For markets in 2023, much hinges on how quickly inflation recedes

Inflation is cooling but remains above central banks’ targets, which suggests room for interest rates to rise further, putting pressure on markets amid a global slump
Equity markets will continue to struggle, but as we near the end of the tightening cycle, support for government bonds will grow

Sylvia Sheng

Published: 10:00pm, 6 Jan 2023

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For financial markets, 2022 was a very challenging year that many investors would prefer to forget. Global equities had their worst annual performance since 2008 with the MSCI All Country World Index down by 18 per cent.

It was also a bad year for government bonds after a multi-decade bull run. US bonds suffered their steepest losses in nominal terms in over 50 years. The biggest driver of all the market turmoil was a much-higher-than-expected inflation, which triggered the fastest interest rate increases by major central banks in a generation.

Some of 2022’s challenges are likely to linger into the early months of 2023 with inflation still elevated and the global growth outlook subdued.

Inflation seems to have peaked in the United States and is peaking in Europe, and these rates are likely to fall over the course of the year. The key question for central banks is how fast inflation will come down.

In the US, much of the inflation outlook hinges on three main drivers. The first is goods prices outside the food and energy sectors, which have begun edging down. With improving supply chain operations, goods prices, which remain high compared to pre-pandemic levels, are expected to ease further.

The second driver is shelter inflation, which includes both rent and utility payments. Private-sector sources show that rental rates on new leases have begun falling. But the consumer price index measures the whole outstanding stock of leases and marginal changes, so even though the direction of travel seems to be lower shelter inflation, it will take time to show up in the official inflation rate.

Shoppers at Costco in Monterey Park, California, on November 22. In the US, goods prices outside the food and energy sectors have begun edging down. Photo: AFP

The main uncertainty lies in the third driver, which is services inflation. Prices in the services sector are tied more closely to wages than for goods or shelter prices. So, some cooling of the labour market is needed for services inflation to decline.

There have been some modest signs of rebalancing in the US labour market in recent months. Employment growth has been gradually declining and job vacancies have dropped meaningfully from their peak earlier in the year.

But job openings remain far higher than normal, and lay-offs are very low. Wage inflation is still running hot in the US at around 5 per cent year-on-year. With the US labour market still tight, risks to inflation remain high.

In Europe, the natural gas crunch is looking less damaging than many had feared, thanks to a combination of increased liquefied natural gas (LNG) imports and efficiency gains. Both households and manufacturers have been able to reduce their gas consumption without much sacrifice to economic activity. Gas commodity prices have therefore fallen sharply from their peaks, returning to the levels observed at the start of 2022, and this is likely to help headline inflation rates recede in coming months.

Inflation is cooling but remains above central banks’ inflation targets, which suggests there is room for policy rates to rise further. The market expects both the US Federal Reserve and European Central Bank to continue their monetary tightening, with the final interest rate increases likely to occur in the second quarter of the year.

As central banks tighten their monetary policies further, major developing market economies are very likely grow at a sluggish pace this year. The risk of a mild recession in the US has increased. Europe may already be in recession, even if less severe than initially feared, given lower natural gas prices.

Customers queue at a bakery stall in the Christmas market at Potsdamer Platz in Berlin, Germany, on December 20. German companies expect a mild recession in 2023 despite headwinds from the energy crisis, raw material shortages and a tepid global economy, a survey of major associations published in December showed. Photo: Bloomberg

The weak macroeconomic backdrop could pose headwinds for equity markets, at least in the early part of this year. Corporate earnings are expected to come under pressure. Corporate revenue growth is likely to moderate as nominal economic growth slows. At the same time, corporate profit margins face challenges from slowing demand and strong wage gains, which push up their costs.

Meanwhile, as we get closer to the end of the tightening cycle, support for government bonds grows. Historical data suggests that the US 10-year government bond yield tends to peak two to three months ahead of the last interest rate increase in a cycle. Lower bond yields are positive for bond prices as they are inversely related.

Sluggish global growth, cooling inflation and peaking policy rates are likely to create a different market environment in 2023, compared to 2022 when both equities and government bonds sold off. Equities may continue to struggle as a recession seems likely in parts of the world and corporate earnings have yet to come down. But it may be a better environment for government bonds given that the rate increase cycles at major central banks are nearing their peak.

Sylvia Sheng is a global multi-asset strategist at JP Morgan Asset Management