is expected to grow by a relatively healthy 1.6% in 2023, avoiding a technical recession but with weak GDP growth in the first two quarter of 2023. China is an exception with an expected recovery in economic growth to 4.7%, albeit an anaemic level.

How will investment markets perform given the uncertainty in the global economy, especially if a global recession eventuates in 2023?

The good news first – almost virtually all publicly traded asset classes repriced significantly in 2022 and entered 2023 with more attractive valuation levels. Arguably, equity markets have priced in at least a mild economic slowdown. Most major equity indices are currently trading at significantly lower price to earnings levels, as shown in the table below. In particular, the fall in 12 month forward P/E in Nasdaq and S&P 500 over 2022 were drastic (refer to chart 1 below). Among the other major equity indices, the valuations of the All Ordinaries and the Euro STOXX also fell by smaller but significant magnitudes. While the Hang Seng was boosted by China’s reopening in late 2022, its valuation remains attractive on a historical basis.  

Table 2: Price to 20 month Forward Earnings of Major Equity Indices 

Source: Factset as at 9 January 2023

The big question is whether better valuations will lead to a positive return for equities in 2023? The risks are more balanced than at the start of 2022, but equities still face some downside risks. Despite the declines, valuations remain slightly expensive or around neutral for most equity indices by historical standards (refer to charts 2 and 3). The main exceptions are the Hang Seng and the FTSE which are attractive, relative to long term medians, as measured by forward looking and trailing price to earnings. In particular, the Nasdaq is still expensive on a tailing 12 month price/earnings basis, although it is around long term median on a forward looking basis. This highlights the risk of any further fall in corporate profits in the event of a severe recession. 

Source: Factset

Source: Factset

What about fixed interest markets after a disastrous 2022?

The story is similar to equities but with a twist. Similar to equities, bonds have significantly better value after the rise in bond yields in 2022. A repeat of 2023 is unlikely for bonds although the asset class still faces some headwinds if inflation remains persistent in 2023. The main downside risk to bonds is central banks raising policy rates significantly more than currently expected in order to fight inflation. In particular, a more hawkish than expected Federal Reserve remains a key risk. The difference with equites is that safe sovereign bonds can rally if there is a significant recession. The good news is the diversification between equities and bonds will likely work better in 2023 than in 2022. 

Are there any other major macro risks investors should monitor?

Apart from the risks outlined so far, there are also a number of “known unknowns” which investors should be aware of. It must be emphasised that some of these issues can evolve in a market-friendly manner. 

At the top of the list is Ukraine. How will the current stalemate on the battleground evolve given the recent renewal of Russia’s military offense and NATO’s increasing willingness to supply Ukraine with more “offensive” weapons such as tanks? Any peace settlement will be beneficial to the global economy, especially Europe. Conversely, a significant military escalation by Russia will be disruptive. Chinese economic policy is another major source of uncertainty. After three years of market unfriendly policies, Chinese policy makers have lately made some noise of at least moderating those policies. Markets certainly have priced in some potential good news, but with political power now highly concentrated in President Xi, there is still a high level of uncertainty. In addition, will China adopt a less hawkish foreign policy and if so, what are the likely economic implications? Finally, an economic slowdown usually exposes previously unknown stress in the global financial system. Will 2023 be different from 2000 and 2009? It remains to be seen.