For the 2023 outlook, we see a Global Economy that is facing the most disparate set of financial challenges this century. The post-GFC and pre-Covid decade was characterised by steadily falling interest rates in all regions, providing a tide to lift all boats across increasingly correlated global equity markets.

This goldilocks environment is over, the return of inflation breakouts, energy supply shocks, and tighter monetary policy are leading to diverging fortunes. Nowhere are these diverging fortunes clearer than in the world’s three main economic regions – North America (USA), Europe, and Asia (China) – each facing a wage-price spiral, energy shocks, and a property crash respectively. This is the first time in many decades that these economic powerhouses are not moving in lockstep.

In our 2023 Global Economic Outlook, we will outline the key issues, likely outcomes, and investment implications of the world’s major economies. This will be followed by our 2023 Asset Allocation Guide, which will draw on this report and our previously released outlooks for Australian Equities, Property, and Interest Bearing Securities.

The problem in the US can be simply summarised as too much economic activity for too few workers. This has driven wages growth above 5% per annum, a level that is too high for the US Federal Reserve’s mandated 2% inflation target, forcing tighter monetary policy (higher interest rates) to reduce job creation and lower inflation. Given the size and speed of this rapid tightening cycle, a recession in the US is likely in 2023.   

Key Issues

Throughout the pandemic the US provided more direct fiscal support to households and businesses than any other major economy, spending over 25% of GDP (Figure 2). This fiscal stimulus ‘primed the pumps’ of the economic recovery in the year following pandemic lockdowns. This was first evident in elevated spending on Goods – electronics, homewares, clothing – and has now shifted to spending on experiences – dining out, travel, entertainment, etc.

It is important to note, that whilst a shift in spending to Services from Goods is GDP neutral, it is not employment neutral as Services are typically more labour intensive than Goods production. This has driven a sharp increase in the number of available jobs (green line Figure 3), which has surged past the pre-pandemic peak.

Simultaneous to the current jobs boom is a worker shortage with roughly 3.5 million people exiting the workforce during the pandemic and failing to return. The reduced workforce is primarily due to workers over the age of 55 entering early retirement following the high levels of job layoffs during the early stages of the pandemic.

This fall in employment participation is unique to the US when comparing to its Global peers, as it didn’t implement a Jobkeeper style support package that tied the worker to their employer. This severing of employment relationship appears to have made it difficult for older workers to reengage in the employment market. The outcome is an unprecedented gap between available jobs and available workers (Figure 3) that has increased competition for workers, driving up wage growth to over 5% per annum for the past year.

A little wage growth is good but too much can fuel inflation to uncomfortable levels, as wages growth has a strong correlation to Shelter & Services inflation (Figure 4), a key driver of core CPI. This is the current situation in the US, and it is known in economic circles as a wage-price-spiral. High wage growth drives higher prices, leading to higher inflation and in turn higher wages.

As the figure below illustrates, the current level of wage growth is inconsistent with the US Fed’s mandated inflation target of 2%. To achieve its goal, the Fed needs wages growth (and therefore services inflation) to fall to no higher than 3.5%.

Likely Outcomes:

Energy prices go up-and-down, but wages only go up. The solution to the economic woes in the US might sound simple – lower wage growth by 1.5% – but history has shown that wage growth tends to be sticky and monetary policy a blunt instrument akin to cracking a walnut with a sledgehammer.

If the Fed can engineer a steady uplift in unemployment and a slowing of wage growth without causing a recession (a so-called soft landing) then US Equities will rally strongly in 2023. Conversely, a steep increase in unemployment coupled with a recession (hard landing) will likely result in a second consecutive year of negative returns.

Looking at history a soft landing is the exception rather than the rule, with only 4 of the last 11 rate hike cycles avoiding an eventual recession. Looking at each of the four successful soft landings in turn (Table 1), we see that they required a supporting hand from an external party.

Typically, a soft landing has tended to occur when: inflation was relatively low at the onset, unemployment was high (and didn’t rise significantly), and rate hikes were small to moderate in size. Further, the Fed has never successfully managed a soft landing when the unemployment rate has risen by more than 0.5%; we forecast that a 1-1.5% increase in unemployment is required to dull wage driven inflation pressures.

Overall, the current environment conditions point to a difficult, but not impossible, environment to manage a soft landing by the Fed in the year ahead.

Investment Implications:

A recession in the United States in 2023 is the consensus view of market, and probably the most widely anticipated recession in history. Does this mean that the downside is fully priced into markets?... Sadly, no.

The market declines in 2022 are due to falls in the price-multiple (PE ratio) for equities from their historically high starting point in January, as interest rates (and bond yields) have risen. The change in EPS (black line) has so far been inconsequential, should a recession occur in the year ahead, history suggests that EPS would fall a further 20-30%.

The potential fall in EPS would be mirrored by the S&P500 Index, given its high weighting to expensive growth / long duration sectors (i.e., Tech). However, this uncertainty is creating opportunities in other parts of the market. We favour a balanced approach between defensive investments in Staples and Healthcare with an allocation to well-managed, industrial companies at favourable valuations that can benefit in the decade ahead in a higher inflation, higher interest rate, higher fiscal spending environment.

As the toll from Russia’s invasion of Ukraine continues to rise, the growth outlook in Europe deteriorates, while inflation shows little sign of abating in a historically tight labour market (6.6% unemployment). It is expected that half of the countries in the eurozone will experience a recession over the European winter as elevated heating costs bite into consumer spending.

