What investors should expect in 2023
Economic data
Financial markets

What investors should expect in 2023

Macrobond customers chart their predictions for 2023. Updated daily.

November 23, 2022
various contributors

<h2 class="blog-h2 blog-h2-styles first-item" id="Watch-for-Japanese-bond-investors-to-pile-back-into-US-Treasuries">Watch for Japanese bond investors to pile back into US Treasuries</h2>
<p class="blog-outlook-date">05 December 2022</p>
<p class="blog-outlook-author"><a class="blog-author-link" target="_blank" href="https://www.linkedin.com/in/tbi/">Tetsuo Harry Ishihara, US Macro Strategist</a></p>

Next year we are likely to see stronger net inflows to USD bonds from Japanese investors. That will help drive down yields once the Fed pauses the current hiking cycle, and marks a contrast to the large net outflows in 2022 (shown in Chart 1).  

In Japan, hedges are widely used to prevent currency losses. They convert USD yields into a “hedged yield” in yen – which, as  Chart 2 shows, that plunged into negative territory this year. The driver was a rise in the FX hedge cost, driven by the wider US-Japan interest rate differential.  

Many investors have discussed publicly how the US debt sales were driven by the double whammy of higher US rates, and the rise in FX hedge costs. However, in the long run, US bond portfolios will still be needed to offset Japan’s low-yielding domestic assets. On top of that, Japanese household assets have swelled to about USD 14 trillion – close to a record high.  

Thus, USD bond appetite should resume – at about the same time as rate and FX hedge cost outlooks improve, when investors are convinced that the Fed hikes will stop.

<h2 class="blog-h2 blog-h2-styles" id="Australian-central-bankers-will-be-less-hawkish-than-the-Fed-in-2023">Australian central bankers will be less hawkish than the Fed in 2023</h2>
<p class="blog-outlook-date">05 December 2022</p>
<p class="blog-outlook-author"><a class="blog-author-link" target="_blank" href="https://www.linkedin.com/in/johnathan-mcmenamin-75573692/">Johnathan McMenamin, Senior Economist, Barrenjoey</a></p>

The prevailing view in financial markets has long been that the Reserve Bank of Australia (RBA) cannot have an overnight cash rate too different from that of the US Federal Reserve. This view is now being tested. The RBA is slowing its rate rises and taking a break over the Southern Hemisphere summer, while the Fed is expected to deliver more outsized rate rises.  

We expect the RBA to take its overnight cash rate to 3.6% by March, while the Fed pushes past 5% by early 2023, as our first chart shows. There are some important reasons for this divergence.

First, the prevalence of variable and short-term fixed-rate mortgages (2-4 years) in Australia means the RBA has a more powerful monetary policy transmission mechanism than the Fed, which must influence the yield curve in order to shift long-term mortgage rates. Even then, the Fed only really influences the flow of new mortgages, rather than the whole mortgage stock.

The second core reason is the prevailing difference between price increases for services in the two nations, as demonstrated by the next chart. Australian services inflation has picked up recently, but remains well below that of the US – where 50% of overall inflation is being driven by high and sticky services inflation. We expect this means that the Fed will stay restrictive for some time.

One question we often asked is how this difference in terminal rates plays for a small, open economy like Australia. A depreciation of the currency is the most direct impact, and this can make the inflationary problem worse as imports get more expensive. While we have seen AUD/USD depreciation in 2022,  Australia’s Import Trade Weighted Index (TWI) is the indicator that really matters for import inflation. The following chart indicates this divergence.

At this point, the RBA does not seem all that worried about higher imported inflation. The resilience of the TWI in 2022 (as our final chart shows) is one factor giving the central bank confidence, and as long as this remains the case, it’s unlikely that the RBA will be overly influenced by other central banks’ decision-making.

That’s another key reason we predict a persistent difference in the terminal interest rate for the US and Australia. The AUD may end up being more important as an automatic stabiliser for the real economy should a global recession emerge.

