Getting Through Market Uncertainty

The way markets respond to events is not always logical. As long as there have been markets, there have been boom and bust cycles, as well as asset bubbles and crashes.

The reason is obvious: investors are people, and they often make decisions based on how they feel instead of how well they think.

Most investors understand the concept of “buy low, sell high,” but many don’t put it into practice because they fear losing money more than they do missing out on possible gains, even if the end result would be the same.

This means that your instincts might tell you to get out of the market at the lowest point of a downturn to avoid more losses.

But if you do this, you might sell for less than you could have and miss out on some of the best deals.

In 2022, the economies of the developed markets (DM) grew, China’s growth slowed, and inflation and interest rates went up. In 2023, sharp rate hikes will cause recessions in DMs. This is the first change from last year. We can already see that rate hikes hurt the parts of the economy that are most affected by interest rates, like housing.

Overall, price increases have a delayed effect that will make Europe’s economy suffer even more from the energy shock and hurt U.S. consumers as they use up their savings. The second change is that we think recessions will make central banks stop raising interest rates.

As U.S. consumer spending shifts from goods to services, inflation will go down as a result (yellow line in the chart). But labor shortages will probably make prices for services stickier (orange line). So we don’t think that central banks will cut interest rates to pull DMs out of recession.

Companies are having trouble hiring people because there aren’t as many jobs available in the U.S.

We didn’t see much in the December jobs data to suggest that things were going to change in a big way. Even though wage growth has slowed, labor shortages are still pushing wages up to a level that makes it hard for the central banks to reach their 2% inflation goal. To get inflation back to where it should be, job demand would have to go down.

This would require a recession that is even worse than the one we see coming. Because of this, central banks tend to keep interest rates high for longer than the markets expect instead of lowering them. Long-term, we see three structural trends that keep inflation pressures on average higher than they were before the pandemic: the aging of the population, the fragmentation of geopolitics, and the move to net-zero carbon emissions.

China is quickly getting rid of restrictions on COVID-19. We think that its economy will grow by more than 6% in 2023. This will help slow down the global economy as the recession hits the major DM economies. But China’s growth will slow down because the United States is spending less on goods and more on services.

Even when domestic activity starts up again, we don’t think the level of economic activity in China will return to how it was before COVID. Once the restart is done, we expect growth to go back down.

We think that earnings forecasts for 2023 still don’t fully account for the recessions we expect in the DM.

We are ready to become more optimistic about DM stocks when more of the economic damage we expect to happen in the future is already priced in or when our view of market risk sentiment improves.

Within fixed income, we think that investment-grade credit, U.S. mortgage-backed securities, and short-term Treasuries offer the best ways to make money. We stay underweight on long-term nominal government bonds because they don’t reflect our view that yields will continue to rise as investors demand more term premium, or compensation for the risk of holding them in an environment of persistent inflation and higher rates.

In China, 2022 was a year of rising inflation, quick rate hikes, and lockdowns caused by pandemics. We think that 2023 will be a volatile year, but we also think that it will be shaped by big changes from 2022: recessions in developed markets, falling inflation, central banks stopping rate hikes, and China reopening.

After figuring out what’s in the price and how the market feels about risk, we’ll probably become more bullish on risky assets. This is one of the main ideas in our new investment playbook.

This week, gains in DM stocks were led by gains in European stocks. Yields on the 10-year German bund led to a drop in yields on other major government bonds. Falling energy prices are making headline inflation go down, which gives people hope that DM central banks will be less strict. A big drop in the U.S. services PMI made people think that the Fed might cut interest rates next year. But we think that sticky core inflation will keep central banks on track to overtighten policy and keep policy rates higher than the markets expect.

We expect the annual change in the U.S. CPI to slow again in December, falling from the 40-year highs reached in 2022. This is because spending is shifting back from goods to services, which puts pressure on goods prices, and because energy prices are falling. But steady wage growth due to a lack of workers is likely to keep core inflation steady and keep the Fed on track to keep raising rates.