The Financial Markets in 2023
In this note, we highlight ten general thoughts on the global and South African (SA) economy as we move into 2023. Over the next year, we expect slower global economic growth to dominate the agenda. A recessionary-like environment can be expected across developed markets (DMs), with more divergence in economic activity for emerging markets (EMs). As such, our base case is for softer and more volatile commodity prices as global economic growth slows. A global shift in monetary policy, to either pause or slow down the pace of interest rate hikes in 2023, will largely remain a function of inflation which is broadly expected to ease — especially towards the latter part of 2023. Consequently, central banks are likely to shift their tone from arresting inflation to supporting growth. Meanwhile, Russia’s war on Ukraine remains a key geopolitical risk that does not appear to be abating anytime soon. The effects of sanctions against Russia and their disruptive nature on oil prices and broader supply chains continue to dampen the economic outlook. The current European Union (EU) ban on Russia’s seaborne crude oil and the expected ban on imports of refined oil products from Russia in 1Q23 are some challenges that will add volatility to the energy market. On the back of this, we caution that the effects of a global slowdown, combined with a higher interest rate environment, will continue to weigh on financial markets.
As such, investors are probably eyeing 2023 with much trepidation after what turned out to be a rather painful 2022 for bonds and stocks alike. A bumpy ride appears to be on the cards for this year, not counting any other idiosyncratic events that are yet to make a (potential) appearance. Whilst it is always hard to say where surprise events might pop up, below, we highlight ten possible factors/events (in no particular order) worth taking note of as we shift into gear for the new year.
Global food price pressures will continue to ease
Food price inflation remains a focal point for investors at the start of 2023, given its impact on inflation and global monetary policy last year. Data released by the United Nations at the end of last week showed that The FAO Food Price Index (FFPI) averaged 132.4 points in December, down 1.9% from its November reading and, importantly, the ninth consecutive monthly decline. Thus, global food prices ended the year roughly where they started despite several disruptions, from the war in Ukraine to extreme weather. A steep drop in the international prices of vegetable oils, cereals and meat drove the decline in December. However, grain prices have also continued to ease as the UN Black Sea crop-export deal was extended. Last week, Ukraine said it would focus on getting vessels carrying agricultural products faster rather than shipping from more ports. Ukraine has accused Russia of intentionally slowing the inspection process. However, if inspections can be done more quickly, then the amount of grains exported by Ukraine will rise, helping to ease price pressures.
In 2022, high food prices were one of the main drivers of inflation, so lower food prices will naturally be welcomed. However, the prospects for 2023 hinge on beneficial weather to boost strained crop supplies and ease supply chain pressures. The slowdown in economic growth is expected to force consumers to cut back their demand, which will likely keep food prices in check. Factors such as intensifying geopolitical tension between Russia and Ukraine could keep food prices elevated over the foreseeable future.
US inflation and the Fed will continue to dominate discourse – but to what end?
US inflation appears to have peaked in June 2022, with the consumer price index (CPI) providing a good reason to believe that we are now at the beginning of a downward trend. The goods sector has primarily driven the decline in inflation over recent months, whilst services prices have unfortunately proven stickier. Nonetheless, the downtrend is welcome news for markets and the US Federal Reserve (Fed), but it does not necessarily mean that we will get back to the Fed’s 2% annual inflation target anytime soon. If historical trends are anything to go by, it could take up to two years for us to get there. Interestingly, the decline in inflation is taking place without a sharp increase in the unemployment rate, which points to a higher probability that the Fed might engineer a much-desired soft landing of the US economy, a scenario that many thought was very unlikely just a few months ago.
The sequencing of how the Fed reaches its dual mandate (taming inflation and maintaining full employment) is key for capital markets as we move into 2023. Taming inflation first and moderating employment later means that the need for the largely feared “demand destruction” on the part of the Fed decreases. A less aggressive Fed (or a potential Fed “pivot” in 2023) would naturally be bullish for asset prices (public and private) ranging from rates to credit to equities. However, that being said, capital markets will likely remain vulnerable in 2023, and volatility will likely persist because capital remains scarce and expensive, and high-yield primary credit markets will probably stay virtually shut down for the time being.
A possible shift in Japan’s monetary policy
2023 will likely see a significant shift in Japan’s monetary policy as the Bank of Japan (BoJ) Governor Haruhiko Kuroda leaves office in April, having been regarded as extremely dovish during his decade at the helm. Whilst his replacement could prove to be similarly dovish, there is a fair chance that he/she will not and that the new governor will usher in a policy change of some nature. Why is this important? The market is currently positioned to expect up to 30 bps of rate hikes by the BoJ this year. Whilst that might not sound much compared to other central bank actions we have seen of late, considering that the critical short-term policy rate has not been raised for seventeen years, it could be a big deal across global financial markets. Still, the question remains whether such action could cause a significant market dislocation. One reason why it could relate to the fact that poor returns at home have led Japanese banks to be the global leaders in international lending with around US$4.8trn in international claims. Its nearest rival is the US at US$4.5trn, but when you consider that the US economy is nearly five times the size of Japan’s economy, it becomes clear that Japanese banks are dominant in the lending space.
