Five Themes Driving Global Markets in a Year of Pivots

Decades of disinflation conditioned investors to expect longer expansions, shorter recessions, and shallower downdrafts in asset prices. The question now is whether the current cycle will upend these expectations – taking us back to inflation regimes when tight labor markets and persistent service inflation were slow to ease, rendering central banks slow to pivot – or whether we’re simply experiencing a longer-than-expected (yet transitory) aberration in inflation trends, owing to the unprecedented nature of its causes. Either way, inflation’s path this year could determine when we’ll see the “big pivot” in central bank policy that markets are looking for. The Fed has maintained its pace of telegraphed interest rate hikes, and a clear deceleration in core inflation and tight labor markets are needed to usher in a pause or reversal, even in the face of rising recession fears. The European Central Bank also seems intent on maintaining its record-fast rate increases to tame inflation as recession looms. Should the Fed “hike and hold” at 4.75%-5% for most of 2023, the impact of higher rates and QT will be tighter financial conditions. Meanwhile, China and Japan are the only major economies currently easing monetary policy after several years of holding it tight.

The dollar has reached multi-decade highs, and its outsize strength continues to weigh on other economies. Notably, the strong dollar is hitting developed as well as emerging markets, feeding inflation and thus raising the cost of imported goods. It’s also contributing to the need for some central banks to impose their own tightening of financial conditions, even if their economies can’t take it. Spooked by fears of a global recession, investors have flocked to dollars as a safe haven, and the Fed’s aggressive interest rate hikes have added to US investments’ allure. That said, we think the dollar is likely to peak in 2023, perhaps around the midyear mark.

A European recession looks increasingly likely, and even today’s resilient US economy is increasingly reliant on a dovish Fed pivot to ward off its own contraction. And while we believed China might help sidestep a global recession with its reemergence of growth after 2021’s policy-driven stall, the improvement we expect no longer looks vigorous enough to offset other downward forces. Recession fears are creating a feedback loop that drums up even more demand for US dollar-denominated assets. This too will pass, yet only after the first Fed rate cut, which may be well into the back half of 2023. The big question for investors is when to shift from defense to offense.

The outcome of China’s 20th Party Congress did not proffer hopes for a growth-oriented policy pivot, and while moving toward more collective ownership and centralized control will likely slow China’s growth over time, 2023 may buck the longer-term growth trend. China’s government has unveiled new, less-disruptive zero-Covid policies, including steps that will ultimately pave the way for a reopening, and just reloaded support for private property developers – changes that may lift China’s economy as the year unfolds. If so, China will be one of the few accelerating economies in 2023. The longer-term weight of greater state control appears more than fully priced in to asset valuations, presenting a potential counter-trend opportunity in 2023.

The war in Ukraine has called into question how Europe will manage through a winter without Russian oil, creating new urgency behind energy autonomy and momentum for green energy and renewables. Multinationals and investors may also be warier about investing in countries under autocratic regimes, where the rules can change on a dime – sentiment that could affect China as well, with Xi’s consolidation of power. Meanwhile, results from the US midterm elections ushered in renewed gridlock, while Brazil’s rejection of Bolsonaro could provide further tailwinds for environmentally friendlier growth. Climate investments appear poised to rise substantially, eating into the global savings glut.