On the Brink of Overtightening

With peak inflation behind us, peak policy rates should follow. The focus shifts back to growth concerns.

Across the world, 2022 has been an incredibly challenging year. Global economies are grappling with inflation, central bank tightening, and expectations of lower economic growth — each of which signals caution for investors. Looking to 2023, we expect market uncertainty and volatility to persist for some time, leading to a bumpy journey ahead with a wide range of possible outcomes. We anticipate more clarity will be achieved in 2023 as we see rates peak in much of the developed world, but what follows is anything but clear. 2023 will not be a straight path. Many risks to a sustained recovery remain.

We remain nimble as we brace for an uneven, turbulent journey in the coming months. We expect 2023 to be a time of “Navigating a Bumpy Landing.” Amid this market volatility, we continue to be underweight risk assets. We favor quality assets in equity markets and a “barbell” strategy in fixed income, i.e., establishing cash and long-term positions. Caution is warranted given the potential for both persistent inflation and overtightening by central banks, but we expect a better environment for risk-taking to emerge in the second half of the year.

In these challenging times, we are focused on issues that are top of mind for investors. Increased market volatility is causing investors to seek downside protection to strengthen their portfolios for all seasons. A cash cushion provides capital preservation, much needed yield, and dry powder to deploy as the macroeconomic picture brightens. Long bonds, particularly Treasuries and investment grade credit, have backed up to levels that look attractive unless inflation fails to moderate, which is not our core call. And a less strong dollar will provide better risk-adjusted return opportunities for non-US assets. We explore these themes and more in this year’s Global Market Outlook.

2023 Outlook

The global economy is rapidly slowing as the current monetary tightening cycle unfolds at top speed, particularly in developed markets. Central bank efforts to tame inflation will inevitably cause some harm in terms of growth and employment, but for now this damage represents an acceptable tradeoff — economies will experience some short-term pain in exchange for long-term gain, and markets will experience some short-term volatility in exchange for long-term stability.

The speed and aggressiveness of these hiking moves concern us, in a world where equilibrium is very hard — perhaps even impossible — to achieve. After all, we are still dealing with the protracted war in Ukraine and its troublesome implications for European energy supplies, as well as with the lingering effects of the pandemic on supply chains, migration, and human behavior. There are plenty of wild gyrations in the current macroeconomic data but no clear indication of where these indicators will ultimately settle. We are therefore reluctant to extrapolate too much from this moment in time.

Policy Risk and a Strong Dollar

Against this backdrop, the risks of overtightening seem considerable. While inflation remains unacceptably high at the moment, a whole range of leading inflation indicators — led by oil prices — suggests that a powerful disinflationary episode lies ahead. Evidence that inflation expectations are de-anchoring seems scant. And while the debate about a new, higher global inflation regime is pervasive, the timeline and magnitude of such a potential shift is highly uncertain and, in our view, improbable.

The global economic slowdown has intensified across both developed and developing economies (see Figure 1). Unsurprisingly, we have lowered global growth forecasts, particularly for next year. We now see global growth at just 2.6% in 2023, a number that is half a percentage point less than it was three months ago and meaningfully below trend. Risks remain to the downside. The substantial appreciation of the US dollar year-to-date has intensified global growth challenges and, while it has reversed quite a bit recently, could still expose other, unanticipated vulnerabilities.

The global macroeconomic and geopolitical environment remains especially challenging for the emerging markets (EM) universe, particularly in economies that are more vulnerable to pricing shocks from energy, food, and raw materials. Coupled with the ongoing monetary policy tightening cycle, the continuing slowdown in global demand, and the current tensions between the US and China, we see a difficult near — term backdrop for EM growth.

A Brighter Horizon Ahead?

Our core view is that, despite these vulnerabilities, at some point over the next 6–12 months conditions will likely begin to improve. A key signal of such an improvement would be clear evidence that the inflation surge of the past year is beginning to subside. We are optimistic that inflation — in the US and globally — will trend visibly and materially lower within the next six months. This would, in turn, facilitate a reset of expectations with respect to how long policy interest rates need to remain deeply in restrictive territory. As markets adjust to this future dovish shift, the dollar would likely take a bit of a breather, supporting financial stability in emerging economies.

Demand — particularly goods demand — is unlikely to rebound in any meaningful fashion over the course of next year. Goods demand broadly (but especially in the US) first needs to normalize lower to correct for the Covid-induced overshoot. The only notable exception to this downshift is automotive demand, where supply limitations have precluded the rebound in sales seen elsewhere in the goods complex. Commodity demand, however, is likely to remain robust, specifically for energy and foodstuffs. We also see opportunity for replenishment of inventories, supporting prices and export revenues for a wide swath of emerging markets.

Despite the underwhelming demand outlook, we anticipate some moderate improvement in emerging markets growth performance in 2023, driven primarily by an acceleration in China. This, in turn, reflects easier base comparisons following a sub-par 2022 performance, a modest recovery in housing investment, and — most importantly — an easing of domestic Covid-related mobility restrictions.

Finally, 2023 should bring about some improvement in the geopolitical landscape. With key political events (China’s Party Congress, US mid-term elections) out of the way, there are compelling reasons for the US and China to seek to scale back their rhetoric. Likewise, though there is no clear off-ramp in the Russia-Ukraine War at the moment, such an opportunity could present itself over the course of next year. The extended duration of the conflict and associated human and economic costs should create incentives for some degree of de-escalation, all of which would help restore confidence.

Macro Takeaways

The global economy is rapidly slowing as the current monetary tightening cycle unfolds, and we are on the brink of overtightening. Against this backdrop and in a challenging geopolitical environment, over the next 6–12 months we expect to see an inflection point, after which conditions should begin to improve. We recognize that a turbulent journey lies ahead with elevated volatility in rates and inflation.

• Global growth will slow into the new year, with US and European growth not much above zero. Risks are to the downside. We expect sub-trend growth into 2024.
• Improved supply and slowing demand allow a powerful disinflationary episode to unfold by mid-2023.
• More favorable inflation data allow the Fed to downshift from its hawkish stance, leading to rate cuts potentially in Q4 2023.
• Peak US rates should lead to a US dollar decline (if global growth dynamics do not deteriorate further).

We do believe that markets will begin to recover in 2023, but we also believe that the pain that investors currently feel may be with us until mid-year, if not longer, with the exact timing of the relief tied to the actions of central bankers. A meaningful lowering of inflation, and some earnings growth visibility, are necessary to enable risk assets to find their bottom. We remain vigilant in looking for conditions and signals to improve. Until then, caution, patience, and agility are warranted.