The question is whether this international lending will be redirected to local markets if domestic returns improve because of higher policy rates. There are already some signs of this in recent data, caused perhaps by higher Japanese bond yields and a possible rise in banks’ risk aversion given the state of the global economy. A rapid withdrawal of Japanese banks from international lending markets could strain the financial system. While an orderly withdrawal seems the more likely outcome, it remains crucial that investors should be on their guard for possible market dislocation if and when the tide of monetary policy turns in Japan.
A potential rout in the global property sector?
Another area that we highlight as a possible cause of concern for 2023 is some form of financial stress in the global property sector. Naturally, there is a well-defined history of tensions going back to the subprime mortgage meltdown in the US and, perhaps more recently, the strains in China’s property sector. It seems evident that global property prices will decrease this year amid the restrictive interest rate environment. However, the question remains whether it will be modest and contained or form more of a global rout. The latter’s chances seem quite elevated, particularly in countries where an unsustainable boom appeared to be in place beforehand, such as New Zealand, Canada and parts of the UK (think London). But even if there is not a rout, the simultaneous slide in prices across countries could cause particular difficulties for those holding depreciating assets. In this case, the risks here would seem to lie outside the banking sector, with private equity firms, for instance, most at risk. Of course, non-banking financial institutions could topple for other reasons, as we nearly saw in the UK last September when the pensions sector creaked under the weight of surging gilt yields. As investors will be keeping a close eye this year for possible economic ‘flashpoints” that could turn what looks to be widespread economic recessions into financial market stress, then the property sector would form a natural starting point in this regard.
Europe has seemingly survived the largely expected energy crises
For Europe, the key risk is less about a housing bust and more about energy supply, given that Russia (the now former supplier of 40% of Europe’s gas) stopped the bulk of its supplies this past summer. With Europe currently in the middle of its winter season, the risk to gas supplies is diminishing due to a combination of sound judgment and good luck amid unseasonably warm temperatures. Europe managed to fill its gas tanks over the summer, mainly replacing Russian gas with liquefied natural gas (LNG) from the US. Since then, Europe has had the good fortune of a very mild autumn and, as a result, enters the three critical winter months with storage tanks that are almost full. Unless temperatures turn and they face bitterly cold weather in the first months of 2023, Europe looks increasingly likely to make it through this winter without resorting to energy rationing.
China to open post-COVID-19, easing global supply chain pressures
After a year of domestic economic volatility and international turmoil, China is expected to focus on economic growth this year, which means the country will further deepen reform and expand opening-up. In that vein, judging by the Central Economic Work Conference held in Beijing in December and the resultant speeches of Chinese leaders, the top policymakers will focus on economic growth to restore the pre-pandemic high-growth environment. As such, fiscal support will be targeted and focused, whereas monetary policy will likely remain cautious and neutral until the end of the US Fed’s tightening. In turn, sectoral success is predicated on three critical areas: COVID-19, the technology sector, and the property market. For the rest of the global economy, normalising the Chinese economy could significantly ease supply chain disruptions that have contributed to rapidly rising goods inflation. However, it is worth bearing in mind that a rebound in growth in China could also boost demand for global commodities, thus contributing to inflationary pressures and proving to be a double-edged sword for global inflation.
A year of (potential) political stability
2023 may hopefully prove to be a more stable period in global politics than we have grown used to in recent years. Barring any snap elections, 2023 will be the first year of the twenty-first century without a general or presidential election in any G7 country (Canada, France, Germany, Italy, Japan, the UK and the US; additionally, the EU is a “non-enumerated member” of the G7). Without any election campaigns or leadership contests, G7 leaders may actually focus on the various global and local challenges facing their respective countries (which would indeed be a refreshing change of pace). After a volatile few years, policies aimed at driving stability will be the name of the game – particularly in light of recent global market volatility and the prospect of a looming recession. The gilt crisis during 2H22 in the UK demonstrated how both economies and political parties could rapidly be pushed to the brink when markets vehemently dislike a given policy agenda. With politicians having plenty domestically to deal with, incentives for stability will also be evident on the international stage.
