Roadmap to recovery: Markets lead, the economy follows

Steven Wieting
Chief Investment Strategist & Chief Economist

We expect global growth will deteriorate for some of 2023. Markets will then increasingly focus on the recovery that lies beyond. We enter the year defensively positioned but expect to pivot as a sequence of potential opportunities unfolds.

Key takeaways

The Fed’s cumulative monetary tightening will likely stifle the world economy no later than mid-2023

For portfolios now, we remain cautious, seeking returns through high-quality equities and bonds, as well as capital markets and alternative strategies for suitable investors

Markets will start focusing on 2024’s recovery sometime in 2023, enabling us to take greater investment risks across a variety of asset classes

As interest rates peak, we would expect to shift first to quality growth equities in non-cyclical industries

A 10% decline in broad corporate profits in 2023 should hit many cyclical industries before any recovery takes hold

As unemployment rises, we expect the Fed to reverse course by the second half of 2023, with fixed income yields dropping

The US dollar’s bull market could overshoot even higher, but chances are building of non-US assets and currencies finding a “deep value bottom” in 2023

While Fed drama has distracted many investors, we call for renewed attention on the unstoppable trends transforming the world economy

The post-COVID economic boom of 2021 has given way to a bad “hangover” as we head into 2023. As with any day-after pain, today’s headache will not last. But many investors find it difficult even to imagine recovery. We believe change for the better will come in 2023, even as markets face challenges along the way. 

Growth and inflation were never destined to stay in their previous narrow ranges given the COVID shock and war in Ukraine – Figure 1. Much of today’s economic distortion derives from unusual disruptions to supply and vast, unpredictable swings in demand. Aggregate demand stimulus was not the right medicine for these problems. Stimulating demand without stimulating supply generates painfully high inflation.

One way to avoid compounding a hangover is to stop drinking. Tightening fiscal and monetary policy is the economic equivalent of that. US federal spending has fallen 11% year to date, for example – Figure 2. Real consumer goods spending has fallen about 1% in 2022 to date with the bulk of Fed monetary tightening’s impact yet to come. The slowdown in consumer spending and the sharp rise in goods inventories will put the brakes on global trade growth and corporate profits in 2023 – Figure 3.

 
Figure 1. How the COVID shock has distorted growth and inflation
 
Source: Haver, as of 29 Sep 2022. Chart shows year-on-year (%) changes in consumer price inflation and real US GDP, with arrows around the 2020-2023 period to denote historically wide ranges in real GDP.
 
 
Figure 2. Fiscal and monetary restraint return
 
Source: Haver, as of 29 Sep 2022. Chart shows US Federal spending and Federal Reserve credit Y/Y%.
 
 
Figure 3. Soaring inventories, weakening trade ahead
 
Source: Haver, as of 29 Sep 2022. Chart shows year-on-year percentage changes in real manufacturing and trade inventories and nominal changes in retail inventories. Gray shaded areas are recessions.
 
 
 
 
Figure 4. Real GDP and Citi Global Wealth Investments forecasts'
Citi Global Wealth Investments
Real GDP Forecasts (Updated as of August 2022)
  2020 2021 2022 2023 2024
China 2.4 7.5 3.5 4.5 4.0
US -3.4 5.7 1.6 0.7 2.0
EU -6.5 5.3 3.0 -0.5 1.0
UK -9.3 7.4 3.4 -1.0 1.0
Global -3.2 5.7 3.3 1.7 2.3
Source: Citi Global Wealth Office of the Chief Investment Strategist assumptions, as of June 24, 2022. Chart shows real GDP changes in percentage for China, the US, EU, UK and world between 2020 and 2024, with forecast data from 2022 onward. All forecasts are expressions of opinion, are subject to change without notice are not intended to be a guarantee of future events. Indices are unmanaged.

We expect a global recession in 2023 – Figure 4. Indeed, the 1.7% annual global growth we expect is likely to be weakest in forty years outside of the Global Financial Crisis year of 2009 and the COVID shutdown year of 2020. Among the major economies, the eurozone and the UK are likely to come out worst, with full-year contractions of 0.5% and 1% respectively as they contend with sky-high energy costs, as well as policy tightening.

