Resilience versus recession

Weak economic momentum is expected to continue into early 2023. Both Europe and the U.S. are caught between a restrictive monetary policy that curbs both inflation and the economy and an expansive fiscal policy aimed at bolstering the economy and cushioning the effects of the current energy crisis, among other things. For the Eurozone, this means that the ECB’s deposit rate is expected to increase to 3% during the course of the year, whereas Germany, for example, has planned fiscal measures equivalent to around 7.5% of its gross domestic product. We are expecting a mild recession overall in the Eurozone at the turn of the year. With recovery starting in the second quarter, economic growth for the full year 2023 is likely to be 0.3%. The main risk factor remains energy, coupled with a possible shortage of gas in winter 2023/2024.

Note: *For the U.S., GDP growth Q4/Q4 % is 0.5% in 2022 and 1.6% in 2023.

A soft landing is possible in the U.S. as well, with a marked economic slowdown so far not resulting in any significant increase in unemployment (and a still large number of unfilled vacancies). Growing evidence of a slightly downward trend in inflation in the U.S. could see the Fed refocusing increasingly on economic growth, with further increases in the base rate likely to be smaller than in the recent past. If inflation rates continue to decline and there is no need for robust Fed intervention, the U.S. economy could return to growth in the second half of 2023, finishing the year overall at +0.4%. Economic momentum in China is likely to be much stronger next year. We are expecting growth of around 5% in 2023 after an estimated 3.3% this year. Long-term economic growth potential depends on the production factors of labour, capital and technological innovation. The importance of technology has been underlined by the global shortage of skilled labour and the need to make more efficient use of resources. Productivity growth has declined considerably in recent decades, especially in developed markets, with a correspondingly negative impact on potential growth.

In the long term, increased productivity will be needed to ensure stronger economic growth. Innovative technologies are the key to this – and are thus the guarantors of the future “wealth of nations”.

Economies are already taking action to counter this. In developed markets, there is a clear focus on increasing productivity in the service sector, which employs up to 80% of the workforce. Key technologies include cloud services, artificial intelligence and digitalisation in general. Increasing automation in the industrial sector also can raise productivity, especially in the emerging economies. Technological productivity will be boosted by economies of scale – by the growing market penetration of renewable energy and battery technologies, for example. Economic development beyond 2023 is therefore likely to depend on future success in commercialising new technologies and integrating them in the economic cycle. In the long term they are the key to further growth and continued prosperity.

Inflation has become a dominant topic again. We estimate consumer price inflation of 8.9% in Germany, 8.4% in the Eurozone and 8.2% in the U.S. for full year 2022. Inflation will still be well above the targets set by the central banks in Europe and the U.S. in 2023. While headline inflation seems to have already peaked in the U.S., it might not peak in Germany and the Eurozone until February or March 2023. For 2023 as a whole, we expect inflation of 7.0% for Germany, 6.0% for the Eurozone and 4.1% for the U.S. High inflation is expected to last beyond 2023. It is unlikely that inflation in the foreseeable future will return to the relatively low levels seen before the Covid-19 pandemic.

Energy could still be a big driver of inflation. The recent slight decrease in oil prices could be followed by another marked increase next year, caused by demand-side factors such as the expected acceleration of China’s economy and supply-side factors such as the self-imposed production cuts by OPEC+ and inadequate oil company production capacity following insufficient investment in recent years. Efforts by the European Union and U.S. to exclude Russian oil from the market will add to pressures too. While gas prices have decreased recently, they remain well above what they were before the Russia-Ukraine war erupted. Current gas consumption as well as timely filling of storage facilities for winter 2023/2024 will be important. Central banks are therefore increasingly looking at core inflation, which strips out volatile energy and food prices. Core inflation responds more strongly to changes in the base rate than headline inflation, which is more supply driven. The relatively late start to the ECB’s current interest rate cycle may relate to this change of focus.

