2023 macro scenario and the ways to use it for the portfolio man
To set a dollar investment strategy for the year ahead, we need to be aware of the macro context.
The current situation resembles the beginning of two stagflations in the early 1970s and 1980s which were characterized by accelerating inflation after reaching its bottom due to record-low unemployment, and the Fed’s rate hike to combat the inflation surge.
Now we see real GDP falling while nominal value is increasing, but unemployment is still at its lows.
We see similarities in the sharp rise in inflation that led to the Fed’s rate hike, but the 2021-2022 inflation surge is different in speed: before the 1970s and 1980s the stagflation rates increased gradually over 3-4 years, but now after low covid base and record amount of money printed the rate is more rapid.
We believe the end of 1969 is similar to the current situation. We see two consecutive quarters of declining real GDP, several quarters of persistently high inflation, which was 1-2% before the acceleration, and the unemployment at the same low level of 3.5%. The Fed’s rate continues to peak, in 1969 it was at its highest level. The consumer also was strong, income increased before and during the stagflation.
Given the experience of the 1970s, the rate exceeded inflation and it resulted in a slowdown, but there was no sharp fall in inflation, it was only 1 percent below its peak for almost a year. That makes sense as strong consumer and gradually weakening but still strong labor market kept inflation from sharp drop. The same factors are in place now, so we expect inflation to be 7-8% in 2023.
The most important factor is rent, which affects inflation with a 6-month lag, it gives + 0.2% MoM. We expect this effect to persist at least till May. Food and other gives +0.3 MoM as most conservative case for 2022. This will lead to core inflation of at least 5% YoY. In addition, higher gasoline prices will result in 5-6% of inflation. Given the situation in housing and oil markets, cumulative inflation could be around 7% by March 2023 and around 5% by May.
Accordingly, the Fed’s rate could reach its peak at 5.75-6.0%.
THE FED'S ACTIONS DURING RECESSION
Given the increase of 0.5% after each subsequent meeting, the rate will peak in June 2023 at 6.25-6.5%.
In the 1970s, the Fed’s rate peaked in August 1969, stayed near the peak over six months, and started to sharply decline in February.
Now the rate’s peak is still to come. We should understand that the Fed does not necessarily stop raising rates if the economy falls into recession. The abovementioned example shows that in 1974 8 months passed from the start of the recession to the rate peaks, and the graph below shows that in 1980 3 months passed from the start of the recession until rates peaked.
LET'S FOCUS ON WHAT A RECESSION IS
Contrary to what many people believe, it is not the GDP decline alone but a combination of factors that have been underway over several months :
So, even if real GDP declines, while employment is record-breaking, it is not yet a recession (as we observe in 2022). The NBER is the official source of the start and end dates of recessions in the US. It provides the following definition: “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”
More details of how and why the NBER identifies the beginning and the end of recessions are available here.
Also, there is a very handy dashboard that displays online all the indicators the NBER looks at when determining a recession– here.
Most indicators do not show the recession yet, and probably it will not appear in the next few months.
THE RECESSION TRAJECTORY EXPECTED IN 2023
There was a big collapse in global bond markets, especially in longs. As a result, those who had savings in bonds lost in nominal terms, and even more in real terms, i.e., adjusted for inflation.
What causes the loss of purchasing power:
Losses on investment accounts (stocks, bonds, and mixed funds)
Higher energy and utility costs in Europe due to multiple increases in gas prices
Gasoline prices growth in the US
Rising interest rates on loans, including housing mortgages
The economy's big surge in 2021 was driven by record liquidity and low rates, shaped by the actions of Central Banks almost worldwide. As there was a gap between consumption and production capacity, inventories slumped and the inflationary spiral began to accelerate: high demand spurs expansion of production and full capacity utilization, which requires more labor. The labor market becomes "tight", employers must increase wages, so commodity prices rise, the demand keeps increasing through income growth and consumers buy at higher prices.
The credit impulse has shifted from stimulating the economy to restraining it. Based on the correlation with the US corporate EPS, from March 2023 it will begin to decline.
Banks in Japan, England and some European countries are forced to buy bonds on the balance sheet (Quantitative easing), while there is high inflation in the country. If they do not do this, the local financial market (the largest bondholders - pension funds) will be jeopardized. As a result, rates in these countries cannot exceed inflation until it remains so high (~10%). And raising the rate above inflation used to be an effective way to combat it. It turns out that banks have no strategy other than to keep inflation high and rates relatively low by boosting their own balance sheets. This is likely to cause a quick reversal of the credit impulse to stimulate the economy, so the recession will not be prolonged, but inflation will remain at elevated levels.
MACRO FORECAST FOR 2023
7% of inflation by March and 5% by May
Fed rate peaks at 5.75-6.0% in June 2023
Beginning and depth of recession from Q2 2023. The depth and duration of the recession depends on the speed with which global central bank policy shifts from containment to support. It is reasonable to expect the first signs of support in late summer/early fall, then the exit from the recession could be as early as in Q4 2023.
Based on this development and the historical analogies to the crises in the 1970s and 1980s, it is reasonable to expect the stock and bond market bottom to be reached within 2-3 months after the end of the rate hike, which means August-September 2023 would be the optimal time to buy.
It is important to follow when the Fed shifts from tight monetary policy to support of the economy, we should expect the markets to bottom within 2 to 3 months. If that happens earlier or later than June, there will be a corresponding shift in timing guidance for buying.
To use this analytics effectively, you need to monthly update the timings to move earlier or later the timing of the rate hike end and the market bottom formation.
