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Published on 16/12/2022
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Outlook for 2023: the year of disinflation!
Now that coronavirus is no longer the threat it once was, the economy and financial markets have been plagued with another scourge: inflation. In other words, skyrocketing prices that started in the summer of 2021, first in the U.S. and then in Europe and elsewhere in the world. Olivier Colsoul, Senior Strategist at AG, looks ahead at what the coming year might have in store for us.
Now that coronavirus is no longer the threat it once was, the economy and financial markets have been plagued with another scourge: inflation. In other words, skyrocketing prices that started in the summer of 2021, first in the U.S. and then in Europe and elsewhere in the world. Olivier Colsoul, Senior Strategist at AG, looks ahead at what the coming year might have in store for us.
2020 was the year of the virus that shut down the world. 2021 was the year of COVID-19 vaccines. 2022 marks the end of the pandemic, the quick return of inflation and the beginning of the conflict in Ukraine. What's your take on these last few months of global economic upheaval?
Well, for starters, once we emerged from the pandemic, the economy and the financial markets have bounced back very quickly, much faster than expected. A major feature of this unprecedented period has been the resilience of households and businesses, thanks in part to COVID relief spending coupled with advances in science, technology, and effective vaccination campaigns. So I have a rather optimistic outlook for the future while still being grounded in reality.
Unfortunately, the positive momentum that started in 2021 took a nosedive in 2022, dragged down by soaring inflation and the unexpected war in Ukraine and its impact on energy prices. Although the context has become more complicated with many ongoing uncertainties, the worst is not necessarily to come. As was the case during the public health crisis, EU governments have taken measures to ensure sufficient energy supply during the winter and to shield households and businesses from the direct impact of rising prices, sometimes by partially freezing gas and electricity prices. At the same time, efforts have been made to reduce energy consumption. Once again, we've seen a certain adaptability of producers and consumers in the face of destabilising factors, even if we could have done better.
The only dark cloud - and it's a big one - is the very high inflation that seems to be taking hold...
It's true, inflation has been a nasty surprise over the past year, rising above the 10% mark in Europe, the highest it's been in nearly 40 years. Atypically, inflation is higher in Europe and will likely take longer to fall than in the U.S. The main causes are cyclical in nature and result from an imbalance in (weak) supply and (high) demand. Factors include the reopening of the economy after the COVID-19 pandemic, the massive fiscal recovery, the Russia-Ukraine conflict and soaring energy prices. In addition, more structural factors are likely to emerge over time: changes in consumer behaviour that influence supply and demand, the energy transition and its impact on energy prices, and the relocation of certain production capacities given the new geopolitical situation.
"Inflation has been a nasty surprise over the past year, rising above the 10% mark in Europe."
For a long time, central banks were convinced that inflation was going to be transitory and that it was mainly the result of a supply shock, something that monetary policy cannot fix. As inflation continued to rise and spread across the economy, they reacted late but aggressively. Central bankers, especially the U.S. Federal Reserve, have announced that they will do whatever it takes to fight inflation, even if it hurts and causes a recession. It seems that this is the right strategy, because giving up this fight would be even more damaging in the long run. At the time this article goes to press, central banks have already tightened the monetary policy screws, more so in the U.S. than in Europe. While interest rate hikes are not over and could still take us by surprise, the pace should slow down as inflation, while still too high, has peaked and may even be receding. This is already the case in the U.S. where two of the three drivers of inflation, notably energy and goods, are slowing down nicely. Since these are essentially global markets, what happens in the U.S. should also spread to Europe, except for gas, where the Old Continent remains in a potentially vulnerable situation.
So there's a light at the end of the tunnel?
In view of the above, inflation should logically start to ease. The great fear in the past months would have been that a wage-price spiral would set in, i.e. a prolonged loop in which inflation leads to higher wage growth, fuelling even higher inflation. A recent IMF analysis shows that the risks in this area are under control. A combination of three factors work to control these risks: inflation shocks do not come from the labour market, the decrease in real wages - after inflation - helps to reduce price pressures, and central banks are aggressively tightening monetary policy. The year 2023 should therefore be the year of disinflation. Seeing inflation cut in half should be fairly easy. The real hard part will be going from there back down to the 2% target.