Note: *Bloomberg

Inflation in 2023 could also be higher than expected due to the impact of high energy costs on the prices of other goods and therefore on core inflation. In Germany, headline inflation will likely fall as a result of the gas price cap coming into effect at the beginning of the year, but core inflation will be stoked further by government stimulus. Overall, the world’s main central banks are therefore likely to keep their monetary policy relatively tight initially. Current capital market pricing reflects this. But there remains a risk that inflation will go higher than expected, requiring central banks to intervene more strongly.

While inflation seems to have already peaked in the U.S., it might not peak in Germany and the Eurozone until February or March 2023.

2022 was a turbulent year for the bond market. Sharply rising inflation and the increasingly tight monetary policy of many central banks resulted in substantial yield increases. 10-year U.S. bond yields, for example, went from 1.5% at the end of 2021 to around 4%. The yield on investment-grade European corporate bonds currently averages 4.3%, compared with just 0.5% at the end of 2021. 2022 may however prove to have been a year of transition to increased bond market stability. Following the great sell-off, 2023 could offer more interesting investment opportunities. The basis for any new equilibrium must be an expectation that inflation will not reach the persistent very high levels seen in the 1970s. It is more likely that inflation rates will be moderately high, like they were between 1998 and 2014. Average inflation forecasts currently stand at around 2.5% for the next five years in the U.S., for example. Overall, current bond yields are fairly close to levels that have historically been associated with a moderately high inflation environment.

Bond market investors will however have little cause to relax. The value of bonds will continue to fluctuate widely, taking time to calm the ongoing hit from inflation and interest rate rises. Further, if less substantial interest rate increases are expected in the U.S. and, above all, in the Eurozone because central banks are likely to pursue their tight anti-inflationary policies, this will create headwinds in the bond market. Due to the ongoing risks, investors will probably initially prefer liquid and investment-grade bonds from the U.S. and Europe in the months ahead, despite the return to attractive yields in most bond categories. Yields and quality are now no longer mutually exclusive. European bank bonds, for example, would seem to be worth greater consideration because underlying capital adequacy and credit risk data have improved substantially in recent years. Following what is expected to be a still slightly bumpy winter economically, the focus in the course of 2023 could turn to riskier and higher-yielding corporate bonds. In the case of government bonds, anticipated interest rate developments mean that U.S. paper should initially prove more interesting than German equivalents.

We have a rather neutral view overall of emerging economies’ bond markets. The expected economic recovery of China in 2023 could stabilise the economies of neighbouring and many commodity exporting countries (such as those in Latin America) given that China is the dominant commodities consumer. Another positive could be the expected moderation in USD strength, as emerging economies’ debt is often denominated in this currency. Active bond portfolio management remains the watchword in 2023, coupled with the dynamic management of maturities and default probabilities (i.e. ratings). Floaters – bonds with variable returns – might be useful here. Investors who are willing to take risks might also be interested in exploiting possible exchange rate differences.

2023 will give bond market investors no cause to relax. On the other hand, high quality bonds offer decent yields again which could compensate for the risk of further rate rises. The ongoing hit from inflation and interest rate rises has been too severe for the situation to calm down quickly, but valuations look more favourable now.

More than 50 years ago, then-U.S. Treasury Secretary John Connally said, ‘The dollar is our currency, but it is your problem’. President Nixon had suspended the country’s commitment to the convertibility of the USD into gold, putting an end to the Bretton Woods system of fixed exchange rates. Connally’s provocative observation remains just as valid today. In 2022, the EUR and other currencies suffered from the increasing economic and political uncertainty around the world and came under pressure. The greenback, meanwhile, was able to profit from strong inflows due to the higher returns available in the U.S. (as the Fed surged ahead with base rate hikes) and the currency’s role as the dominant ‘safe haven’.