The current situation resembles the beginning of two stagflations in the early 1970s and 1980s which were characterized by accelerating inflation after reaching its bottom due to record-low unemployment, and the Fed’s rate hike to combat the inflation surge.
Now we see real GDP falling while nominal value is increasing, but unemployment is still at its lows.
We see similarities in the sharp rise in inflation that led to the Fed’s rate hike, but the 2021-2022 inflation surge is different in speed: before the 1970s and 1980s the stagflation rates increased gradually over 3-4 years, but now after low covid base and record amount of money printed the rate is more rapid.
We believe the end of 1969 is similar to the current situation. We see two consecutive quarters of declining real GDP, several quarters of persistently high inflation, which was 1-2% before the acceleration, and the unemployment at the same low level of 3.5%. The Fed’s rate continues to peak, in 1969 it was at its highest level. The consumer also was strong, income increased before and during the stagflation.
Given the experience of the 1970s, the rate exceeded inflation and it resulted in a slowdown, but there was no sharp fall in inflation, it was only 1 percent below its peak for almost a year. That makes sense as strong consumer and gradually weakening but still strong labor market kept inflation from sharp drop. The same factors are in place now, so we expect inflation to be 7-8% in 2023.
The most important factor is rent, which affects inflation with a 6-month lag, it gives + 0.2% MoM. We expect this effect to persist at least till May. Food and other gives +0.3 MoM as most conservative case for 2022. This will lead to core inflation of at least 5% YoY. In addition, higher gasoline prices will result in 5-6% of inflation. Given the situation in housing and oil markets, cumulative inflation could be around 7% by March 2023 and around 5% by May.
Accordingly, the Fed’s rate could reach its peak at 5.75-6.0%.
THE FED'S ACTIONS DURING RECESSION
Given the increase of 0.5% after each subsequent meeting, the rate will peak in June 2023 at 6.25-6.5%.
In the 1970s, the Fed’s rate peaked in August 1969, stayed near the peak over six months, and started to sharply decline in February.
Now the rate’s peak is still to come. We should understand that the Fed does not necessarily stop raising rates if the economy falls into recession. The abovementioned example shows that in 1974 8 months passed from the start of the recession to the rate peaks, and the graph below shows that in 1980 3 months passed from the start of the recession until rates peaked.
LET'S FOCUS ON WHAT A RECESSION IS
Contrary to what many people believe, it is not the GDP decline alone but a combination of factors that have been underway over several months :
- Falling real GDP
Increase in unemployment
Lower retail sales
Declining real income and spending of the population
Drop in production volume
So, even if real GDP declines, while employment is record-breaking, it is not yet a recession (as we observe in 2022). The NBER is the official source of the start and end dates of recessions in the US. It provides the following definition: “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”
More details of how and why the NBER identifies the beginning and the end of recessions are available here.
Also, there is a very handy dashboard that displays online all the indicators the NBER looks at when determining a recession– here.
Most indicators do not show the recession yet, and probably it will not appear in the next few months.
THE RECESSION TRAJECTORY EXPECTED IN 2023
There was a big collapse in global bond markets, especially in longs. As a result, those who had savings in bonds lost in nominal terms, and even more in real terms, i.e., adjusted for inflation.
What causes the loss of purchasing power:
Losses on investment accounts (stocks, bonds, and mixed funds)
Higher energy and utility costs in Europe due to multiple increases in gas prices
Gasoline prices growth in the US
Rising interest rates on loans, including housing mortgages
The economy's big surge in 2021 was driven by record liquidity and low rates, shaped by the actions of Central Banks almost worldwide. As there was a gap between consumption and production capacity, inventories slumped and the inflationary spiral began to accelerate: high demand spurs expansion of production and full capacity utilization, which requires more labor. The labor market becomes "tight", employers must increase wages, so commodity prices rise, the demand keeps increasing through income growth and consumers buy at higher prices.
The credit impulse has shifted from stimulating the economy to restraining it. Based on the correlation with the US corporate EPS, from March 2023 it will begin to decline.
Banks in Japan, England and some European countries are forced to buy bonds on the balance sheet (Quantitative easing), while there is high inflation in the country. If they do not do this, the local financial market (the largest bondholders - pension funds) will be jeopardized. As a result, rates in these countries cannot exceed inflation until it remains so high (~10%). And raising the rate above inflation used to be an effective way to combat it. It turns out that banks have no strategy other than to keep inflation high and rates relatively low by boosting their own balance sheets. This is likely to cause a quick reversal of the credit impulse to stimulate the economy, so the recession will not be prolonged, but inflation will remain at elevated levels.
MACRO FORECAST FOR 2023
7% of inflation by March and 5% by May
Fed rate peaks at 5.75-6.0% in June 2023
Beginning and depth of recession from Q2 2023. The depth and duration of the recession depends on the speed with which global central bank policy shifts from containment to support. It is reasonable to expect the first signs of support in late summer/early fall, then the exit from the recession could be as early as in Q4 2023.
Based on this development and the historical analogies to the crises in the 1970s and 1980s, it is reasonable to expect the stock and bond market bottom to be reached within 2-3 months after the end of the rate hike, which means August-September 2023 would be the optimal time to buy.
It is important to follow when the Fed shifts from tight monetary policy to support of the economy, we should expect the markets to bottom within 2 to 3 months. If that happens earlier or later than June, there will be a corresponding shift in timing guidance for buying.
To use this analytics effectively, you need to monthly update the timings to move earlier or later the timing of the rate hike end and the market bottom formation.
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