Outlook 2023: the year of disinflation? Yes, but what else?

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What conclusions can you already draw from the first six months of the year?

Unlike 2022, full of increasingly gloomy developments in the economy and the financial markets, we've had more good news than bad so far in 2023. At the very least, some fears have been allayed.

First of all, the worst didn't happen. The European economy managed to stay afloat despite the energy crisis. We got through the winter without any major problems, thanks to lower gas consumption by households and businesses, rapid diversification of our supply sources with liquefied natural gas, and milder weather. Fortunately, the energy situation has improved. But there could still be further upheavals if there are unfavourable, concomitant circumstances in the energy sector.

With the drop in sky-high energy prices, inflation started to go down as well. While still high, it is no longer as worrying as it was last year. Other than in the case of automatic indexation, wages have generally increased throughout the euro area, but less than consumer prices. Fears of a wage-price spiral have not materialised, and the current slowdown in inflation should reduce this risk.

Central banks continued to raise interest rates, albeit at a slower pace than last year. While the upward cycle is not yet over, we are getting closer and closer to peak interest rates, which translates into less turmoil on the financial markets than a year ago. Equities have performed very well, and even a little too well, despite a temporary setback triggered by the U.S. regional bank crisis in March. After a historically lousy year for bonds, fixed income markets are off to their best start to a year ever in 2023.

In short, the first half of 2023 looks a lot brighter than the same period last year. But there are still some clouds on the horizon.

What's your analysis of the current economic and financial situation?

The words "split personality" immediately spring to mind. On the economic front, it's the services sector that's driving GDP growth. The manufacturing sector, meanwhile, is struggling to recover. And as investors and the capital markets know all too well, manufacturing has an outsize contribution to the economy. The contraction in the money supply does not bode well for reviving the economy. Secondly, sentiment indicators, which gauge market psychology in the form of investor or consumer behavior and beliefs, are resilient. However, expectations for the coming months are, at best, flattening out or falling back significantly. Finally, while growth forecasts for the year have been revised slightly upwards, the trend for the coming quarters is likely to be gloomier. 

The financial markets are also having a good year. With their heavily inverted curves, the bond markets are expecting the central banks to unwind their accommodative monetary policy rather quickly, even if the central banks have announced loud and clear that this isn't on the agenda. Since the start of the year, growth stocks, especially the technology sector, have been driving an ever-increasing share of stock market gains. On Wall Street, just 20 stocks account for almost 100% of S&P 500 returns.

As such divergences are difficult to sustain over time, upward or downward adjustments are likely, so it's a good idea to take a somewhat cautious approach.

While the economic cycle has been blowing hot and cold, flip-flopping between marked slowdowns and timid recoveries, we mainly see a lot of resilience.

Inflationary shocks and higher energy bills have, of course, had a negative impact on growth. Companies have been able to pass on some of their higher costs in their selling prices. While it's true that households have had to draw on their savings, a buoyant jobs market and government aid to shield consumers from soaring energy bills have kept household consumption at a high level. There is evidence of economic resilience, which can be observed on both sides of the Atlantic Ocean.

In the U.S., growth has historically been driven by household consumption, and this remains the case. Despite high inflation, consumer spending remains strong, propelled by a still very robust labour market and a reduction in excess savings set aside during the Covid-19 pandemic. The financial situation for U.S. households and businesses is solid, and the mini-banking crisis doesn't seem to have had any negative repercussions on bank lending despite the tightening in credit conditions.

On the other side of the Atlantic, after a downward revision in the official figures, the eurozone slipped into recession due to non-recurring factors. Unlike in the U.S., consumers have had to cut back on spending but aren't yet cracking under pressure. In any case, it's less than at year-end last year, and is likely to stabilise in the near future as the labour market remains buoyant and price increases gradually ease. What's more, with lower energy bills and the associated cost of imports, foreign trade has once again become a net positive contributor to growth, which is a welcome development.

