The persistence of core inflation will be the key to determining the outlook for markets next year, said Harriet Ballard, multi-asset fund manager at Aviva Investors.
With energy prices beginning to drop, headline inflation in most major economies has either peaked or is near peaking, Ballard said.
Headline inflation, known as the consumer price index, includes food and energy prices, which are more volatile, whereas core inflation excludes these.
“Looking forward to 2023 the global economy is expected to enter a mild recession as growth slows further and central bank policy remains tight…however, it will be the persistence of core inflation that will be key in determining the outlook for policy rates, growth, and markets,” she said.
If core inflation shows signs of abating, central banks will have the confidence to stabilise the base rate of interest, and even potentially look to cut it.
This would most likely mean a mild global recession, and the idea of a “soft landing”, Ballard said.
“On the other hand, should inflationary pressures, particularly those in the labour and service sectors, prove to be more embedded, high levels of core inflation will likely be more persistent.”
In this scenario, central banks will feel compelled to raise rates higher, generating a more severe recession.
Ballard said she is more concerned that inflation will remain “sticky”, and will get stuck on the way down, which will make central banks less willing to reduce rates from “restrictive” levels.
“Given our growth outlook and expectation for central bank policy we see equity valuations as unattractive at this juncture, especially following the year end risk rally we have seen over the last few months,” Ballard said, adding she will be watching earnings revisions closely next year.
It is not all doom and gloom, however, she said.
With headline inflation peaking and most of the required tightening now done, the outlook for fixed income should be better in 2023 than it was in 2022.
“While this may not be a very high bar, more cautious investors should take comfort in the balance of risks being more favourable.”
Commodities could also perform well in a world where inflationary pressures are persistent, she added.
“The worst of the economic downturn is yet to come, but financial markets have a forward looking bias and therefore there is scope for better performance in markets even before the growth outlook turns.”
As the markets get closer to a recovery, credit is likely to start to perform better, and as such there will be more economic and policy divergence than was the case in 2022.
“We believe this opens the door for a higher number of relative value opportunities that macro investors can take advantage of.
“Greater diversification through relative value positions should also help portfolio managers if the correlation between equity and bond returns remains positive or unstable.”