<h2 class="blog-h2 blog-h2-styles" id="inflation-will-stick-around-shattering-misplaced-interlinked-macro-narratives">Inflation will stick around — shattering misplaced, interlinked macro narratives</h2>
<p class="blog-outlook-date">01 December 2022</p>
<p class="blog-outlook-author"><a class="blog-author-link" target="_blank" href="https://www.linkedin.com/in/phillip-colmar-b3a82514/">Phillip Colmar, Founding Partner, Global Strategy, MRB Partners</a></p>

The past year has been characterized by the capitulation of developed market central banks and bond investors after being deeply wrongfooted on inflation. The latter was rooted in misplaced macro narratives, including some variant of secular stagnation.  

The capitulation process is not complete but will ebb over the next several months as measured consumer price inflation erodes. This should allow G7 bond markets to temporarily calm and provide a window for risk assets to firm, albeit within the context of a mature economic and investment cycle.

Subdued economic growth during the 2010s was not structural in nature, but rather the result of powerful deleveraging drags from households and banks in the U.S. and euro area, two major sources of final demand and key global price setters. With these drags over, underlying activity will prove more resilient and less vulnerable to higher borrowing rates than the consensus fears.

Likewise, the anchoring of consumer price inflation last decade was caused by sluggish demand, massive production and labour market slack, as well as ongoing drags from globalisation and technology. These anchors began to lift prior to the pandemic and will not return meaningfully even in the event of a recession. Inflation will ease in the coming months, but underlying price pressures will prove stickier than implied by longer-term market-based inflation expectations.

<h2 class="blog-h2 blog-h2-styles" id="policy-maker-uncertainty-begets-volatility-forward-guidance-please">Policy maker uncertainty begets volatility — forward guidance please!</h2>
<p class="blog-outlook-date">30 November 2022</p>
<p class="blog-outlook-author"><a class="blog-author-link" target="_blank" href="https://www.linkedin.com/in/rob-waldner-invesco/">Rob Waldner, Fixed Income Chief Strategist and Head of Macro Research, Invesco Advisers, Inc.</a></p>

Central banks are expected to continue to raise rates as inflation data has yet to cool sufficiently to allow them to slow their pace of tightening.  As rates get firmly into restrictive territory – where we will be shortly in our view – and as financial conditions tighten, the markets are going to look for some clarity from global central banks as to where things are headed next.  

In other words, it is time for some forward guidance.  Forward guidance is a tool to help markets understand where policy makers are headed and should help reduce uncertainty.  Forward guidance could consist of a set of expectations from the central bank on where they are likely to take policy over the coming quarters.  Forward guidance would give investors a broad idea of where central banks are likely to head.  Currently we have virtually no forward guidance; instead, the Fed has been reacting in real time to inflation data.  

The lack of forward guidance is creating large amounts of investor uncertainty about the path for interest rates, and serves to push up interest rate volatility. Interest rate volatility, in turn, makes it more difficult for investors throughout the global economy to plan and invest in the face of an uncertain discount rate.  Since the US is the global reserve currency, US interest rate volatility has a large impact on investment decisions made the world over.  

Recent market events in the UK serve as an example of the types of dislocations that can come with increasing interest-rate volatility.  In the case of the UK, uncertainty around monetary policy paths was amplified by instability in the government and surprising fiscal easing through tax cuts and energy subsidies. The combination of fiscal and monetary uncertainty created massive volatility in the UK gilt (government bond) market. The rise in yields and volatility in the Gilt market created further disruption as UK pension funds were forced to raise cash to meet margin calls on their interest rate hedges.  

Higher yields are, in aggregate, a positive for long-term investors like pension funds. It’s just the speed and extent of the move that created such dislocations.  While most other pension systems are not susceptible to such a margin squeeze, it is emblematic of the problems investors can face from high and rising interest rate volatility.  High government bond volatility will have impacts well beyond the government bond market itself.

