Keep Rollin' (in 2023)
On September 6, 1620, a ship started a journey into the unknown from the city of Plymouth, South England. The goal of the people on board was the new world, the Hudson River in northern Virginia. As we know today, that journey influenced the founding myth of a whole nation. The arrival of the Pilgrim Fathers in the United States is celebrated each year on Thanksgiving, traditionally with the same meal, turkey.
Most Pilgrim Fathers on the Mayflower were people one can describe as extremists nowadays. Calvinists detached themselves from the Anglican Church and wanted full community autonomy. They believed that each congregation was directly subject to god and none else. Thus, conflicts with the English Crown were predetermined.
Some years before the Mayflower set sails, many of the Calvinists emigrated to the Netherlands, at first to Amsterdam, later to the City of Leiden, which attracted protestants from all surrounding countries after the Spanish reign spread over the continent.
However, even dutch Calvinism was not what those people wanted, so they decided to leave the Netherlands after 12 years and return to England. From England, they wanted to start their journey to the new world.
On the Speedwell, they sailed back to Southampton, where they went on board the Mayflower. After a short stop in Plymouth, the journey into the unknown started. Two months later, in November 1620, the Mayflower finally reached the American coast.
After arrival, the uncertainty was not over, and the people could only survive the winter because of help from the Native Americans. Especially the tribe of the Wampanoag was friendly to the immigrants. As it would turn out, the arrival also marked the beginning of the end of many North American tribes.
Similar to the Mayflower, the world economy faces uncertain times ahead. The first two years of the new decade were determined by multiple crises and put things in motion, which usually only change over half a century.
After 2020 and 2021, 2022 also had some surprising turnaround events for market participants, and some will have more substantial effects on economic and political developments down the road. Again, the new year will mark the start of a journey into the unknown.
The time of globalization, of more and more economic integration, is coming to an end after the pandemic has unveiled the disadvantages of worldwide branched supply chains and just-in-time production of goods.
Tensions between political rivals have increased, especially between the United States and China. Over the last decades, international trade flows have shifted. While the United States was the most critical trading partner for most of the world, China has slowly replaced it.
It was expectable that this shift would lead to political tension between those two. Since the beginning of the pandemic in 2020, the relationship has tensioned after both governments blamed each other for playing a crucial role in spreading the virus. The start of the war in Ukraine can be seen as the next step of escalation between China and the US, as Russia is an ally of China.
The start of the war marks a new division of the world into west and east. Currently, many nations in South America, Asia, and the Middle East are leaning towards China and not the United States. Long-term that could have several implications for currency markets, primarily because the west decided to freeze Russian FX reserves. Many countries will have to rethink the composition of their reserves down the road.
Nonetheless, the US dollar is still the world’s reserve currency. However, freezing the Russian reserves has exposed the vulnerability of dollar and euro reserves for countries that the west might consider enemies.
While European countries have continued to accumulate US treasuries as reserves (for example, Great Britain holds 1.5-fold more US treasuries than in 2017), South American and Asian states have already reduced them over time. After freezing Russian FX reserves, one can assume that this trend will continue.
Does that mean that the dollar supremacy will end? Not at all, because there is still no alternative to combat the US dollar’s status as the world reserve currency. However, the latest development might cause some nations to use their dollars, which they acquired through trade surpluses, to buy commodities.
Thus, one can assume that the dollar's importance will slowly vanish over time. If countries decide to use their dollar reserves to buy commodities, one will perceive a rise in demand for commodities and, thus, higher prices. The importance of tangible goods like oil, precious metals, or grains as economic reserves, which states can store domestically, will gain prominence over the decade.
Simultaneously, the times when the stock market produced gains year after year after year are coming to an end. Just like in the 1970s, it could be expected that the current decade will not be good for equity prices. Cyclical ups and downs must be scheduled over the coming years, revealing that the widespread buy-and-hold strategy will not be as fruitful as it was during the last thirty years.
Though, that does not mean that some stocks will not be a good investment in the coming year. Especially stocks within the energy sectors could be attractive for investors, as the industry has suffered from chronic under-investment, fueled by the west’s aim to swiftly switch from fossil to renewable during the green transition with a neglect of nuclear.
The world’s hunger for commodities is not over, and analysts expect a rising demand for commodities like metals and fossil fuels like oil or gas in the coming years. To satisfy the rise in demand, investments have to be made, and thus businesses in those sectors might turn out as fruitful investments.
