A Closer Look At The State Of Global Economy As We Head Into 2023

A recession is coming (and may already be here). Why it may signal a time to exhale.

Investors had very few places to hide in 2022. Broad equity indexes fell by double digits in the U.S. and globally. While certain pockets of the market held up better than others (notably, value equities topped growth stocks), it was a dismal environment for stocks. Unfortunately, the same held true for debt markets. Bonds, often seen as a safe haven in bear equity markets, began the year with low yields before suffering from steep price declines as central banks sprinted to catch up with inflation.

As weary investors look toward 2023 and assess the ongoing macroeconomic risks, it may be tempting to reallocate assets or sit on the sidelines to escape further damage, to either react by risking-off or get a jump on risking up. But, as a recessionary environment arrives, some signs show staying the course will be rewarded when the other side of this economic contraction becomes visible, likely sometime in late 2023.

Inflation was the primary economic headwind in 2022, causing headaches for investors due to higher business expenses and the uncertainty of central bank rate hikes. Complicated by supply chain issues and the geopolitical shock of Russia's invasion of Ukraine, the rapid recovery in demand following the pandemic-related recession drove inflation to rates that central banks did not anticipate. Runaway inflation fears and the lag in central bank responses led to a historically rapid rate hiking cycle.

Inflation and rate hikes created miserable market conditions this year, but with rising indications that some countries and industries are now in or just entering a recession, the hard and often clumsy work of getting inflation under control seems to be working. Central banks have either slowed the pace of rate hikes or have paused increases.

The goal eyeballed by central banks, an improbable task to pull off, was to create a soft landing – to slow economies enough to tamp down inflation without causing a recession. Now, some reliable recession benchmarks have been reached – an inverted yield curve, falling consumer confidence, and declining price-to-earnings. The Fed and other central banks have signaled a growing acceptance of deteriorating labor markets, a tell that the goal has shifted towards keeping an inevitable economic downcycle as mild as possible while finding an acceptable maintenance level for rates.

Growth amid recession in 2023

Within this reality, there are positive developments for investors entering 2023. With rates kept at historic lows for years, there was a lack of a risk-free rate acting as an anchor for debt markets and sharpening equity valuations. The establishment of a new risk-free rate should help normalize bond markets that have been out of sync for years. And equities should benefit from predictable credit projections, too.

Some uncertainty on the future direction of rates still exists - whether pauses will be followed by the need for further increases on persistent inflation or economic declines will necessitate rate cuts later in 2023. But it is welcome news that it appears we have seen the peak of this rate hiking cycle.

While many countries and industries may see material deterioration in corporate revenues and labor markets, conditions are still favorable for growth among many markets and regions. This could make the recession more unpredictable and uneven than other downturns, rewarding some companies while providing headwinds for others.

These disparate economic conditions have been created by the uneven effects of the pandemic and subsequent recovery. An example of this ongoing disparity is the legacy impact of China's zero-Covid policy and the economic implications of the country easing its Covid-related restrictions. The Chinese economy will likely expand upon its reopening. Familiar patterns of higher demand, supply chain constraints, further Covid outbreaks, and inflationary pressures will sweep through the country and economy as has happened in many other economies.

An asynchronous distribution of recessionary effects will mean that the coming year should present both risks and opportunities for investors. With this in mind, investors will need to pay attention to some broad themes and specific corporate performance. Volatility will likely persist, and there's no guarantee of where markets will finish, but navigating the 2023 market will likely mean finding growth in a few areas of new market leadership.

As previously mentioned, value held up better than growth stocks in 2022. There's no compelling reason to think that the trend will revert to a growth-led market anytime soon. Value equities generally have strong balance sheets without as much leverage. Less debt means that a company will not need to refinance debts at higher rates. Value stocks also tend to pay more consistent dividends, a signal of fiduciary health. But caution is still warranted for value equities, and investors should pay attention to earnings compared to industry peers and the broader market. And, keeping growth in a portfolio is still warranted, as growth equities can provide compelling returns after a recovery, especially if investors are able to acquire growth stocks at reasonable prices during market dips.

Depending on the depth of a recession in the U.S., international stocks may also provide more upside going forward into 2023 and beyond. Assuming currencies moderate from 2022's swings in the U.S. dollar's favor, continued strong demand for commodities and the evolution of supply chains can provide a tailwind for global stocks.

Bond investors should have an easier time seeking returns in 2023. The bond market will begin the year with much more attractive yields than in 2022. Debt investors should not worry too much about an inverted curve, as solid returns are still possible across the yield curve, and the ebbing of rate hikes will likely mean yields will peak soon too. It's difficult to perfectly time such peaks. Investors can finally return to executing their individual strategies rather than managing the unmanageable damage of this rate cycle's record pace. However, running up risk should be tempered with the expectations that defaults will rise. Chasing yield will be tempting, particularly with higher yields on the shorter end of the curve, but a patient strategy, with an eye on risk, will probably reward long-term investors who stay the course.

The bottom line

There's no way to predict the impact of this rate hike cycle, as the effects usually appear in lagging economic indicators. Inflation can also be unpredictable. These forces will likely contribute to sentiment in 2023, but other investor-sentiment drivers will emerge as we work through economic contraction. Eyes will be on corporate earnings and forecasts. A bottoming of labor markets, which have only recently shown cracks, may be a positive signal. A recovery in housing markets and consumer sentiment will also be encouraging news. In the meantime, investors can breathe a little easier with rates much closer to a sustainable level entering 2023.

( Kavan Choksi is a successful investor, business management consultant and wealth advisor.)