Mid-year Outlook 2023: entry points?

For investors, we think the coming months will likely deliver more than their share of twists and turns. Whether negotiating the path of interest rates or confronting the possibility of recession, it will be essential to stay agile, because opportunities should also arise. Learn how to prepare for what comes next – and be ready for the entry points that market shifts may bring.

We will highlight asset class views from our global CIOs in the coming days, after we start with the macro view by Stefan Hofrichter, CFA , Head of Global Economics & Strategy:

Macro view: better than feared, but instability risks remain

Let’s start with the good news. Since late 2021, global supply chains have very much normalised: the Federal Reserve Bank of New York’s Global Supply Chain Pressure Index is now at one of the lowest readings in history – which should at least help to bring down goods price inflation, everything else being equal. And global economic activity is hovering along at a rate of close to 2.5%, according to OECD[1] data. This is not amazing, but it is still significantly better than feared during the winter.

The last couple of months have also turned out to be a good period for investors: global equities, measured by the MSCI World, have returned around 10% adjusted for US inflation since last October (as at mid-June). Bond yields have remained quite stable since early 2023, thereby generating a positive nominal return for investors.

So, are we back in a “Goldilocks” environment that is supportive for all major asset markets, where the economy is running neither too hot or too cold? Not so fast: we think there are several challenges ahead of us and investors face a bumpy ride in the coming months:

1. Inflation remains stubbornly high. True, headline inflation has moderated – thanks largely to a fall in energy prices. However, annualised core inflation (excluding highly volatile energy and food prices) has been hovering at around 4% to 5% for several quarters already – significantly above central banks’ targets of 2% (see Exhibit 1). Due to second-round effects such as wage increases, it takes longer for inflation to moderate once we have been in a high-inflation regime for an extended period, as academic insight and our own research shows.[2] It is also worth noting that central bank rates at current levels are not overly tight, if at all. Given the persistent underlying inflation, we do not share the market’s optimism that the world’s most important central bank, the US Federal Reserve, can afford to cut interest rates in the second half of this year. We expect further rate hikes in the US. In fact, at the Federal Open Market Committee meeting in June, the Fed pointed to two more rate rises before the end of the year. And the European Central Bank will likely have to hike by more than currently priced by markets. We therefore consider the chances of a further drop in bond yields to be limited.
2. Recession in the US and Europe later this year is our base case. Admittedly, high-frequency data continue to point to an ongoing expansion of economic activity in the near term. Still, various leading indicators are consistent with our recession call: the inversion of yield curves, the contraction in money supply measures, and the topping out of the financial cycle (a measure for the joint dynamics of house prices and private sector leverage). Historically, whenever central banks have hiked rates to tight levels to fight inflation the outcome is almost always a recession. This matters for investors, as risk assets typically start to outperform during rather than ahead of a recession. The consensus seems to be that the downturn will be soft and shallow. We are not so convinced. The topping out of the real estate market, both residential and commercial – as a period of rising prices comes to an end – could result in a more marked economic slowdown than so far anticipated by investors.
3. Financial instability risks persist. Certainly, all the US banks that either failed or had to be bailed out earlier this year looked to be undone by issues unique to them. The same goes for Credit Suisse. The common denominator, however, was their failure to adapt to the sharp rise in interest rates at a time of high leverage in the private sector following the economic boom in 2021. Higher rates have impacted not only banks, but also non-bank financials. Markets for illiquid assets, especially real estate, may turn out to be a source of financial instability, as the International Monetary Fund has warned repeatedly. Financial stability considerations will make central banks’ job more complicated. However, so far, they have shown no appetite for letting these financial stability risks interfere with the fight against inflation.

To conclude, while we do not expect a smooth ride in financial markets for the remainder of the year, investors may find good entry points across the asset classes. In equities, that could be when earnings expectations trough during the anticipated slowdown and stock prices “climb a wall of worry” even in the face of market negativity. Given our growth outlook, and following the rise in bond yields in 2022, we expect positive returns for bonds – although without any guarantee. It is a time to stay agile.

Exhibit 1: When will core inflation lose its stickiness?

US inflation, 3 months annualised

[1] Organisation for Economic Cooperation and Development

[2] Source: BIS Papers No 133 The two-regime view of inflation by Claudio Borio et al , March 2023

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