While tech stocks have dominated the price action over the last two decades, the tide might turn during that one. Last week I discussed that tech companies have already started reducing their white-collar workforce, while industrial, blue-collar jobs are still highly demanded. That could be seen as a sign that higher interest rates have triggered a transition of the economy back to real economic production.
Also, the recent rise in consumer prices probably marks a reversal of the trend of the last forty years and signals that the times of low consumer price inflation are over. For years, the rise of globalization has led to an off-shoring of production to Asia and lower inflation rates. Still, since the pandemic, many politicians have talked about re-shoring production to countries considered friends to the west.
A friend-shoring of production will lead to higher prices, as friendly countries are not necessarily the ones where production is the cheapest. There are two scenarios of how consumer prices will develop further. If central banks are serious and keep monetary policy tight, even in times of economic weakness, then relative prices will have to adjust. If that happens, one can assume that this will lead to money flowing from the financial economy into the real economy, which will elevate consumer prices while asset bubbles deflate simultaneously.
However, if one considers the huge debt burden of the United States and other western countries, that might turn out as an impossible task. The US and Europe are currently trying to dampen inflation pressures via higher fiscal spending. Yet, the politicians overlook that this will help keep inflation elevated and force central banks to a higher for longer policy stance.
Jerome Powell repeatedly said the Fed would only change its recent tight stance on monetary policy if a systemic financial risk occurs. Still, a weakening economy and a possible recession might lead to a Fed pivot next year.
If one assumes that equity prices are forward-looking, we could expect the inflation rates, which have fallen since June, to fall further to somewhere between 3 and 5 % in the second quarter of 2023.
Chart 3 also indicates that it is not impossible for inflation to fall even further if it turns out that the economy is not as strong as markets expect. Inflation will probably fall even faster after the November bear market rally ended in December.
If you remember, I pointed to rising inventories last week, which could be a warning sign, and that the latest positive surprises in US business earnings might soon turn into negative ones. More profound than expected earnings cuts would be a deflationary impulse which, possibly paired with a credit shock, might lead to a Fed pivot.
Nevertheless, that does not mean that one should position for a pivot immediately because one could assume that stocks and bonds will sell off further in such an environment. But the moment the Fed pivots, I expect it will lead to chances for some tactical longs in tech stocks because I assume that market participants will think that the good old times of the last thirty years are back.
Another problem investors should be aware of, however, is that central banks are currently out of sync. While inflation will drop in the United States, inflation in the eurozone is still at 10 %, and fiscal policies and price caps on energy on the consumer front are fueling it further. Therefore, assessing how the ECB would react in such a scenario is challenging.
The situation in Europe is much more precarious than in the US because Europe is highly dependent on energy imports, and the United States is self-sufficient from an energy perspective. Europe has significantly lowered natural gas imports from Russia since the war started. In contrast, it has banned Russian oil entirely from the market and thus has to buy oil from other suppliers.
This week, EU countries agreed on a price cap of €180/MWh (roughly $56 per million British thermal units) on natural gas. The problem here becomes apparent when we look at the times when gas prices spiked over that level this year. It was when EU nations desperately bought gas on the world market to refill storage and bid up the price. As European prices rose, suppliers rerouted their LNG deliveries from Asia to Europe, but that would not have happened had the cap been in place. Hence, it is possible that the supply would shrink if the situation repeats.
Given the current situation, Europe will suffer economically and lose attraction for investors in the coming years solely because of permanently high energy prices. In Austria, energy supplier EVN noted that gas prices would stay high even after a possible end of the war in Ukraine. Many companies are already thinking about shifting production away from Europe, while others, like fiber manufacturer Lenzing AG, plan to cut jobs.
That is currently contrasted by an improvement in business and consumer sentiment, but I think this is caused primarily by the significant fiscal stimulus of European governments. Fiscally, Europe is already in a bad situation because of the pandemic, and I doubt the situation will improve in the coming years. On the contrary, the rising fiscal stimulus could lead to a scenario where it might force the ECB to tighten more aggressively while the Federal Reserve is already loosening.
While I expect that rates will start to fall somewhere between Q2 and Q3 next year, I still think that interest rates and inflation will rise further over the medium term, higher than market participants currently expect. Depending on the response of central banks, inflation may reach new highs medium-term because not only can one expect inflationary impulses from the side of production but also the wage side.