The difference between returns in the U.S. and the Eurozone should diminish as the year 2023 progresses. The U.S. interest rate cycle will probably reach its peak in spring 2023 while the European Central Bank raises interest rates further. Growth in the Eurozone and in China in particular may pick up again following a weaker winter. For this reason, we expect the EUR/USD rate to be around 1.05 at year-end 2023. With a less buoyant USD the Japanese yen may also be able to appreciate. The JPY in particular came under heavy pressure in 2022 as the Bank of Japan maintained an extremely loose monetary policy. The Japanese currency lost up to 10% of its value against the EUR and up to 22% against the USD in 2022. The CHF which is also seen as a ‘safe haven’ currency, should remain one of the stronger currencies in 2023, especially as Switzerland can now also offer positive base rates combined with relatively low inflation of 3%. By contrast, the pound sterling could continue its downward path in 2023, as the post-Brexit United Kingdom faces up to a range of economic difficulties.

Following the winter, growth in the Eurozone and in China in particular should pick up again. This could weaken the USD and lift the EUR.

Emerging markets boast the weakest as well as the strongest currencies. The latter include Brazil, Uruguay, Chile and Peru, countries that are profiting from high commodity prices. South America’s central banks were also quick to start raising their base rates. The expected global economic recovery in the second half of 2023 should benefit most commodities. In this context, the currencies of other commodity-exporting countries such as Australia, Canada and Norway seem to have (catch-up) potential, too, following the pressure that the Australian dollar and the Norwegian krone experienced in 2022.

2022 was a tough year for stock market investors. Despite the overall increase in corporate profits, stock prices came under pressure due to high geopolitical uncertainty, increasing inflation and a bond market sell-off. The latter pushed real yields back into the positive territory ending the era of TINA (There Is No Alternative) in which investors increased their stock allocations at the expense of bonds, driving equity valuations to near-record highs. After the yield moves of 2022 TINA has left the stage, though, and the market setting has flipped to TAPA (There Are Plenty of Alternatives), which has resulted in lower equity valuations. At the index level, the declines varied across stock market regions. At times, NTM price-earnings (P/E) ratios fell below their long-term averages. The NTM P/E ratio of the MSCI World Index was 15x at the start of November 2022, a decline of -25% on the start of the year and 7% down on its 10-year average. Currently, equities therefore seem to be valued on the low side.

For the full year 2023, we believe that nominal company profits will match their prior-year levels and will not fall as they did in previous recessions. The basis for this assumption is the nominal growth of gross domestic product – the development of economic output without adjustment for inflation. For the full year, increases of 5% in the U.S. and as much as 6-7% in Europe are considered possible. There are many reasons for our relatively robust forecasts for nominal economic and profit growth. Unlike in previous recessions, private consumption could be supported by high levels of savings built up during the coronavirus pandemic. High energy prices should continue to bolster the profits of energy companies in particular and also of companies in primary and mining industries. Financial companies should also benefit from the new (higher) interest rate environment. So while aggregate index margins have probably peaked, we do not believe that they will collapse. For the stock markets, this could mean that the revaluation following the recent large interest rate hikes have now more or less ended. A high valuation phase due to very low interest rates has been followed by a low valuation phase, and we are currently transitioning to a medium valuation phase for the years ahead. While this is no indication that 2023 will be a great year for stocks, we do expect solid price increases in the single-digit percentage range. Stocks therefore remain a particularly interesting asset class and essential components in a diversified portfolio. Nonetheless, we believe that short-term and even substantial price fluctuations could occur at any time during 2023 given investor caution, analysts’ continued overestimation of profits in some cases and the many political and economic risk factors. Market participants may continue to react strongly, even to less significant news. Although defensive sectors could continue to outperform over the medium term, valuations now look rich. Sectors that are more cyclical and value-oriented in nature appear attractive to us. Financials, materials (ex. chemicals) and energy stocks in particular are trading at depressed valuation levels on a historical comparison. Investors wanting to position themselves more defensively may want to consider healthcare stocks. The sector offers above-average earnings growth supported by strong secular trends at a reasonable price. In regional terms, one investor focus in 2023 could be Europe. Recent valuation discounts in this region have been disproportionately high, with economic and geopolitical risks already factored in. Extensive fiscal programmes and high levels of savings should buoy private consumption, and expected stronger Chinese growth will be important to many European companies. The U.S. stock market will of course remain the focus, but its technology bias, and the resulting greater sensitivity to interest rate movements, may lead to greater investment risks, as could the expected weakening in the USD.