China looks to be one year ahead of the US and may provide some diversification to portfolios in the years to come. Amid weak labor markets and a real estate crisis, the world’s second-largest economy is already in monetary easing mode. After two dismal years, we expect low Chinese profits to rise along with expanding money supply, just as US profits and money supply contract. However, its near-term prospects rely on the ongoing relaxation of its strict COVID measures and continued support for its nascent real estate recovery – see Asia: Broader re-opening to enable regional recovery.

With the US likely entering a mild recession and unemployment probably exceeding 5%, we see the greatest surge in inflation as largely behind us in 2022. That said, US inflation is unlikely to reach pre-COVID norms in 2023. We see it retreating to 3.5% by end-2023 and 2.5% by end-2024, while averaging higher during those calendar years. Our estimates are unchanged despite our reduced economic growth forecasts since June 2022 and slow recovery expectation for 2024.

The Fed has not been able to end recessions quickly once underway. However, it does have a history of frequent policy reversals. In the past 45 years, peak policy rates have been sustained for only seven months on average before cutting rates. If the Fed can soon find a balance between the excessive easing of 2021 and the rapid tightening it has “rhetorically” encouraged in 2022, it might avoid amplifying financial and economic excesses. 

Positioning for a year of challenges and change

Across 2022, investors braced for the forecast 2023 recession. The resulting bear market is well underway, although incomplete. A new bull market has never begun before a recession has even started. Most typically, a bull market begins at around the mid-way stage of a recession. The very strong communications of the Fed’s intentions and a year of bearish anticipation may see markets bottom somewhat sooner than usual. However, as of late November 2022, a recessionary decline in employment and corporate profits has not even begun. 

Within 2023, we expect investors to start discounting 2024’s recovery. Only twice in the past century – including the Great Depression – did US equities take more than two calendar years to find a lasting bottom. But further losses might still come first.

What might mark the bottom for markets amid the coming recession? As usual, producers will overreact to demand weakness, cutting output too far. Within several months of that moment, the “excessive caution” will be followed by reports of falling inventories. Such datapoints will be among the preconditions for recovery. Earnings per share will likely only follow equities higher, with the past lag having been about six months – Figure 5.

 
Figure 5. Earnings per share bottom later than markets
 
Source: Haver, as of 30 Oct 2022. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Past performance is no guarantee of future results. Real results may vary. All forecasts are expressions of opinion, are subject to change without notice, and are not intended to be a guarantee of future events.
 
 
Figure 6. Dollar reaching historic extremes
 
Source: Haver, as of 30 Oct 2022. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Past performance is no guarantee of future results. Real results may vary. Chart shows US dollar index between 1973 and 2022. Gray areas represent US recessions.
 

The US dollar may overshoot

In the coming environment, we look for an end to the US dollar’s mighty ascent. This period of strength has been its third such secular bull market since it began floating freely in 1971 – Figure 6. However, there is a risk that it will overshoot, rising for longer than is justified by fundamental drivers. 

There are precedents for such an overshoot. While the Fed began easing during the 1982 recession, the dollar continued rising sharply until 1985. And the currency’s strength persisted through much of 2002, despite the 2001 tech bubble burst. 

The US experienced an asset bubble-induced recession in 2001. Despite sharp declines in real interest rates and a dramatic drop in equity valuations during the period, the US dollar continued to rise through much of 2002.

Given this, predicting a peak in the US dollar is tricky. We feel confident in our view that US and global equities will find a bottom and US rates a peak. Nevertheless, present circumstances suggest a peak value for the dollar – and trough values for major currencies – will be reached in the coming year. This will have lasting positive implications for returns in non-US assets for many investors for years to come.

 
Figure 7. Our potential "glide path" for 2023
 
Source: CGWI Office of the Chief Investment Strategist, as of October 11, 2022. All forecasts are expressions of opinion, are subject to change without notice, and are not intended to be a guarantee of future events. Indices are unmanaged. An investor cannot invest directly in an index.
 

A possible path through: opportunities now, opportunities later

In the year of challenges and change that we expect, we see various potential opportunities for investors. A sharp fall in valuations across many markets have driven up our ten-year strategic return estimates – see The brighter long-term outlook for asset classes. On a tactical view, the opportunities may present themselves in a sequence, some sooner and others later. In early 2022, rapidly rising interest rates created uncertainty for valuing any financial asset. The rough doubling in government bond yields over the past year has boosted higher quality fixed income yields to a more appropriate level for the first time in several years. Given a slowing cyclical backdrop, we see a stronger potential opportunity for fixed income assets within overall portfolio construction and to earn income on excess cash – see Pursuing portfolio income with short- term bonds. In the environment we expect, US 10-year Treasury yields may end 2023 at 3.0%.

