A Year of Inflections

The past year has demonstrated how policy choices not only add to volatility, but also have the potential to change the trajectory of asset markets. Russia’s invasion of Ukraine, China’s approach to managing COVID-19, and even the financial instability spurred by the UK’s “mini-budget” all affected global economies through multiple channels. In 2023, the key policy risks include an escalation in the Russia-Ukraine war, economic policy missteps in China, heightened geopolitical tensions, and monetary or fiscal policy errors.

Escalation in the Russia-Ukraine war

As well as being a humanitarian and environmental disaster, Russia’s invasion of Ukraine in 2022 had a significant impact on the global economic trajectory—adding an inflationary shock to a world already navigating resurgent demand, tight labor markets, and supply chain disruption.

As we enter 2023, Russia’s annexation of occupied territories in Ukraine poses a threat to global markets. The annexation brings these areas under Russia’s nuclear doctrine, meaning that if Ukraine continues its efforts to reclaim these regions, a retaliation by Russia beyond conventional warfare cannot be ruled out. In turn, this would increase the risk of a direct confrontation between NATO and Russia.

Economic policy missteps in China

After many years in which China’s policy measures were oriented toward driving economic growth, the country’s leadership is now focused on achieving a broader range of objectives—including self-sufficiency, national security, and common prosperity. In the near term, the greater consolidation of power under President Xi following the 20th Party Congress has prompted concerns about a continuation of pandemic controls. If China extends its zero-COVID policy through all of next year, it would make it less likely that global growth will trough in 2023.

Separately, the consolidation of power has also led to investor concern over less support for the private sector, a heightened risk of policy mistakes, and lower long-term rates of economic growth.

Oil transmits geopolitical tension into economic outcomes

Brent crude oil prices, in USD/bbl

Higher interest rate expectations were a key contributor to weak market performance in 2022. History tells us that, prior to market bottoms, investors usually begin to anticipate Fed rate cuts. We think inflation should be close enough to target by the end of the year for the Fed to consider rate cuts.

At the time of writing, interest rate cuts seem a distant prospect. Inflation is far higher than official targets, and with central banks seeing their credibility at stake, rates are likely to be hiked further still. We expect interest rates to peak around 5%, 2.5%, and 1.5% in the US, the Eurozone, and Switzerland, respectively.

That said, we do think that year-over-year rates of inflation have topped out in the US. Real-time indicators of future inflation, including new rents, wage growth, import prices, and price-paid indexes, are almost all pointing down; durable goods prices are falling; and services inflation is largely being driven by profits—an unusual and likely temporary phenomenon.

Inflation is also likely to peak in Europe soon, as the impact of higher energy prices begins to fade and as higher rates discourage consumer and business spending. Falling rates of inflation should allow the Fed, the ECB, the SNB, and the BoE to complete their hiking cycles in the first quarter of 2023, or the second quarter at the latest.

How quickly central banks and investors then turn their attention to potential rate cuts will depend on the data, as they both seek evidence that inflation is heading sustainably back to target before contemplating lower rates.

In our base case, we think year-over-year rates of inflation in the US and Europe will be close enough to central banks’ 2% target toward the end of 2023 for policymakers to refocus their attention on economic growth and employment, and consider rate cuts.

What does it mean for investors?

We think that high inflation and still-rising interest rates are likely to mean continued volatility for risky assets in the near term.

But evidence that inflation is falling sustainably, an end to Fed rate hikes, and anticipation of potential rate cuts should present a more supportive backdrop for markets as 2023 progresses. So while we advocate a defensive posture as we enter the new year, it is also important for investors to stay invested in line with longer-term plans, and retain upside exposure so that portfolios do not get left behind as markets attempt to anticipate a turning point.

Two-year Treasury yields usually fall prior to market bottoms

Fall in 2-year US Treasury yield from peak in the six months prior to bear market bottom, in basis points

Tight US monetary policy, the energy crisis in Europe, and ongoing COVID-19 and property market challenges in China are likely to contribute to lower economic growth and earnings declines in 2023. But we think global growth should trough during the year.