Among the emerging economies, Asian markets remain the most attractive. Strong capital flows to “safe havens” caused marked declines in valuations in northern Asian markets, such as South Korea, Taiwan and China in 2022. The average drop in these markets was around 20%, a trend that has now been partly reversed. These markets may make a comeback when the macroeconomic environment and investor sentiment improve. In recent months, the Indian stock market has performed well despite volatility. Corporate EPS is currently forecast to increase by around 17% in 2023 although the Indian market’s 12-month P/E ratio of around 20 is comparatively high. However, given the country’s continued strong economic momentum, it is difficult see to the Indian stock market as fundamentally overpriced. Japan should benefit from its delayed and still-ongoing Covid-19 recovery as well as accommodative fiscal and monetary policy. Similar in some ways to Germany, the country’s cyclical structure is highly dependent on China, which could provide a tailwind in 2023 and make Japanese equities a useful tool for diversification.

Stocks remain an essential component of a diversified portfolio. Decent overall price gains are expected in 2023, but with periods of perhaps substantial volatility.

Well-functioning infrastructure is essential to economic growth, ‘green’ growth and sustainable economic transformation. The development of resilient infrastructure is one of the 17 Sustainable Development Goals (SDGs) set by the United Nations. Significant investment in infrastructure will be required around the world over the coming years and decades. Infrastructure ranges from traditional activities such as building and operating roads, bridges, railway networks, ports and airports, to developing and expanding stable energy grids and a safe drinking water supply as well as telecommunications and data networks. Businesses involved include the operators of the relevant infrastructure as well as infrastructure planners and builders.

Governments worldwide are seeking to drive the expansion of their infrastructure with considerable investment. The U.S. has initiated no fewer than three major investment programmes recently. A USD1.^2tn infrastructure package was passed in 2021 aimed at modernising the country’s roads, bridges, ports, airports and railways; a CHIPS and Science Act followed in 2022, which provides for total investment of USD280bn – including USD52bn in chip manufacturing. In August 2022, U.S. President Joe Biden then signed the Inflation Reduction Act, which comprises a USD430bn package of climate, social and tax measures. In Europe, the European Union launched its NextGenerationEU development fund back in 2020, now worth around EUR800bn taking inflation into account. This will be disbursed to individual member states partly in the form of loans and partly via direct grants for use primarily on climate protection and digital transformation.

Governments worldwide are seeking to drive the expansion of their infrastructure with large amounts of investment. The market for listed infrastructure investments alone is currently worth approximately USD7tn.

These funds have only just begun to be distributed in Europe as well as in the U.S. Accordingly, the best things in infrastructure are probably still yet to come – from our planet’s perspective as well as the investor perspective. The market for listed infrastructure investments alone is worth approximately USD7tn according to current estimates. What is appealing for investors is, among other things, that the earnings from major traditional infrastructure operations may offer a level of protection against inflation. By contrast, innovative newer ‘green’ infrastructure projects aimed at decarbonisation and digital transformation are often smaller in scale but offer the prospect of capital growth. Note however that infrastructure projects can be subject to external influences in a strong and direct way. For example, the Covid-19 pandemic resulted in a massive drop in aviation in 2020 and, consequently, in income for airports and investors.

Stocks and bonds are essential to a balanced portfolio but, of course, they do not have to be the only components. There are a variety of alternative asset classes available to investors depending on the objectives they wish to attain with their portfolios. Investors seeking a yield in excess of the market return (positive “alpha”) may want to investigate actively managed illiquid investments such as private equity, private debt (non-bank corporate financing), venture capital and infrastructure investments. Investors hope that these will improve the diversification of their portfolios, deliver reliable and high returns and provide a certain degree of protection against inflation. Investors looking to hedge their portfolio against inflation might look to real estate, especially as rents can rise faster than the inflation rate during phases of high inflation. This approach can be successful but also has risks and must be appropriate to the investor.