Heading into 2023, we believe defensive equities may perform best near term and we remain overweight US dollar assets. By contrast, we remain cautious on Europe and Japan. However, we note that most non-US equities’ poor performance in 2022 was owing to collapsing local currencies rather than local returns falling. This may start correcting in 2023 as peak fear and peak policy divergence with the US sets in – Figure 8.

 
 
 
Figure 8. US dollar surge could reverse after overshoot
Country/region YTD return (local ccy) YTD return (USD) YTD FX return (vs USD)
Brazil 7.7 12.5 4.8
US -15.9 -15.9 0.0
Switzerland -13.7 -17.7 -4.0
Canada -3.3 -9.1 -5.8
China (A shares) -22.1 -30.9 -8.8
Europe -7.3 -16.7 -9.4
Australia 4.8 -5.0 -9.8
Korea -19.1 -29.2 -10.1
India 3.5 -5.7 -9.1
Taiwan -18.6 -27.8 -9.2
UK 5.6 -8.0 -13.6
Japan 0.5 -18.6 -19.0
Source: Haver, as of 24 Nov 2022. Table shows the performance of various national equity markets in local currency terms, US dollar terms and the contribution to return of foreign exchange movements. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Past performance is no guarantee of future results. Real results may vary.
 

If so, long-lasting income-producing assets in Europe, Japan and others might be bought at unusually depressed values – see Europe: Bracing for winter recession and Asia: Broader re-opening to enable regional recovery. Just as a single example, German REITs have returned negative 40% in US dollar terms in 2022 and now yield 12%. If Europe were to recover half of its losses of the past two years, the annualized return would be 19% in US dollars, even assuming no change in REITs’ price.

For many cyclical industries, however, a bottom may occur late in 2023. Before then, economic weakness will depress interest rates. Industry-leading growth equities may bottom before cyclicals, however. We also look for the recessionary conditions to create potential opportunities for certain alternative strategies – see Alternative investments may enhance cash yields.

We continue to focus on what drives economic growth over time and generates real investment returns. Apart from population growth, real economic growth is entirely determined by innovation. Developing new tools or better processes leaves us with means to create more output per person. Money – what central banks give and take away – provides us none of it. In general, the information technology and healthcare sectors have capitalized most on innovation and enjoyed the most potent demographic forces to drive superior long-run return – Figures 9 and 10. We explore these in How unstoppable trends are redefining real estate and Digitization and the growth in alternative investments.

Although the valuations of many innovative companies and sectors are under pressure, there is no fundamental change in their prospects. While there were many distortions in the COVID economy, we do not expect a global reduction in expenditures in essential areas such as cybersecurity and green tech – see Energy security is vital. By contrast, at the end of the “dot-com” bubble in the early 2000s, both valuations and fundamentals unwound very sharply together.

 
Figures 9 and 10. IT and healthcare's growing importance
 
Source: FactSet, as of 21 Nov 2022. Charts show the rising trend of the market capitalization and earnings per share for the IT and healthcare sectors, expressed as a % of the total S&P 500 Index. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Past performance is no guarantee of future results. Real results may vary.
 

How to invest portfolios in 2023?

While investing in 2022 was deeply challenging, any one year represents a mere “moment” in the lifetime of a portfolio. And even though the economic environment in 2023 may prove to be difficult, the greatest risk at times like these comes not from enduring the turbulent conditions but from trying to avoid them by market timing.

Given the high probability of recession in the US and elsewhere in 2023, we enter the year with a defensive asset allocation, albeit fully invested. However, as 2023 unfolds we will take a dynamic approach to tactical asset allocation. As markets ultimately find a bottom, our positioning is set to evolve toward equities and alternatives that anticipate a recovery.

As a first step toward building portfolios for the year ahead and beyond, investors should assess their present positioning. To help our existing clients in this review, our Outlook Watchlist report can review your exposure to key sources of potential risk and return, including our long-term investment themes. We can then discuss actionable strategies to help you adjust your allocation for the coming year and beyond. Please note this is not available to prospective clients at this time.

Outlook 2023 is your roadmap to understanding the route to economic recovery. Let us be your partner and guide on this road to recovery.


 


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