Taming the dual beast: Managing market exuberance and inflation challenges in the second half of 2023

As economists anticipated a recession in early 2023, markets defied consensus expectations and exhibited notable trends and themes.

Since the last quarter of 2022, economists have been in a rare consensus zone. The first half of 2023 would see a recession in the US and in some other geographies, coinciding with peak or terminal interest rates. The Central banks’ interest rate cycle would peak, pause, and then reach rate cut territory by Q3; 2023 as economic slowdowns sharply brought down inflation.

In consonance with this “most forecasted” or “most anticipated” recession in history, market analysts were projecting a market fall in the first half of 2023, followed by a strong recovery in the second half of 2023 and well into 2024.

US interest rates were projected to be down 75 basis points by December 2023 and by nearly 2 percent by December 2024.

As complex, forward looking, rapidly adaptive mechanisms, designed to inflict the maximum pain on the maximum number of participants, the markets chose to not follow the consensus playbook. A recent estimate of short positions in the US market forecasted that bearish bets are probably sitting on over USD 100 billion of unrealised losses, from shorting stocks and indices that chose to soar, rather than sink.

Five major themes played out in the first half of 2023.

* Global economic growth slowed, but the most anticipated recession transformed into the most postponed recession. The China reopening trade disappointed and Chinese stocks too underperformed as a result.

* Inflation came down as supply chains got restored to more robust levels and because commodity prices fell on prospects of slower global growth.

* In geopolitical risk, Ukraine-Russia remained as a potential flashpoint and the US-China tensions grew as the biggest source of future risk. China has ended its strategy of ‘hide your strength and bide your time’ to emerge as a more assertive geopolitical player. The resulting Cold War 2.0 will remain a long-term issue to be priced into markets.

* Instead of “Pause and Cut”, the Reserve Bank of Australia and Bank of Canada surprised the markets by doing a cycle of “Pause, convert the Pause to Skip, Hike again.” The Fed remained adamant on “higher for longer,” leading to 2023 rate cuts being ruled out and the possibility of two further rate hikes in the second half of 2023.

* Financial conditions have tightened, with COVID-era fiscal deficits being reined in, and with higher rates having an impact on the broader economy, with the usual lag. One impact of this was the regional banking crisis in the US. Though stress tests by the Fed on the major US banks gave them a “Pass” mark, unrealised losses on bond portfolios of USD 600 billion plus remain a continuing concern for US banks. By acting fast in providing massive liquidity windows to banks, the Fed and the US Treasury were able to contain the fallout of the US banks’ 2023 crisis, but the wider impact is still a work in progress. The resolution of the US Debt ceiling till January 2025 was another relief for markets.

In terms of performance, both stocks and bonds had a strong start to the year due to resilient economic data, a bounce-back in profit margins and moderation in the market’s expectations for interest rates. Commodities finished the first half down due to cooling energy prices and weakening global manufacturing demand.

Japan’s market and the US Nasdaq (up 32 percent YTD) led the way. The Dow was up by a more sober 4.9 percent and the Russell 2000 was up 8 percent versus the S&P 500’s 16.9 percent. The rally was concentrated, driven entirely by the market’s largest stocks, with the top 10 companies in the S&P 500 accounting for over 95 percent of the index’s YTD performance.

Globally, DM and EM stock indices increased 11.2 percent and 4.8 percent respectively, as a weaker U.S. dollar and stable economic data in both regions buoyed returns even as China proved to be a dampener as recent economic data from China disappointed relative to expectations.

AI is promising to provide a thrust similar to the “internet boost” of the dotcom era, with technology stocks benefitting. Nvidia Corp, up 189 percent YTD, is the leading beneficiary among tech stocks.

Global financial markets are at a critical mid-year juncture. The Federal Reserve’s tightening cycle has likely reached near its peak with maybe two more rate hikes to come. China’s post-reopening recovery has underwhelmed so far and Xi’s control on the economy has meant that the stimulus from China has been much below expectations, especially in comparison to 2008.

The US has grown at 2 percent in Q1 and a similar performance seems well underway in Q2 as well. Europe appears to have avoided a sharp contraction to date.

Central bankers in the world’s 20 largest economies have now increased rates by an average of 3.5 percentage points each since they began tightening borrowing costs. However, neither Federal Reserve chair Jay Powell nor European Central Bank president Christine Lagarde expect inflation to return to their common 2 per cent target before the start of 2025. Central banks have been raising interest rates at the fastest pace since the 1990s, but the most severe bout of inflation in a generation is yet to be tamed.

Many developments over the last thirty years, from the share of services in the economy to outright house ownership to the still massive expansion of money supply post the COVID stimulus have increased the lag with which monetary policy transmission filters through to the broader economy.

Inflation therefore remains a challenge, and the sudden turbulence in the global banking system in March 2023 demonstrates that higher interest rates are having unintended consequences.

Looking ahead, investors should continue to be active and diversified, as the stock market’s narrow breadth, weakening expectations for forward earnings and the possibility of further rate hikes from the Fed could weigh on markets in the quarters ahead.

As the second half of 2023 begins, investors must face a balancing act between returns and risks as global economic growth slows, uncertainty lingers over the Federal Reserve’s path, and geopolitical tensions remain heightened.

The big themes we are looking out for in the rest of 2023 are:

– DM equities could lag, as we see a soft landing in the US and Europe with corporate earnings falling. We expect earnings to rebound in 2024 but a lot will depend on the trajectory of interest rates and inflation.

– Japan and EM equities look attractive with stronger growth, lower inflation and earlier easing of monetary policy in some Ems.

– Thematically and sector-wise, there may be a preference for defensive sectors over cyclicals as the soft landing sets in. The concentrated rise in the US markets on the back of the top 10 stocks could be followed by a sector rotation into defensives in a slowing economy marked by “higher for longer” rates.

– Soft economic growth without a recession in developed markets suggests that long duration, as well as higher quality investment-grade bonds could provide positive returns. – US dollar should stay strong: In currency markets, the US dollar appears attractive as investors are drawn to its safe haven qualities.

– For commodities, a lot will depend on a Chinese stimulus and revival. We see commodity prices recovering in 2024 and staying flattish in the rest of 2023.

While headlines about central bank actions, the impact of artificial intelligence, US-China tensions and the war in Ukraine dominate the news, we believe there are opportunities emerging for flexible investors.

Fixed income investments offer meaningful yields as well as an opportunity to play duration into a possible rate cut scenario in mid to late 2024 which can generate both good coupons as well as capital gains.

The big risk remains that of a non-soft economic landing and an overreach by central banks by raising and holding rates “too much higher for longer”, leading to a sharp recession. That remains a low probability event for now, but things could change in a matter of weeks.

The big opportunity stems from the fact that this has been the most anticipated and most postponed recession as well as the most forecasted bear market. If a huge majority is expecting that, markets will not oblige and will continue to rally.

Written by Ajay Bagga. Mr. Bagga is a market expert. He was MD and Head of Deutsche Bank Private Wealth Management, CEO of Lotus India AMC and Chairman of the Financial Planning Standards Board of India.

Views are personal and do not represent the stand of this publication.