Key Issues

The embargo on Russian oil and gas pipeline shutdowns following the invasion of Ukraine has triggered a supply-side price shock in oil and gas markets, with natural gas prices increasing by up to 6-times before settling at double the start of year price. The issues haven’t been isolated to oil products, with Ukraine and Russia accounting for ~30% of global wheat exports. The loss of this production is flowing through to food prices across the continent (and the world).

Like other Developed Markets, the Eurozone is experiencing a period of relatively low unemployment, at 6.6%, this is the lowest since the launch of the common currency. The tightness in the labour market has seen bourgeoning wage rises and the broadening of inflation to domestic service prices.

On the back of these commodity market dislocations, other war-related cost pressures, and the lingering effects of the pandemic, inflation in Europe has soared to double digit, multidecade highs. Placing central banks in the unenviable position of needing to increase interest rates into a weakening economic outlook.

Forecast Outcomes & Implications

The policy response will aim to give with one hand and take with the other. Walking an extremely tight line between tightening macroeconomic policies, fiscal & monetary, while helping vulnerable households and firms cope with the energy crisis.

While the strong labour market and pandemic savings have supported household incomes in 2022, we expected to see falling real incomes combined with higher spending on non-durables, such as good and gas, weigh on consumer demand and ultimately drive most of the continent into a recession over their winter months.  

The risk of further energy market disruptions looms large over the outlook in Europe, but thus far the energy storage and saving measures have avoided forced shutdowns in energy-intensive industries. We expect to see further targeted support for industries to prevent medium-term output scarring, and a higher share of household spending on essential goods and services. Investments in the region should be selective, to capitalise on uncertainty in markets.  

China finally finds itself in the same place that most Developed Markets experienced in mid to late 2021; relaxing Covid restrictions and reopening the economy. Whilst this process will be slower than other regions, the policy headroom provided by low inflation should enable fiscal stimulus that will support stronger consumption growth in 2023. Risks in the form of a further deterioration in the property market, weaker export growth, and further trade decoupling are present, but after a terrible 2022 the year ahead will show marked improvement.

Easing lockdowns

As we noted earlier in 2022, China’s lower number of hospital beds per capita, lack of an mRNA vaccine, and lower vaccination rates has inhibited their reopening in 2022. Whilst many of these challenges remain, the balance from policy makers has shifted to a pro-opening stance to reduce the negative economic impact.

The timing of the reopening will be dependent on a scaling up of medical preparation but it is likely to start in the second quarter of 2023. We expect that China’s pathway to reopening will be a stop and start process similar to the experience of Taiwan, with Covid cases surging due to lower prior infection and vaccination rates, leading to mobility restrictions and likely production issues (worker absenteeism).   

The relaxation of restrictions is a positive step forward for Chinese growth, albeit with a short-term drag, that should drive above-trend consumption growth in the second half of the year as pent-up demand enters the market.   

No Inflationary Pressures

As a major exporter of goods to the world, China has been largely immune from the supply-chain inflation that impacted global economies during Covid. This, coupled with its non-participation in the Russian oil embargo and extended lockdowns has kept inflation relatively low at 2.1%.

Consequently, China is at a very different point in the economic cycle to developed world economies with the ability to deploy additional fiscal and monetary stimulus to support the economy during its (likely) stuttering reopening. Using credit impulse as a proxy for monetary policy, we can see that the tighter restrictions in 2020 were relaxed at the end of 2021, and this is expected to flow through to the real economy as it reopens.  

Risks: Property Downturn, Trade Decoupling & Weaker Exports

The future appears to be brighter in the year ahead, but it is not without its risks and challenges, we highlight the key watchpoints below:

• Property – The near 40% contraction in new housing starts and the boycotts on mortgage repayments will be a drag on economic growth given property indirectly contributes 25% to GDP. However, the policy actions to support troubled developers in delivering pre-sold homes, cutting mortgage rates, and increasing lending from banks should stem the downward momentum.

• Falling Exports – As we have outlined in the previous sections on the US and Europe it is likely that demand for Chinese goods will fall due to a combination of recessions and shift to services consumption. Our base case it this will be moderate, but risks lie to the downside.

• Trade Decoupling – We expect to see further trade decoupling in select, strategic, high-tech industries, as demonstrated by the recent controls implementation by the US on companies exporting chips to China using US tools or software. However, outside of sectors with defence capability implications, we expect China to expand its market share.

• The economic environment in the United States is not supportive of a soft-landing to the current, rapid, and large tightening cycle.

• The equity market falls in 2022 are due to de-rating of equities from historically high valuations in response to higher interest rates.

• Current pricing implies that markets are positioned for a very mild US recession or softish landing; with EPS falls of a further 20-30% likely if a stock-standard recession occurs.

• The Eurozone will likely slip into recession over their Winter due to surging power and food prices impacting consumer spending.

• The easing of restrictions in China and policy headroom should support strong growth in consumer spending and GDP.

• In equity portfolios, we favour a balanced approach between defensive investments in Staples and Healthcare with an allocation to well-managed, industrial companies at favourable valuations.

• Over the medium term, we expect ‘old-fashioned’ industrials to outperform in an environment of higher investment, higher inflation, higher interest rate, higher fiscal spending.