Most notably, efforts are underway to ease tensions between the US and China. At the G20 summit in Bali, presidents Joe Biden and Xi Jinping met in person for the first time as leaders, and the results were generally considered to have exceeded expectations. The White House stated post-meeting that both leaders had “agreed to empower key senior officials” to communicate on issues such as climate change, food security, and global macroeconomic stability. In addition, it was agreed that US Secretary of State Antony Blinken would undertake a follow-up visit to China. Furthermore, the will to foster stability has been noticed in the broad reaction to Russia’s invasion of Ukraine. Even countries that have previously been closer to Russia have suggested their disquiet with the conflict and a desire for peace. Indeed, the fact that Russia has been internationally rebuked to the extent it has demonstrates its behaviour has been an outlier within the global political arena.
Reluctant trade partners: A slowdown in globalisation?
Several lines were crossed in 2022 concerning the international trade arena, primarily due to Russia’s invasion of Ukraine. As such, 2023 is a year where countries may test new ways to weaponise their economic advantages via trade. Consider the trade disputes that featured so heavily in 2022 – first and foremost, the US froze foreign currency reserves held by Russia’s central bank. It also used its control of payment systems to restrict Russia’s access to trade. In addition, wealthy Russian expats had their assets expropriated by various Western countries while many Western companies self-sanctioned. In turn, Russia broke new ground in restricting commodity exports. As a result, Europe spent most of 2022 scrambling to find alternative natural gas supplies. Furthermore, many countries have been at risk from restrictions on food exports from ports in the Black Sea. The US also upped the ante on China and implemented a host of new restrictions on technology exports and dealing with companies tied to the military. Consequently, as we move into 2023, countries may further push the barriers on the types of economic capabilities they can use as trade weapons.
Labour markets will likely soften
While the unemployment rate remains low and job growth is still healthy in the US, demand for labour may now be past its peak. Both the job openings and the quits rates have declined, albeit to elevated levels. Average hourly earnings seem to have hit their high-water mark and are now rising at a c. 4.5% pace. Corporate earnings reports also suggest moderating labour demand and subsequent cost pressures. As such, these data points signal that the Fed is now slowly reaching its desired effect of lower demand for workers. However, success is far from assured, and turning points in the US labour market are difficult to identify in real-time. As demand erodes and corporate profit margins deteriorate, more companies will likely freeze hiring or lay off workers to cut costs. Many companies that were darlings of the COVID-19/social distancing era (e.g., Amazon, Peloton and Meta) have done so. As such, we expect the unemployment rate to rise in 2023 as higher rates broadly slow the economy. The latest numbers from the US jobs data have been dubbed by economists as a “Goldilocks” situation—not too hot, not too cold, but just right. Since both the labour shortage and the strident wage growth it drove seem to be waning, the hope is that inflation will continue to decline. At the same time, a stable labour market (albeit gradually softening) might allow the US economy to avoid a recession caused by interest rate increases.
The SA political economy: President Cyril Ramaphosa survived a deeply fractured ANC in 2022
No one will disagree that 2022 was an arduous year for SA, politically and economically. As a political institution, the ANC remains in a state of deep internal unease – with ongoing implications for the broader political economy. Many of these divisions and internal institutional weaknesses were displayed at the ANC’s 55th National Conference in December. 2022 saw a record level of loadshedding; Transnet’s crippling challenges; an ongoing breakdown in local government; and an elevated and poorly addressed crime crisis (particularly organised crime), which have all sapped local sentiment and undermined SA’s stuttering economic recovery. These and other deep structural concerns face the ANC’s new(ish) leadership, which continues to be impeded by three primary and ongoing growth constraints – ideology, patronage, and state capacity.
However, it is not all doom and gloom – the outcomes of the top seven and National Executive Committee (NEC) votes from the December conference provide a far more conducive basis for navigating these various challenges. It is also worth bearing in mind that since 2017 the president has made significant additional political headway, consolidating his internal authority in a deeply divided and often dysfunctional party. This has allowed the president to drive critical institutional and governance reforms, offer executive support for fiscal consolidation, and introduce some (if not exactly ideal) economic reforms. Most importantly, however, post the December conference, the troublesome so-called radical economic transformation (RET) faction of the ANC appears to be in retreat-which should provide investors with some definitive relief. Nevertheless, unlike in 2017, when Ramaphosa’s election as president of the ANC (and later the country) initiated a period of heady investor optimism, this time around, any material improvement in sentiment will rely not only on the signals emanating from the ANC’s recent conference but, instead, on the concrete, lasting reforms that the president and his allies push for in the new year. The most notable signal of intent in this regard will be the next cabinet reshuffle, which will likely be announced at some point early this year.
The Bottom line
All being said, the above factors are just mere musings/considerations on our part, and the above list is not mutually exclusive or exhaustive. At the end of the day, 2022 has, if anything, taught us that there is always the risk of some new idiosyncratic event popping up. Whilst it is impossible to make provision for such unexpected events, investors should remain cautious of negative surprises when the global economy is so vulnerable and central banks cannot yet ease rates, making these unexpected events more potent than usual.
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