Looking ahead in 2023 : how will be the US and India landing – ‘Softish hard’ or ‘Hardish soft’

During last few weeks, having perused over a score of 2023 outlook reports from different sources - asset managers, economists, investment bankers et al, just thought of starting the year with assembling the thoughts on global macro-outlook. Objective of the write-up is to filter out short term noise & analyse basic long term macro indicators for CY23.

As a prelude, it is imperative to acknowledge that 2022 was one of the most unexpected years in terms of Financial market performance. As Global Macro follower and Market dealer for last 2 decades, none of us would have witnessed such year of high volatility in rates and currency. This was majorly for two reasons - 1. Market did underestimate the effect of tighter liquidity & withdrawal of easy money, to which financial system got used to for two years, and 2. Of course,?a Black Swan event like war and the resultant crisis in energy supply. Without war & geo-politics, the majority of 2022 forecasts on financial asset performance would have proved 5-7% near to accurate.

Coming to 2023 outlook & forecasts, very important to start with US inflation and growth. These will be the most predominant macro data points across the globe; and will drive the corresponding reactions by DM & EM central banks.

Firstly, as 2022 has been the year of historical high headline numbers on prices, 2023 should be the year to follow Core CPI trend. Over a medium-term time frame of 2-3 years, headline CPI would mostly follow the Core CPI . This is because all the other non-core components are cyclical in nature and as the noise settles down, non-core CPI will show mean reversion. More important US inflation metric - Core services ex shelter, remain uncomfortably high till Dec'22. Going ahead, core CPI (or PCE), which is direct measure of service sector prices and consumption growth, is very likely to slow down in H2 CY23. It is almost impossible in the US to have 0.2% or above MoM services inflation on a sustained basis when Fed rates are at 5%+ levels. So, market should assign a decent probability of Headline CPI in the US reverting towards 2.8-3.3% band by later half of CY23.

Similarly, for US GDP, it is almost a certainty to witness very flat or marginal negative growth during Q2 – Q4. Although it is being termed as ‘engineered’ recession by Fed and expected to be short & shallow cut in growth, nobody in the recent history has seen such high Fed rates, that too hiked at such fast pace. Repricing of bank funding cost and borrowing rate for economy to take effect of full Fed rate hikes will need at least 6-9 months’ time. So, 2023 will be a year to worry about growth and not so much the prices.

Secondly, DXY strength had been one of the themes in 2022. A very simplistic way to explain DXY strength in terms of basic macros is - relative strength or growth in US economy, compared to other major DM economy growth rate. Come 2023, this strength could get challenged because of two themes – Europe growth & energy supply stabilizing and China reopening.

In 2022, another unique scenario unsettled the markets was the simultaneous strength in DXY & commodity prices. This off course was due to the aftermath of war & energy supply chain issues. Otherwise, it is not possible to experience both DXY & commodity strength at the same time, as fundamentally these are inversely correlated.

Now in CY23, as neither ECB nor BOE is close to policy normalization compared to Fed, continued USD weakness during H2 ’23 is expected. Terminal rate differential of 150-175 bps between Fed & ECB also should add to strength in EUR. Overall, resilience in macro data from EU area & Asia (Japan, China) and more hawkish stance from other major CBs (ECB, BOE, BOJ) to set the theme for USD weakness in CY23. This should have a correlated impact in gradually higher commodity prices, with brent crude moving towards upper end of $75 – 95 / bbl range.

Thirdly, Indian macro fundamentals are very much at the cross-roads in 2023. Most part of selling in INR currency & rates in 2022 was due to external reasons like high commodity prices, strong USD, tighter global liquidity etc. In 2023, India currency and rates need to manage the internal macro challenges. Sum total of CPI, Fiscal deficit & CAD – this in elementary way indicate macro stability of a country. This number have seen record highs in 2022 for India and will have to come down in current CY meaningfully for the country in order to show outperformance in rates & currency market.

One narrative is often heard in India outlooks is ‘worst is over’, majorly because both US & India rate hikes are all done. One relevant question to recognize here is – how much of these rate hikes have been passed on to the economy ??

One needs to understand how liability re-pricing happens in banks or NBFC in such sharp rate hike cycle. Till April 2022, all the short-term bank liabilities were raised within 3.5% -5% cost. Then within eight months, effective borrowing rates were hiked by 300+ bps by RBI. Good part of the low-cost deposit base not yet matured or repriced till Dec '22. By April – June ’23, almost all these 4% handle deposits will mature, and bank’s cost of fund will fully reprice the rate hike impact at 7.8 – 8.0% range. Further, there will be shift of flows from savings to deposit accounts, as the rate differential keep moving higher. This higher CoF obviously needs to be fully passed on to lending rates by banks & other financial institutions, after providing for CRR, SLR & other regulatory cost.

India growth is to large extent dependent on urban & rural consumption. It will be interesting to see how the growth engine performs in H2 CY23, when minimum lending rates will start at 10-11% range. During later part of the year, growth could fall in 4-5% handle. Now, regarding prices, similar to the US & other DMs, Core CPI for India will be important macro variable to track; more than the headline number. Till now, Core CPI has been sticky , but should fall toward 4.5-5% as growth falters in 2nd half of CY. However, India growth number could still be better than average G20 growth rates in 2023.