Real estate illustrates the risk and opportunities involved. Rising interest rates in 2022 have challenged the upward movement in prices in the global residential real estate market. In the U.S., for example, mortgage interest rates are at their highest level in more than 20 years and the number of houses sold has fallen by almost 30% since its peak in 2020. However, persistently high demand for housing could increase further in the next few years and vacancy rates in the U.S. are still at a historical low. Financing and construction costs are also likely to hold back supply, meaning that the price of new-build residential property is not likely to fall by any significant amount in the near future. Within the commercial property sector, the logistics segment may offer interesting opportunities. The growth of online retail and rising demand for warehouse capacity to safeguard against supply chain issues are keeping vacancy rates low, making rent increases feasible. The vacancy rates for retail and office properties, on the other hand, are significantly higher. Overall, real estate markets may be going through a rather fragile transition period that will potentially last one to two years. However, our sentiment towards this asset class remains generally positive, especially as rents will likely increase further in the long term. In times of high inflation rental properties can offer resilient earnings and inflation supports the argument that property should remain a key component of diversified portfolios. Highly energy-efficient “green buildings” may be an area of particular interest, and not just because of current energy price concerns. With regard to listed investment vehicles such as real estate investment funds, investors should however factor in relatively high volatility for the foreseeable future.

In particular, investors hope that alternative investments will improve the diversification of their portfolios, deliver reliable and high absolute returns and provide a certain degree of protection against inflation.

The biggest risks to the economy and capital markets in 2023 might appear to be familiar foes: geopolitics, the fight for global technology leadership, the Covid-19 pandemic, China’s real estate market and a potential sell-off in the bond market. However, if you look more closely, there are important differences.

Military and political tensions, most visible in eastern Europe and the East China Sea, ramped up in 2022 and are likely to pose major challenges for the global community in 2023 as well. Solutions to end Russia’s invasion of Ukraine remain elusive. This in turn means no solutions to the knock-on effects of this conflict on areas such as migration movements, global supplies of fossil energy commodities and food; and potential geopolitical shifts extending far beyond the region. In East Asia, long-standing tensions remain between North and South Korea and in relation to China’s declared claim to Taiwan. From a purely economic point of view, the latter is particularly important as Taiwan is the world’s largest supplier of semiconductor chips. Elections in Spain, Poland, Turkey and India will also demand additional attention from investors in 2023. In the contest between the U.S. and China for global technology leadership, the battle lines may harden further. The points of conflict still include U.S. allegations of intellectual property theft by China, significant data privacy concerns on both sides, and restrictions on mutual market access that include far-reaching trade sanctions. The extent of this ‘tech war’ is becoming increasingly apparent, too: a trade conflict has now morphed into an effort to set the applicable long-term standards in highly important fields such as 5G, artificial intelligence and chips. Success will expand the country's power base over the long term. So both sides will not want to yield ground easily. It is important in 2023 to build on the success achieved in containing the Covid-19 virus. China in particular needs this from a macroeconomic point of view, as extended lockdowns continue to cause considerable disruption to economic activity in key urban centres. Signs still point to an improvement in the global situation, but potential new outbreaks and the associated restrictions must be monitored closely. The Chinese property market’s long-standing problems have been exacerbated to some degree by the Covid-19 pandemic. The sector is responsible for roughly 25% of the country’s economic output and is therefore extremely relevant. We expect that the Chinese government will be able to further stabilise the market as the year progresses. Stimulation of buyer demand by rolling back the country’s strict Covid-19 restrictions further would of course help – but international capital markets may remain sceptical. We do not expect another 2022-style sell-off in global bond markets in 2023. However, if high inflation should prove to be more stubborn than generally expected or climbs even further, this could drive up bond yields again. If the yields on 10-year U.S. government bonds were to rise markedly, we believe that this would risk another sell-off with a significant impact also on stock markets and especially on securities with high interest rate sensitivity, such as those in the technology sector.