Population growth has fallen for years, but now the baby-boomer generation is coming close to retirement while fewer young people are joining the workforce. That means that wage pressures will increase at a point where economic growth will likely stay low because of the shrinking share of the working population. The only way to boost economic growth is through technological progress, but therefore one needs higher real economic investment and higher interest rates to channel it there.
Given the current economic environment, I think businesses engaged in energy (oil, gas), agriculture, and metals (precious metals and those needed to deliver the green transition) will profit medium term. However, short-term and given the current economic slowdown due to the monetary tightening, commodity prices might have some room to fall further.
Still, as commodity prices are more affected by supply factors than demand, I would expect a limited downside. If central banks loosen monetary policy again, the added liquidity will cause demand to rise faster than supply, leading to higher prices.
Looking at currency markets, the dollar has depreciated quite a bit in recent months. Still, given the economic turbulence in Europe and Asia, I think the dollar is poised for another rise in the coming months. The latest fall in the exchange rate was primarily caused by the expectations of market participants that the Fed will hold rates steady while central banks elsewhere will continue to tighten.
Nonetheless, the composition of the eurozone combined with the vast indebtedness of some member states might turn out to be like a millstone around the ECBs neck. The announcement that the ECB will wait to start Quantitative Tightening at the end of Q1 2023 suggests that the ECB might still hope it can avoid it.
After Powell and Lagarde crushed hopes for a strong rally into new years eve last week, short-term stock market gains should be limited. We will probably see stocks moving sideways, and volatility likely remains low.
Considering bond markets, it is still too early to think about recovery. Moreover, Powell and Largarde’s comments from last week suggest that we might retest this year’s lows. So, if you are hoping for a central bank pivot, you can hope for better entry points. If the Fed is signaling a pivot somewhere in the first half of the coming ear, that might signal the beginning of a rally in the bond market.
The fact that most analysts and economists think that the US is headed for a mild recession causes me to assume that we can either expect a severe recession or no recession. However, my hunch says that a deep recession is more probable.
Despite the improvement of sentiment in the euro area, one can assume that the recession will be deep because I expect fiscal policy to reach its limits soon next year. A new sovereign debt crisis is still possible as debt to GDP ratios are still around 90 %, despite high inflation.
Regarding the US, one needs to await the coming economic numbers because if profit margins do not fall as much as I expect, falling inflation means that real earnings will rise and thus delay a recession. Further, it would mean that the Fed will have to be restrictive for longer until the shrinking liquidity shows some effects.
My base case for 2023 is that stocks and bonds will have trouble starting into the year. Inflation will fall further in an area between 3 and 4 %, and probably that or a more profound inflation drop, possibly paired with a credit event, will force central banks to reverse course.
If central banks reverse course, I expect bond prices to rise and stock prices to follow with a lag driven by increasing liquidity. However, as a result, inflationary pressures will build up again until year-end and start the second inflation wave. At that point, tech stocks will come under pressure while the demand for real goods will keep commodity prices elevated or push them higher. At that point, market participants will realize that they underestimated inflation pressures in the long run, and long-term interest rates will spike again.
Definitely, the world economy is chartering unknown territory again, similar to the Pilgrim Fathers around William Bradford in 1620, when they left Plymouth in southern England. The events in 2022, the reoccurring conflict between the west and the east, high inflation, the war in Ukraine, and the energy crises have intensified economic uncertainties.
Overall, 2023 will be an exciting year (again) politically and economically!
Keep rollin’, rollin’, rollin’, rollin’ (uh)
Keep rollin’, rollin’, rollin’, rollin’ (what?)Limp Bizkit - Rollin’
Have a great Christkind (Austrian version of Santa) and a great start to the New Year!
Fabian Wintersberger
NOTE: That was my last blog post this year. The next post will be published on January 13)
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(All posts are my personal opinion only and do not represent those of people, institutions, or organizations that the owner may or may not be associated with in a professional or personal capacity and are no investment advice)
pretty interesting investment decision tree for 23 could be constructed based on your reasoning.
I find it so interesting to read all the different views of the upcoming year, and yet, at times, I think we are better off not trying to game out the results, but rather responding to the impacts of all those things that are going to come along out of the blue while maintaining a stable, product diversified baseline portfolio