2023 Outlook2023Outlook

Overview

Despite market volatility, rising interest rates and creeping inflation the multi-asset team’s nimble, systematic approach identified some potential areas of opportunity for asset owners:

• More attractive valuations have contributed to higher equity forecasts, while rising yields are driving fixed income return forecasts higher.
• Market valuations outside the US are more favorable. Forward multiples for EAFE equities are very attractive compared to their 20-year history.
• Asia may present a number of interesting opportunities. China's economic activity is expected to accelerate given the relaxation of its zero-COVID policy, and while Japan's growth is likely to slow relative to 2022, it may hold up better than growth in either the US or Europe, driven by solid consumption and improving investment spending.

Executive Summary

Economic Outlook

• The global economic outlook for 2023 is extremely uncertain with a range of possible outcomes. We think there is a high risk of economic downturns across much of the developed world.
• The global economy was plagued by persistently high inflation in 2022, prompting dramatic central bank tightening to try to bring inflation under control. Russia’s invasion of Ukraine led to a surge in energy prices, further exacerbating inflation and making the task of central banks even more difficult.
• Europe is most vulnerable to recession (and may already be there given the severity of its energy shock and high dependence on Russian natural gas). Manufacturing disruptions stemming from war-related supply chain issues and deteriorating consumer and business sentiment underline downside risks for Europe.
• The UK’s economy is likely to shrink in 2023 as high inflation cuts into real spending, the government pursues austerity measures and businesses put spending plans on hold.
• Compared to Europe, the US is heading into 2023 on a firmer economic footing, thanks in large part to the still-strong labor market. Although a US recession doesn’t look imminent, we think one is likely on the horizon as the economy contends with ongoing monetary tightening, elevated inflation, negative wealth effects and a correcting real estate sector.
• The US bond market yield curve remains deeply inverted, historically an effective recession signal.
• Japan’s 2023 growth may hold up better than growth in either the US or Europe, driven by solid consumption and improving investment spending. Nevertheless, Japanese growth in 2023 is likely to slow relative to that of 2022.
• One exception to the deteriorating growth among major economies is China, where we expect economic activity to accelerate given the relaxation of its zero-COVID policy.
• Inflation is likely to have peaked in late 2022 as lower commodity prices and easing supply chain bottlenecks appear to have pushed inflation lower. Inflation could retreat significantly in 2023, especially in the context of likely economic recessions. However, there is a high risk it could remain above the comfort zones of central banks.
• Major central banks retain hawkish positions as we enter 2023 and signal they are unlikely to pivot until there are clear signs that inflation is sustainably slowing towards their targets. Given the uncertainty on inflation we see high risk of policy mistakes among central banks in major economies.

Market Outlook

• Financial markets were hit by multiple shocks during 2022, leaving investors few places to hide as both stocks and bonds posted significant declines.
• While most asset segments posted negative returns, commodities were the exception, advancing by double digits and further burnishing their credentials as effective inflation hedges.
• Economic and earnings growth stayed positive in 2022. With considerable risk of a global economic downturn and increased prospects that central banks could make policy mistakes in their attempts to tame inflation, the earnings landscape looks poised to change for the worse in 2023.
• We see considerable scope for earnings downgrades in 2023 and US earnings could fall 10%-15% in a moderate recession.
• While US equity valuations have improved over the course of 2022, they remain elevated. If 2022 was the year of downward valuation multiple adjustment, 2023 will likely be about economic recession and earnings downturn.
• We see room for US stocks to correct further and set a new low before reaching a durable bear market bottom, probably in the first half of 2023. Stocks will likely recover sharply after this trough as investors begin discounting eventual economic and earnings recovery.
• Outside the US, market valuations remain more favorable. Forward multiples for EAFE equities are very attractive compared to their 20-year history.
• The short-term outlook for commodities is challenged in the face of recession risk but still very positive on a multi-year horizon given the strong demand outlook combined with constrained supply.
• Given the carnage bonds experienced this year, yields (and potential returns) on major bond indexes look more attractive than they have in some time. Recession risk and the end of central bank tightening in 2023 should exert less upward pressure on yields. This could result in fixed income outperforming equities in 2023, especially on a risk-adjusted basis.
• One silver lining is our improved 10-year return forecast, as represented by our Capital Market Assumptions (CMAs) following dramatic moves in markets this year.
• More attractive valuations have contributed to higher equity forecasts, while fixed income return forecasts have been revised considerably higher given the rise in yields across multiple sectors.