Beware, as the economy is facing a gloomy and uncertain outlook and is unlikely to improve in the short term, we could end up in a deep recession, especially if there's a new geopolitical/energy shock or due to an overly restrictive/damaging monetary policy. Similarly, the spectre of stagflation cannot be ruled out if inflation pressures prove to be broader and more persistent than anticipated. But at this stage, neither the first nor the second scenario is the most likely. Our baseline scenario for the coming year is a prolonged economic slowdown that may possibly lead to a mild recessionary phase but with inflation falling more than growth. This would gradually increase purchasing power and, in the absence of a sharp rise in unemployment, boost consumption and the economy in the process. The hope is that 2024 will become a relatively normal year, but we're not there yet.
Beware, as the economy is facing a gloomy and uncertain outlook and is unlikely to improve in the short term, we could end up in a deep recession, especially if there's a new geopolitical/energy shock or due to an overly restrictive/damaging monetary policy. Similarly, the spectre of stagflation cannot be ruled out if inflation pressures prove to be broader and more persistent than anticipated. But at this stage, neither the first nor the second scenario is the most likely. Our baseline scenario for the coming year is a prolonged economic slowdown that may possibly lead to a mild recessionary phase but with inflation falling more than growth. This would gradually increase purchasing power and, in the absence of a sharp rise in unemployment, boost consumption and the economy in the process. The hope is that 2024 will become a relatively normal year, but we're not there yet.
"In the U.S., two of the three drivers of inflation, notably energy and goods, are
slowing down nicely."
In the context of a pronounced economic slowdown, which assets are likely to perform well?
Let's start with bonds. We're seeing a paradigm shift here compared to previous years when low interest rates made this asset class rather unappealing to investors. The sharp rise in yields combined with the rise in spreads - risk premiums - has made bonds attractive again. While further interest rate pressure is still possible, we see a lot of value in investment grade corporate bonds. Moreover, their risk premiums already largely reflect the imminence of a technical recession. Buying these types of bonds is a great investing move right now as they have the best ratings, are relatively immune to default risk (according to past performance) and have yields in the neighbourhood of 4%. Other, more speculative categories of fixed income or debt securities are even more attractive but potentially more volatile. So there are investment opportunities, but we can't go overboard.
What about equities?
We are relatively neutral right now but more constructive in the long run. Despite the drop in share prices since the beginning of the year, the appeal of equities has waned because there are other attractive alternatives and because the economic slowdown coupled with continued high inflation is weighing on corporate profit margins and eroding future earnings expectations. That being said, the looming technical recession doesn't necessarily mean we'll see a recession in earnings. This would certainly be the case if a hard landing in the economy were to happen. This is not our baseline scenario but we'll have to watch out for any signs that point in this direction. After the recent rebound, valuations rose a little too much and too fast.
In addition, without a nice lift from corporate earnings, equities are likely to fluctuate without any real trend, but without floundering. We therefore believe that a sustainable recovery will not happen for some time. For this to happen, there needs to be more evidence that central bank rate hikes are coming to an end and that the economy is able to avoid a severe recession. This is what investors will be looking at next year, but all of this will still depend on one key variable: inflation, or rather disinflation.
"The year 2023 should therefore be the year of disinflation."
In conclusion, after a very destabilising year, 2023 should be more balanced.
From an economic point of view, 2022 will have been the year of
“slowflation" - a contraction between slowing growth and high inflation. While 2023 will still be characterised by a sluggish economy and persistently high inflation, with the appearance of stagflation, price increases should actually be on a downward slope. Despite the persistence of many uncertainties, the upcoming prospect of a peak in central bank interest rates should bring more serenity to the financial markets, especially since there are opportunities right now in bonds.
Olivier Colsoul in a few words For the past 25 years, Olivier Colsoul has held a variety of investment-related positions: equity analyst, portfolio manager, third-party fund analyst and economist at various renowned financial institutions. Since 2020, Olivier has been our Senior Strategist at AG. He devises AG's overall short- and long-term investment strategy by analysing macroeconomic developments and the evolution of financial markets. |
- The Pension & Health Academy will be back in 2023
Building on the success of the previous years, the Pension & Health Academy will be back in 2023 with some fascinating new webinars. And Olivier Colsoul, AG's Senior Strategist, will be giving the first of these digital Snack & Learn sessions on Thursday 19 January (Dutch) or Tuesday 24 January 2023 (French) from 1:00 PM to 2:00 PM. At this webinar "Economic Outlook 2023", he'll be sharing his insights on the current economic context and the financial outlook.
Intrigued? Save the date and sign up for the first Pension & Health Academy webinar via this link (French or Dutch). I look forward to seeing you there!
