Remember this tongue-twister of “P” words as you aim to keep your investments straight this year: peak; pause; pivot; put; pitfall; persistence; pain, panic.
Investors in U.S. markets can expect all of this in 2023, following a disappointing 2022 that brought the highest inflation in decades, the sharpest interest rate rise in recent history, and falls in asset values: global equities declined around 20%; bonds were down 15%, and real estate markets weakened. The average diversified portfolio (60% equities/ 40% bonds) lost 15%.
The new year has ushered in optimism about a more modest downturn than earlier projected and abating price pressures. This has driven asset markets higher. Even previously eviscerated cryptocurrencies and unloved tech stocks have risen.
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The bullishness is underpinned by four “P” words: peak (on the assumption that inflation is reversing ); pause (rate rises will halt soon); pivot (rate cuts later in 2023), and put (central banks will continue to underwrite equity and real estate prices to avoid destabilising the financial system).
There is a caveat to this rosy forecast: “pitfalls.”
Core inflation (currently running at around 5%-6%) ia unlikely to fall to central bank targets (2%-4%) for some time. Prices, especially of essentials (housing, food and energy) will remain high for several reasons.
The real driver of inflation — supply issues — remains unchanged. Labor markets shortages and wage rises will flow through into prices. The Ukraine war shows no signs of resolution. The effects of the West’s oil price cap and increasing cooperation between Saudi Arabia and Russia on energy markets are unknown. Despite the relaxation of controls, the effects of COVID-19 on Chinese production remains uncertain.
Moreover, longer term factors — including geopolitical events (sanctions, trade restrictions), resource scarcity, climate change-driven extreme weather events that affect food and transport links and deglobalization, especially reshoring or “friend-shoring” — also will increase costs.
Government’s fiscal missteps also continue. In the U.S., for example, the 2021 American Rescue Plan and the U.S. Inflation Reduction Act, along with the substantial cost of living and energy subsidies in advanced economies, will boost demand at a time when economies lack spare productive capacity. A Chinese recovery, central to upward revisions of growth projections, also may increase commodity prices.
“ Policy mistakes are likely. ”
Investors’ touching faith in central bankers accurately reading events and implementing the policies may be misguided. It is worth remembering that these same officials failed to act in a timely fashion because inflation was “transitory,” believe that higher rates can fix supply side problems, and created the current asset price bubbles with reckless monetary policies. Policy mistakes are likely.
Three additional ‘P’ words may be relevant for investors in 2023:
Persistence: Prices may remain high. Interest rates could increase further. Central banks might have to be more aggressive than expected. Rates could remain at elevated levels (by recent standards) for longer than anticipated. With wage increases lagging actual price rises, reduction in disposable income and discretionary spending may slow economic activity.
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This will exacerbate the effects of already slowing consumption, which was financed in 2022 by excess savings (G-7 households accumulated around $3 trillion or about 10% of annual consumer spending from pandemic stimulus and lower outlays in 2020-21).
Pain: A longer than expected period of higher interest rates will test the debt servicing capacity of both governments and households (mortgage debt). In Europe, sovereign debt remains high in France (government debt at 113% of GDP), Greece (193%), Italy (151%), Portugal (127%) and Spain (118%). Higher borrowing costs and reduced debt purchases by the European Central Bank may reignite the unresolved 2009 European debt crisis. Overindebted emerging markets face financial distress. Losses will hit both banks and investors.
Other concerns include the opaque, large shadow banking system, overextended valuations (despite some retracement), and highly leveraged transactions that proliferated during the past decade. The problems of Archegos and U.K.’s Liability Driven Investments schemes highlight hidden risks that may emerge.
The values of private market unlisted investments , to which institutions and high net worth individuals are increasingly exposed, have not, to date, reflected the falls in public market prices. Given that these frequently highly leveraged holdings are affected by higher rates and ultimately will need to priced against public benchmarks, unpleasant write-downs would not be surprising.
Panic: The ability of asset holders to ride out a prolonged period of higher rates and lacklustre growth remains unknown. As history illustrates, price falls, margin calls, forced selling as investors seek to generate cash, illiquid markets, suspension of redemptions and falls in credit availability can fuel a rapid negative financial cycles.
In the final analysis, it is difficult to see how a highly-levered system dependent on low rates and abundant liquidity can easily and painlessly adjust to a world facing multiple challenges or a poly-crisis. Replacing the magical thinking of the last decade with wishful thinking won’t serve investors well.
Satyajit Das is a former banker and author of A Banquet of Consequences – Reloaded ( 2021) and Fortunes Fools: Australia’s Choices (March 2022)
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