"As in any economic cycle, at some point an upturn will appear on the horizon."

China, however, has major challenges on its hands. The slowdown in global growth is having a major impact on China's production and export figures. The real estate slump will likely be a multi-year growth drag for the economy and represents a significant financial risk. As a result, households are saving rather than consuming. What's more, state intervention in various sectors doesn't always inspire confidence, even if it's to control certain financial risks that have accumulated over too long a period. The traditional remedy of injecting more public money and bank debt into the system is less and less effective over time. The downside is that all of this has a rather counterproductive effect on economic growth and the strength of the recovery. And there's no magic cure. 

What about skyrocketing inflation in 2022?

We hit peak inflation at year-end 2022. Data show that inflation is cooling, but not necessarily quickly or in a linear pattern. Barring any major surprises, we expect to see continued deceleration. Indeed, central banks have raised interest rates multiple times to curb this historic inflation. Why? Because the rise in energy prices has also spread to food, goods and services. These last two categories are what is known as core inflation, while energy and food are considered volatile items. We can see that core inflation has been slower to climb than headline inflation, and will also take longer to start falling again. As long as there are no new shocks, inflation will continue on a downward trend. The only unknowns are the timing and the level it will stabilise at. But as time goes by, inflation is becoming less and less of a concern. 

So what's the economic outlook for the months ahead?

Overall, although it may seem paradoxical, we expect the global economy to slow further amid signs of resilience. This means stalled economic growth in 2023 before a slight recovery in 2024 or 2025, which would be supported by a gradual increase in purchasing power, i.e. wage growth while inflation continues to relent. Uncertainty as to whether the economy will recover could depend on monetary policy, as interest rate hikes not only lower inflation but also slow economic activity. And this impact takes time to work its way through the economy, a process that can take a year or more. The interest rate hikes that we're seeing now could weigh on the economy in 2024. The slowdown is still in progress: a slowdown, yes, but not a collapse. And then, as in any economic cycle, at some point an upturn will appear on the horizon. 

And what about the financial markets?

Stock markets are doing exceptionally well given the situation, and have been on an upward trend since October. That being said, the quality of the stock market rally is far from uniform. Apart from the recent hype over artificial intelligence it's mostly technical factors that are moving prices up. Admittedly, corporate earnings show that U.S. profit margins have stabilised compared to Q4 last year, and expectations are no longer deteriorating. However, after the upturn at the start of the year, the economic situation in the manufacturing sector is becoming increasingly sluggish. The latest figures aren't very inspiring, but they're not alarming either. And the trend is still not reversing.

A wait-and-see attitude and diversification are still the wisest strategy. We expect to see returns stabilise and the surge in equity markets to slow down. We are maintaining our balanced split between equities and bonds. Within the equity portfolio, diversification via geographical region, sector and management style remains a priority, at the risk of missing out on trend reversals. And there have been a few in the last year or so. A consolidation phase, combined with a reduction in certain stock market excesses, could create new entry points. Alternatively, a more tangible improvement in outlook could also strengthen investors' stance on equities.

Conclusion

Growth will remain weak, but the economy continues to show resilience in a challenging global context. Disinflation is rather good news, but as the hardest part is still ahead of us, we shouldn't be too quick to cry victory. We cannot ignore or minimise the impact of monetary tightening – we know that central banks prefer to do too much rather than too little – which would hamper growth. At this stage, a soft landing for the economy looks like the most likely scenario. 

The risk of cracking under pressure is fairly low, given the resilience and relatively good financial health of households and businesses. Furthermore, as time goes on and inflation continues to fall, central banks could more easily take corrective action than if we had experienced a major recession. Although not optimal, such a scenario would not necessarily be the most frightening for investors, who seem to have come to terms with it. In any event, fixed-income securities now offer attractive yields, particularly investment grade corporate bonds, which we feel positive about. Although we are cautious rather than suspicious about investing in equities in the short term, our stance is more constructive in the medium to long term.​