Central banks have been successful in resetting the level of interest rates and have now tightened financial conditions into restrictive territory in our view.  This will go a long way to ensuring long-term inflation remains under control.  A byproduct of this has been an increase in investor uncertainty and market volatility.  Markets have successfully managed through this volatility so far, but sustained high levels of volatility, particularly in longer term interest rates, may start to negatively impact investment decision making.  Forward guidance from the monetary authorities would be a constructive step toward containing volatility.

<h2 class="blog-h2 blog-h2-styles" id="recession-indicators-are-starting-to-flash-for-2023">Recession indicators are starting to flash for 2023</h2>
<p class="blog-outlook-date">29 November 2022</p>
<p class="blog-outlook-author"><a class="blog-author-link" target="_blank" href="https://www.linkedin.com/in/michael-anthonisz/">Michael Anthonisz, Chief Economist, Queensland Treasury Corporation</a></p>

A key uncertainty for 2023 is whether the world’s biggest economy, the United States, will experience a recession. In an earlier note in May, we used the yield curve as well as other market and fundamental-based measures to estimate the probability of a recession over the subsequent 12 months.  

At that time, the chance of recession was low, but was starting to look more plausible two years out. Subsequent developments – not least the Federal Reserve’s 300 basis points of rate rises – make this exercise worth revisiting.  

Our updated daily estimates now point to a recession next year, as the first chart shows. This could soon be reaffirmed in future updates to the New York Fed’s monthly measure of recession probability.

A recession has increasingly come into view with the Fed taking rates into restrictive territory. Market pricing suggests that by Q3 2023, the stance of monetary policy as proxied by the interest rate gap – the difference between actual and neutral rates – might be the tightest in 40 years, as the second chart shows. The early 1980s was also the last time inflation was this high.  

With the gap typically peaking just ahead of a recession (the green dots in the second chart), this also points to the potential for a recession later next year. The gap does, however, occasionally provide a false recession signal (the orange dots), hence the uncertainty.   

<h2 class="blog-h2 blog-h2-styles" id="sticky-inflation-a-lack-of-policy-support-and-geopolitics-will-set-this-cycle-apart">Sticky inflation: a lack of policy support and geopolitics will set this cycle apart</h2>
<p class="blog-outlook-date">29 November 2022</p>
<p class="blog-outlook-author"><a class="blog-author-link" target="_blank" href="https://www.linkedin.com/in/lauren-goodwin-cfa/">Lauren Goodwin, Economist and Director of Portfolio Strategy, New York Life Investments</a></p>
In our view, three key factors differentiate this cycle from those in recent decades:    

1. Inflation is likely to “stick” around.

Inflation has been largely absent from the U.S. economy since the 1990s; now we expect it to drive the policy outlook and asset allocation choices for the next several years. What will it take for inflation to fall to tolerable levels and stay there? In a word: time – time for restrictive interest rates to filter through and slow the economy; time for policy to soften the labour market and relieve upward pressure on wages. Until then, we expect firmer average inflation.  

Sources: New York Life Investments Multi-Asset Solutions, Bloomberg Finance LP, Bureau of Labor Statistics, November 2022. The Employment cost index is s a quarterly economic series published by the Bureau of Labor Statistics that details the growth of total employee compensation. The job quits rate is the number of quits during the entire month as a percent of total employment, and is meant to measure labor market flexibility.

2. Policy support won’t save the day.

Stubborn inflation may limit policymakers’ ability to support growth next year, even as the U.S. teeters on the brink of recession. The Fed may pause – not pivot – as it works to bring inflation down. The firehose of policy support that was quantitative easing has now become a liquidity drain. And appetite for fiscal spending has faded – due both to the understanding that spending has been a key culprit in today’s inflationary environment, and to increasing concerns about debt sustainability.  

Sources: New York Life Investments Multi-Asset Solutions, Macrobond, Central Banks of the U.S., United Kingdom, European Union, Japan, China; International Monetary Fund, November 2022. Observations within 2022 are based on International Monetary Fund World Economic Outlook estimates of global GDP.