As we enter 2023, the world economy is decelerating. The US is still in expansion, but higher interest rates, tighter financial conditions, and weakening property and labor markets will have a lagged, negative impact in the months ahead. The Eurozone and the UK are likely already in contraction given the combined impact of the energy crisis, inflation, and monetary tightening. And China’s recovery continues to be delayed by issues relating to COVID-19 and the property market.

Given the likelihood of a near-term deterioration in economic growth, we think further downward earnings revisions can also be expected in the months ahead. Overall, we are looking for a 4% earnings contraction in the US, a 10% decline in Europe, and 2% growth in Asia, below consensus expectations of growth of 4%, 3%, and 7%, respectively.

But while the near-term outlook is challenging, we also think world economies will trough in 2023.

In Europe, growth should start to improve midyear as the continent’s energy crisis begins to ease after the winter, even if next winter may also pose challenges. In China, contingent upon a reopening in the middle of the year, economic growth should also improve, potentially with the help of higher infrastructure spending. In the US, a trough is likely to come later, given the strength in the economy thus far and the lagged impact of tighter monetary policy. But consumption and investment could be supported in the second half provided inflation is lower and financial conditions are looser.

What does it mean for investors?

Downward revisions to company earnings estimates mean the risk-reward is unfavorable for risky assets over the coming months. But we note that historically markets start to turn between three and nine months prior to a trough in economic activity and corporate profits.

With this in mind, a more constructive environment for risky assets should start to emerge during the year, as markets anticipate potential turning points in economic and earnings growth rates.

History also tells us that trying to anticipate a precise turning point for the market can often result in failure, and the best way for most investors to position for more favorable markets ahead is to keep a diversified portfolio, consistent with long-term investment plans.

Once a turning point arrives, markets that have already priced in most bad news and where valuations are lowest have the greatest potential for a rebound, which currently look like European and emerging market equities.

Global GDP growth to decelerate but improve in the second half

Real GDP growth including UBS forecasts starting 3Q22, q/q, in %

Markets tend to trough ahead of the economy

US stocks, earnings, and GDP months before and after equity market low, indexed

This “Decade of Transformation” has already brought significant changes in the global economic, political, societal, and environmental landscape. But we think a more positive secular backdrop remains possible. That said, each of these potential positive drivers has a flip side that could make for a more challenging environment in the years ahead.

Central banks are determined to bring inflation under control

Unlike in the 1970s, central banks today are highly focused on reducing inflation, even if it comes with short-term economic costs. This policy focus should mean that inflation does not become entrenched, and a period of higher rates should ensure that investment is not directed to nonproductive areas, and that capital is allocated more efficiently in the long term.

A secular transition to green energy will spur investment.

The global transition to clean energy and net-zero carbon emissions was already well underway as we entered this decade, but Russia’s invasion of Ukraine has heightened the need for investment for national security reasons. While we think we will see continued reliance on fossil fuels in the decade ahead, driven by strong demand for energy and relatively low current supply of alternatives, in the longer term the race to create a greener economy should boost growth. Greater investment in industrial metal and agricultural production may also be required, given a likely increase in demand for transition metals and for food, creating investment opportunity for all investors, not just those focused on sustainability.

The era of security will drive public spending on infrastructure and R&D

We are entering an era of security where countries are increasingly focused on achieving self-sufficiency in strategically important areas such as energy and food production, technological development, and national security. Measures like the US CHIPS Act (aimed at boosting semiconductor R&D and manufacturing) and Inflation Reduction Act (in part aimed at promoting clean energy) will stimulate public and private spending over the coming years.

The digitalization of business models is likely to gain momentum

The past two-and-a-half years have demonstrated that companies can deploy technology to run their businesses in ways thought inconceivable before the pandemic. Looking ahead, entire business models will increasingly be built around digitalization, potentially resulting in greater efficiency gains. Amid concerns about elevated inflation, it is worth noting that digitalization can be a disinflationary force.

Despite heightened risks to the near-term outlook, lower equity valuations and higher bond yields should also be supportive of stronger returns for diversified portfolios over the decade ahead.