The major risks in 2023 will be familiar ones from previous years: geopolitics, the fight for global technology leadership, the Covid-19 pandemic, China’s real estate market and a sell-off in the bond market. But there will be important differences too.

India, Indonesia and China – three of the four most populous economies on earth with more than three billion inhabitants in total – could each see GDP grow by 5-6% in 2023. The developed economies of South Korea and Japan may also grow more rapidly than those of most other developed markets. We expect Asian economies to largely reopen by no later than spring 2023. The Chinese government’s fiscal measures, which have been restrained so far, could then have their full impact, for example, in the areas of digital transformation, infrastructure, transport, renewables and biotech. This would be advantageous for China’s trading partners in Asia, too. Accumulated private savings in China may be spent on holiday travel, and popular destinations such as Thailand, Malaysia and the Philippines would profit from this. India is currently expanding its manufacturing sector on a massive scale and launched a major infrastructure investment programme in early 2022 to encourage foreign company offshoots. The Japanese government is banking on comprehensive fiscal support to alleviate the energy crisis for its domestic businesses. The risks to growth in Asia in 2023 emanate primarily from increasing geopolitical tensions, especially in the Pacific, a potential reigniting of the Chinese real estate crisis, and from delays in rolling back the strict Covid-19 containment measures in China.

Investors in Asia must differentiate between the individual capital markets in terms of share valuations and expected profits. Stock exchanges in China, Taiwan and South Korea saw significant capital outflows and drops of up to 30% in share value in 2022 amid the global uncertainty and investor concentration on “safe havens” for investment. These markets in particular are hoping for a comeback given the improved macroeconomic environment, with South Korea experiencing substantial net capital inflows in November. The Indian stock market has performed well in recent months, with strong growth in corporate profits expected in 2023. Japan, the sole traditional industrial nation in the region, might represent something exceptional for investors: with a cyclical economic structure that could benefit particularly strongly from recovery in China. The upcoming year is the Chinese Year of the Rabbit, which symbolises confidence and strong-mindedness – like the region itself.

Many Asian markets that were hard hit in 2022 are hoping for a comeback with an improved macroeconomic environment and, by extension, improved investor sentiment in the upcoming Year of the Rabbit.

ESG investment aims to change the way we live and do business. A fundamental shift needs to take place, as virtually all experts agree that the “triple planetary crisis” – climate change, pollution and loss of biodiversity – constitutes an existential threat to humankind.¹ The primary cause of the structural market failure that has led to this crisis is that we have neglected to integrate the systematic value of nature into our economic model. Overcoming this challenge therefore requires a holistic approach that incorporates all the relevant economic and social aspects of the necessary transformation. These aspects are far more expansive than climate change and need to include social and governance dimensions. Nevertheless, the energy transition must remain a key element in strategies to overcome the triple planetary crisis. According to estimates, energy production accounts for around three-quarters of the world’s greenhouse gas (GHG) emissions.² The significance and urgency of the energy transition for the climate was highlighted once more at the UN Climate Change Conference 2022 (COP27) in November.³ Worldwide, great efforts are being made to implement the energy transition. These include the Inflation Reduction Act (IRA), probably the most significant climate protection legislation in U.S. history. This envisages providing a total of USD369bn to promote clean energy technologies and greater environmental equity at the local government level.^4,5 In the European Union (EU), increasing the share of renewable energy used in different industry sectors is seen as a crucial building block for achieving EU energy and climate targets. These envisage a reduction in greenhouse emissions of at least 55% by 2030 compared with the 1990 base year, and climate neutrality in Europe by 2050.⁶

The debate about the energy transition and energy resilience has gained momentum recently in the light of the Russia-Ukraine war. We face a global challenge that requires consideration of the ideas and goals of developing and emerging economies especially, and also of the resulting social and regulatory issues.⁷ The success of the global energy transition will depend largely on its fair implementation, addressing the social and governance issues.

Global energy transition success is essential to continued development but must be seen as being implemented fairly.