3. The geopolitical risk premium is elevated.

The driving force behind decades of globalisation has been the reduction of costs. But as the past two years have made painfully clear, “globalised” supply chains can create concentrated sources of risk. Concentration of global semiconductor and vaccine production involves the smallest of components – from disposable gloves and glass vials to batteries – but contributes to a much larger reality: for sensitive industries, including tech, medicine, food, defense, and energy, globalisation can create national vulnerabilities. As risks (and costs) rise for companies, the prices they demand may rise as well. Investors, for their part, may require more compensation (higher yields) for the risk taken.

<h2 class="blog-h2 blog-h2-styles" id="stock-performance-will-depend-on-corporate-earnings-quality-rather-than-valuations">Stock performance will depend on corporate earnings quality, rather than valuations</h2>
<p class="blog-outlook-date">25 November 2022</p>
<p class="blog-outlook-author">Tomohiro Takahashi, Head of Japan Equity (Institutional Investors), Managing Director, Phillip Securities Japan</p>

In 2022, we saw real interest rates rise and an adjustment in stock valuations in response to the correction of historic monetary easing -- particularly in the U.S.  

In the first half of 2023, we expect a return to normalcy in the asset mix, especially the correlation between bond and stock markets. A slower pace of U.S. interest rate hikes will lead to a rise in risk assets in the short term, including commodities -- a well-known dilemma in an inflationary environment.  

The geopolitical risks between Russia and China and the Western countries have yet to be fully resolved and have a cost-increasing factor -- via commodity prices and supply chain constraints.  

Although we are halfway toward a soft landing in the balance between monetary policy and the slowdown in economic activity, our past experience suggests that the current situation won’t result in a smooth start to the next economic expansion.  

As the extreme pace of interest rate hikes is adjusted, and interest rate volatility is calmed, the next consideration is a greater-than-expected decline in corporate earnings per share in anticipation of a recession. As the following chart shows, we are watching CEOs’ sentiment about the US economy as a key indicator: the Conference Board’s CEO Confidence Index closely tracks changes to forward EPS in the S&P 500, seven months later.

As the shift from stocks to fixed income is realised, US interest rates won’t be increased. Japanese equities will see a relatively large decline in yen terms (the flip side of 2022). This will also coincide with the dollar-yen peak-out.  

We will be paying particular attention to events including the arrival of the terminal U.S. interest rate and the end of the current governor of the Bank of Japan’s term in April.

<h2 class="blog-h2 blog-h2-styles" id="employment-is-the-determining-factor-for-real-estate-returns-in-2023"><span class="blog-h2-semibold">Employment is the determining factor for real estate returns in 2023</span></h2>
<p class="blog-outlook-date">23 November 2022</p>
<p class="blog-outlook-author"><a class="blog-author-link" target="_blank" href="https://www.linkedin.com/in/maartenvanderspekphd/">Maarten van der Spek, Founder, Spek Advisory FZE</a></p>

Due to the spike in interest rates, real estate investors are worried about their returns.

Although it is clear that bond yields are a driver of real estate performance -- and prime transaction yields have been moving up due to higher rates -- investors should know that this is not the most important factor.

As the chart shows, the most important driver of returns is employment growth. Negative employment growth leads to pressure on rental income and a likely increase in vacancies. Employment growth affects both income and valuation: this is reflected by its correlation of 0.68 with real estate returns.

Employment has held up strongly through 2022, underpinning the property sector, but it’s expected to weaken in 2023 – and, therefore, real estate returns might deteriorate as well. If employment growth weakens only lightly, real estate might not suffer as much as some would believe. The opposite will obviously be true should employment growth deteriorate sharply.

All opinions expressed in this blog: "What investors should expect in 2023" are those of the guest contributors and do not reflect the views of Macrobond Financial AB.

All written and electronic communication from Macrobond Financial AB is for information or marketing purposes and does not qualify as substantive research.