Investment Strategy Design: Macroeconomic Analysis - 2023 Forecast

1. Macroeconomic Analysis. 

To better understand where we are headed in 2023, it is important to review where we are coming from in terms of macroeconomics, monetary policy and the business cycle.

In 2022, the inflation crisis was tackled by the central banks rising interest rates at an unprecedented rate only comparable to the 1980s. This had a devastating effect on both the stock market and fixed income securities (one could say the only sector with positive real returns was Energy) with the 60/40 portfolio having its worst performance of the century.

History says that it is highly unlikely that such a bad-performing year is followed by a second one. Motivated by this statistic, falling levels of inflation and a warmer than expected winter in Europe has motivated investors in January and valuations are rising again. (The Euro Stoxx has had its best beginning of year in history almost!).

However, we should be careful to determine that the bear-market has ended and even if it that was the case, we shouldn’t expect a bull market to start much less a fast rebound such as the one we had in 2020.

-        Inflation.

While it is true that inflation rates have been following a downward trend, this could be due to not-very-optimistic factors. On the one hand, it is important not to forget that inflation is still increasing on a monthly basis. However, due to a purely statistical factor when measuring inflation as the year-on-year change, prices seem to be coming down. When in reality we are just seeing inflation rise (but slower) than last year. Studies show how this mathematical effect is due to end in the second quarter of the year.

Another factor that is pushing inflation down is the fear of recession which will entail a contraction of demand (this is no good news at all). In addition, core inflation (change in prices except for those from the food and energy sectors) is not falling in Europe which means inflation could be stickier than it seems (Figure 1).

The markets are now discounting that inflation will return to the 2% mark soon and a prevision of high inflation for a longer period of time is not taken into account. Looking ahead, I do not deem likely that inflation goes back to the level settled by central banks. In the past, two factors have made it easy for inflation to remain at 2%. On the one hand, a context on increasing globalization has enabled cost reduction by delocalization of factors of production (outsourcing) and access to global demand has pushed prices down. On the other hand, labor factor substitution for technological machinery has also made it possible to cut costs in many stages of the production chain. In the present, COVID and geopolitical tensions have shifted countries’ approach to international relations from globalization to multilateral protectionism where countries do not only want to produce cheaply but are looking for security, proximity, and certainty too. I believe that sooner or later, central banks will rise their inflation targets (2.5%-3%) and this will have disruptive effects on several markets.

Figure 1. Inflation Expectations are not promising for the Euro Area.

-        Monetary Policy.

Since the 2008 Crisis, the market has come to be extremely dependent on the monetary policy carried out by central banks. Many businesses have become “addicts” to cheap credit granted by financial institutions and will have it difficult to thrive in a context of contractionary monetary policy.

Low interest rates and QE programs have had two major effects on the market. On the one hand, they have favored the formation of the speculative bubble that busted in 2022. To foster recovery after the COVID-19 Pandemic, governments went as far as to establish cash-transfer programs to households who directed this money into the stock market. Cheap costs of financing also allowed for tremendously exaggerated valuations (Tesla’s valuation greater than that of the biggest car-manufacturer companies combined, Cryptocurrencies, Tech companies that did not generate profits, Meme stocks, etc.) because of discounting future cash flows at an artificially low rate of interest.

States were also able to finance their budget with close to 0% interest rates (we even had the largest pool of bonds with negative coupons due to some insurers and pension funds needing to purchase these securities) which went against all economic logic. As a result, Debt to GDP ratios have skyrocketed and are posing serious threats to highly indebted countries which will have to face debt restructuring at higher rates while seeing tax revenue diminish if we were to have a recession.

As we said, central banks are rising rates to counter inflation and the effects have been notable. Now the question is: what do we expect for 2023? The year has started with a strong divergence between what the market believes and what the FED says. Who will win? Let’s put ourselves in the shoes of the FED managers. Inflation is still well above their target, employment is strong, financial conditions are not stressed and more importantly, they do not want to repeat the mistakes committed in the past when the central bank though inflation was over, started cutting interest rates and inflation marked another peak (to which Paul Volcker responded setting the official rate at 20% and causing two consecutive recessions). Even if there are only two more meetings with rates increases, we do not expect the FED to start lowering interest rates until the end of the year.

The bond market is discounting a whole other idea. After the new FOMC meeting on February, the yield of the 10 year Treasury Bond will be lower than the FEDs effective rate what has always been followed by a cut in interest rates. The bond market believes the economy is getting into a recession and the FED will be forced to cut rates sooner than expected.

With regards to monetary policy, it seems like Europe lags 3-4 months behind the United States and also the ECB has to be extra careful due to the accumulated debt by sovereign states.

In either case, it is highly likely that interest rates do not go beyond 5% in the US and 3.5% in Europe during 2023 and this will offer promising returns in fixed income securities. An investment idea could be: long high-quality Fixed Income assets, short non-investment grade. This will be carefully examined in the Security Selection section of this paper.

-        Business Cycle: Hard or Soft Landing?

In our opinion, the effect of the sudden increase in interest rates is yet to be felt in the market. Some economists point stress out the idea that these effects are seen 6 to 9 months into the business cycle. In addition, the expected QT policies will take money out of circulation, and this will be reflected in companies’ earnings.

Are there any sings of economic contraction? To this we would like to point out to the drop in both the Institute for Supply Management (ISM) and Purchasing Manager’s Indexes under the breakeven 50 mark, the biggest yield curve inversion in 40 years, and the drop in the Conference Board index of Leading Indicators raise our concern (Figure 2).

Figure 2. Signs of Industrial Production Declines. Retrieved from MS Capital Market Outlook.

 

The housing market could also pose many threats since mortgages costs are rising fast and this could translate into a credit crisis (in the US, mortgage rates spiked from 3.2% in Dec. 2021 to 7.2% in Oct. 2022) and an economywide contraction since it would depress consumer spending on goods and services.

 

-        China reopens after the pandemic.

China’s reopening after a three-year shutdown is possibly the most significant event of the year. The elimination of the “Covid-zero” restrictions is expected to have a similar effect to the one we lived in the West: massive infections, widespread fear, etc. which could slowdown the recovery process. However, in the long run these are very good news for China and will increase the demand of commodities and other consumer-related goods and services.  

-        Swans: Black or White?

Finally, as in every other scenario we should bear in mind some possible threats and opportunities which will largely shift our prospectus. Here we will just mention the ones we consider more relevant.

o   War in Ukraine.

o   China demands oil and pushes inflation up again.

o   Geopolitical conflict between US and China over Taiwan.

o   Bank of Japan shifts its president (Kuroda) – uncertainty in the bond market.

 

1