Four things investors need to watch out for in 2023

The first area he has identified is the tug of war between the need to raise interest rates to combat inflation, even at the risk of causing a deeper recession by reducing the level of demand in the economy.

He says: “Inflation has dogged markets this year and is likely to remain high, bringing an end to the era of easy money and increasing the risk that overtightening by central banks will trigger a sharp recession, an 'inflation bust'.

According to McCaffrey, markets want to believe that central banks will blink and change direction, negotiating the economy towards a soft landing.

It has a deflationary impact via consumers and businesses.David Jane, Premier Miton

But, he adds: "A hard landing remains the most likely outcome in 2023. The previous norm of central bank “whatever it takes” intervention during the financial crisis and the pandemic is going or has gone.”

In terms of what this means for investors, he says: “Until markets absorb this fully, we could see sharp rallies on the back of expected action by the Fed, only for them to reverse when it doesn’t materialise in the way they expect rates should eventually plateau, but if inflation remains sticky above two per cent, they are unlikely to reduce quickly.”

Oliver Jones, asset allocation strategist at Rathbones, says the UK is headed for a recession “regardless”, but that the recent Autumn Statement at least means the UK is pursuing the same policy priorities as its peers, something which he feels has soothed the nerves of bond market participants. 

Bang for your buck  

The second trend identified by McCaffrey is the impact of the rising dollar on other asset classes.

The dollar rises when US interest rates rise and when investors are in a risk off mood. The latter is because investors seeking safe havens tend to buy US government bonds, known as Treasuries, which are denominated in dollars.

Additionally, in times of such strife, US investors tend to withdraw their capital from overseas and bring it back to US dollar denominated assets. 

McCaffrey says: “A key factor to watch is where the dollar goes from here. In 2022, the strong dollar has proved to be a wrecking ball for other economies, both in the developed world and for emerging countries that rely on hard currency debt.

"If the Fed continues to raise rates, an even stronger dollar could accelerate the onset of recession elsewhere. Conversely, a marked change in the dollar’s direction could bring broad relief and increase overall liquidity across challenged economies.”

Silvia Dall'Angelo, senior economist at Federated Hermes says: "Judging by the updated forecasts, the Fed has now acknowledged some degree of pain will be necessary to bring inflation down to target and the odds of disinflation taking place without much cooling of the labour market – the so-called immaculate disinflation – are low." 

The challenge for investors in this scenario is that, if policy makers continue to lift rates, that would keep the dollar rising, while Chris Beauchamp, chief market analyst at IG Group, says that if the global economy experiences a profound economic downturn next year, this may also cause investors to view the dollar as a safe haven, preserving its strength relative to other currencies. 

He says the dollar has been relatively weaker recently as a result of market expectations that US rates may peak at a lower level than was previously expected. Beauchamp's view is that while there may be some dollar weakness in the first months of 2023, as the recession he expects to take hold next year comes to the fore, the dollar will become stronger as investors begin to prize it as a safe haven. 

Diversification nation?

While many of the major developed market economies are battling a similar set of foes, McCaffrey believes 2023 could be a period where those economies on a divergent path could become more attractive.

He singled out Japan and wider Asian economies as likely to be on this divergent course next year.

McCaffrey said: “Japan has so far maintained looser policy settings, but any shift from its current yield curve control could lead to unintended consequences for the yen and potentially add another layer of risk to the already elevated levels of volatility in FX markets."

He believes China has also taken a different pathway in 2022, thanks to its zero-Covid policy and the reining in of its property market.

McCaffrey adds: "In the next 12 months, we expect policymakers to continue to focus on reviving the economy, investing in longer-term areas such as green technologies and infrastructure.

"Any loosening of Covid restrictions will cause consumption to pick up. The deglobalisation that has arisen from the pandemic and tensions with the US will take time to work its way through but is a theme that will grow.

A hard landing remains the most likely outcome in 2023.Andrew McCaffrey, Fidelity International

“Emerging markets and Asian countries, with a weaker growth correlation with the US and Europe, present one way to increase diversification, while cash and quality investment grade securities offer defensive characteristics.”

But Rupert Thompson, chief economist at Kingswood, takes the view that Chinese equities have bounced a little in recent weeks as the market has begun to expect the country’s Covid policies to move towards the rest of the world’s, rather than diverge, as is presently the case.

Within this theme, sector diversification plays a part

David Jane, multi-asset investor at Premier Miton, says one outcome of the higher-interest rate environment is that sectors such as technology and cryptocurrency are falling, which will reduce some individuals wealth and also cause unemployment to rise,  both scenarios which would be expected to cause inflation to fall in 2023. 

He adds: “It has a deflationary impact via consumers and businesses. The same goes with the collapse of unprofitable technology stocks. Note the recent large layoffs at Twitter and other technology companies.

"All these are necessary to bring forward the point where inflation is back at a more normal level, interest rates can be cut, and the economy can start to rebound. Whilst it is happening in parts of the economy to which we are unexposed to, all the better. 

All this is not to say the bear market and recession are coming to an end, that we cannot know, Jane comments.

"We can say that things are progressing as you might expect. The time is coming closer where sufficient slack has been built in the world’s economy that inflation will temporarily abate.

Opportunities should also begin to emerge.McCaffrey

"Markets at some point will want to start to discount the forthcoming rate cuts. Bond yields will then fall and eventually equity markets will recover. Indeed inflation, during the recession, will no doubt overshoot to below its long-term average."

In terms of what this means for investors, he adds: “During this process we expect the market to believe we have returned to the era of lower for longer, where equities and bonds were negatively correlated, and growth was the main style driver of equities.

"We think this will be a false hope, a temporary phenomenon. The structural drivers which drove lower inflation for the past two decades have reversed, we are in an era of deglobalisation and resource shortages."

According to Jane, if you combine this with fiscally reckless governments, then you have a recipe for inflation settling at a higher rate than is generally expected for many years.

Nobody knows anything 

The final trend McCaffrey has identified are what he calls “idiosyncratic risks”.

He explains such idiosyncratic risks by saying: “As the dispersion of returns increases, investors will be able to seek out idiosyncratic elements in their portfolios rather than rely on whole market moves to generate returns.

"Opportunities should also begin to emerge among securities driven by longer-term themes such as decarbonisation and reindustrialisation, which could draw investor attention sooner rather than later.”

david.thorpe@ft.com