The above scenario will induce the push for higher credit growth and expansionary fiscal policies in CY'23. Credit growth is always better looked at as 'real growth', after adjusting for CPI. Major part of credit growth in 2022 was due to inflation & resultant WC demand. So, real credit growth to fund capex / investment is still not in double digits and expected to pick up in 2023. This will continue upward pressure in 5-10 years bond credit spreads and tighter liquidity will keep term premia higher.

Moreover, on India macros & markets, oil prices are always the overriding factor, as this affects fiscal, current account, CPI & ultimately growth. Assuming current energy supply demand dynamics remains as expected in CY23 and OPEC+ cuts continue, Brent crude should inch towards $ 90 – 95 /bbl price band & could stay there mostly during Q2 - Q4 ’23.

So, 2023 should be the year for slower than expected growth for India, sticky core inflation and challenging twin deficits. RBI could have to hike another 25-50 bps, over & above the priced in terminal rate (6.50%), for managing internal macro shocks; as both fiscal & current account deficits could initiate another round of INR assets sell-off. This will take the terminal repo rate for CY23 close to 7% mark, which has anyways got priced in the 6m-9m AAA curve.

Finally, the foremost discussed question for 2023 - soft or hard landing. More than Fed pivot, the paramount event will be inflation pivot in the US. One of the interesting narratives heard recently is the ‘softish hard’ landing, which mean a shallow and short recession and rate cuts could start during Q4 ’23. Risk in this view comprise of - not accounting for the probability of any sharp growth cut despite record high rates of 5%+ sustaining for 3-4 quarters. Another risk being Fed may choose to keep rates high long enough to see core CPI subsiding till 2% and so that there is no risk to Fed credibility.

This is a very fine balancing act, more like a fairy tale expected from Fed and may not pan out exactly in reality. Fed may want to go for a Type 1 error, with higher rates for longer period, than a Type 2 error by not hiking enough or cutting early. As the transmission of Fed rate hikes is done entirely by banks after March ’23, it will be difficult for 3rd & 4th quartile corporate borrowers to sustain such towering cost of funds.

However, it is base case expectation that DM inflation should cool off very fast towards CY23 end and start of CY24; whereas such sharp reversion won’t happen for most EM inflations. Thus, it will be difficult for RBI or some other EM central banks to start cutting rates, even if Fed rates are lowered. RBI cut cycle won't seen starting before Sept CY24. India could still face a longer period of very slow growth & higher rates, leading to 'hardish soft' landing.

Now moving to Market forecasts, mostly these should follow economic forecasts as markets try to price in macros 10-12 months in advance. US fixed income performance looking better in CY23, specifically during H2 when growth concerns will dominate market sentiments. India rates and currency both could show ‘sell on rally’ pattern; as IGB 10Y should gradually move towards 7.60-70 levels , before RBI starts OMO purchase by July -Sept quarter. Credit spreads for AAA/ AA bonds to expand in 2023, as more supply & credit off-take kicks in. It is not probable for India AAA credit spread and 2x10 year speads to sustain at such lower levels for longer period. One of the ‘throw of dice’ event for India this year could be IGB inclusion in global bond index, and whenever that happens, both rates & currency will see sustained rally. However, GoI not seemingly prioritising the bond index inclusion and related Capital gain tax issue resolutions as of now.

Equity is not a fundamental asset class like rates, currency or commodity; and as risk asset, equity market requires overall risk-appetite & sentilement to support the prices. In order to forecast equity markets performance in medium to long term, only 3 dominant drivers are to be evaluated -?1. current year earnings growth, 2. Next year forward growth and 3, Market liquidity. There have been few years in the past when first 2 drivers were uncertain, but liquidity pushed the risk assets higher. In 2023, all three drivers could face hurdles for US & most global markets and so it is difficult to see any meaningful appreciation in equity market. Having said this, India equity and some more large EM markets could still experience out-performance by 5-8% in headline index level compared to US equity indices.

One of the salient concepts to fathom here - during 2023, bad economic data in the US will be bad for equity market, unlike what happened in 2022, when worse economic data release meant lower rate hike extectations, lower UST yields and better equity market performance. But, in 2023, most rate hikes are all done and worse US data release will substantiate the worry on slower growth & will take equity markets down with it.

Thus, broadly looking a better year for US fixed income market, negative biased & range bound equity market in US, EU & India, weaker dollar, strong commodities and gradual sell off for India rates maket in 2023. Let's see where do we end up in December.

*PS - India rates view on RBI terminal rate target of 6.50 for Mar'23, shared as on June '22 looks panning out exactly as per forecast now, whereas market consensus & most economist polls during June -July '22 was indicating RBI repo hike would stop at 5.75 - 6.00 band in FY'23.

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Disclaimer – above mentioned views are only based on personal research and has nothing to do with any house view of employer organisation or any other institution.