What is the economic picture?

Growth and inflation rates are expected to slow as monetary policy normalisation takes its toll and pandemic-related constraints ease. Nonetheless, strong employment trends and divergent regional dynamics should prevent a global recession. While Europe’s energy supply risks have eased meaningfully, such concerns may persist for some time. Let’s take a look at the main focus points in more detail below.

Moving from stagflation in 2023

Given that inflation rates usually lag, we could still use the ‘stagflation’ label for the year ahead.

Yet, at face value, there will likely be more ‘stag’ and less ‘flation’, as inflation rates should fall more than growth rates. We expect the world economy to grow by merely 1.9% in 2023 after a solid 3.3% in 2022. This does not signal a global recession yet, but a major slowdown is likely, as suggested by the leading global economic indicators.

Central bank policy has one of the longest lead times until it has an effect on economic activity, but it defies the widespread opinion that central banks cannot steer the economy any longer. In fact, the importance of central bank policy has rather increased lately, and our expectation is that economic growth will decrease further in 2023 before central banks backpedal (which in turn should lead to stronger growth in 2024 again).

Why do we not expect a global recession? First of all, we still see strong employment trends in many industrialised countries, which are keeping these consumption-heavy economies afloat. Second, the regional dynamics are likely to stay very divergent. This reduces the odds of a synchronised global recession, since, for example, a recovery in Asia could compensate for some softening in the US on a global scale.

Most importantly, the sky-rocketing inflation rates in recent quarters should be over soon. On a global level, we expect the inflation rate to cool off from 8.5% in 2022 to 5.1% in 2023. While this is still a high number, we expect most of the pressure to be front-loaded, i.e. it should be present rather early in the year, which means that most of the inflation pressure will start to abate sometime during the first half of 2023.

Discover more in our full Market Outlook 2023 here.

Fixed income: Locking in quality bond yields

Real bond yields rebounded in a painful manner for investors in 2022, as central banks ended financial repression. ‘Financial repression’ means a way of taxing bondholders by holding bond yields below inflation rates, which creates a negative real return. While the way to exit financial repression was tied to major losses for fixed income investors (as higher yields mechanically come with lower bond prices), the good news for 2023 is that fixed income assets offer real yields again – across the credit ladder. So even high-investment-grade bonds are back in town when it comes to real yields.

In the era of financial repression, bond investors had to take on more credit risk in order to mitigate negative real yields. However, this is no longer needed. So given the risks of a slowing economy (and the chance that the world slips into a recession), bond investors can avoid the highest credit risks, such as high yield, and turn to good-quality bonds while still receiving a decent yield.

As with other assets, though, there may come a time during the year where the risk/return balance advocates a move into the highest credit-risk brackets yet again, i.e. taking more credit risk, for instance, when leading economic indicators bottom at some stage in 2023 and the economy recovers into 2024, as we expect. At the outset of the new year, we are not there yet. The same holds true for emerging market bonds, where selectivity remains key.

For more on fixed income, download our full report.

Equities: What comes after the valuation reset?

Equity markets across the globe came under immense pressure in the first nine months of 2022, driven by a sharp tightening in liquidity conditions as a response to sky-high inflation rates and geopolitical jitters. What made this sell-off so unique is that it was almost entirely driven by ‘multiple deratings’, i.e. declining valuations, while earnings expectations remained stable. The end of financial repression and the associated rise in bond yields has been painful, especially for highly valued segments of the equity markets.

For 2023, investors will increasingly shift their focus towards the earnings outlook, in particular, to how resilient corporate earnings are in the face of a sharp slowdown in economic activity coupled  with inflationary pressure. Based on this, analysts have started to trim their earnings estimates for next year in anticipation of a more challenging outlook. The key question in macroeconomic terms for 2023 is whether the US will be able to avoid a recession, which would lead to an earnings recession (i.e. a sharp downward revisions of estimates.)

For now, we recommend that investors stick to a bias towards defensive-quality and high-free-cash-flow names in their equity portfolios. Further down the road, in the first half of 2023, we anticipate an opportunity to rotate into more cyclical regions and sectors, which will likely start to look beyond the temporary slowdown and price in an economic recovery in 2024.

Next Generation: Preparing for the next cycle

The aim of our Next Generation investment philosophy is to identify global megatrends and transform them into tangible investment themes. While thematic investments have suffered with the valuation reset last year, some have been better shielded. We take a closer look and outline how to be best positioned while preparing for the next cycle.

The focus within our Next Generation themes is on companies in structurally growing industries, and we select those with a competitive advantage, as they are most likely to benefit from the identified trends. The emphasis is primarily on profitable growth companies. As 2023 begins, we will thus focus on the following three Next Generation themes:

What about alternative investments?

Given the high volatility in public markets, investors can consider alternative investments. These are ways to access additional sources of return and have the potential to improve the risk/return profile of a portfolio.

Private market investments provide an important gateway to a growing set of real assets and can offer investors different premiums as compared to traditional investments. Hedge fund strategies can utilise the rich opportunity set arising from macroeconomic volatility and external shocks due to their ability to invest in various asset classes and to go both long and short.

What does all this mean for you?

For an even deeper dive into the year ahead, download our full report here.