Key Insights

• The global economy is poised for further normalisation, as pandemic-era pressures ease.
• Imbalances in labor and energy markets pose a greater inflation risk for Europe than the U.S.
• China to redouble efforts to boost economic growth in order to put its economy on a path of short-term stability.

Three Themes for 2023

Global rebalancing is underway following the surge in post-pandemic demand and the supply-side disruptions to trade and energy markets. As widespread imbalances begin to gradually unwind, we foresee three key trends to watch in 2023: Labor markets, global energy supplies, and China’s twin challenges of reopening post-COVID and its ambitious program for economic reform.

1. Labor Market Resilience

In both the U.S. and Europe, labor markets look set to stay relatively resilient compared to past slowdowns. However, greater flexibility in the U.S. employment sector suggests its economy is better placed for wage growth containment than Europe, where labor markets are less flexible.

• Robust demand for workers has outpaced hiring, leading to an extremely tight jobs market. The supply-demand mismatch reflects companies’ overly aggressive expansion plans and a reduced willingness to work by employees coming out of the pandemic. This dynamic provided willing workers greater negotiating power, which they used to win higher wages.
• However, signs point to a gradual adjustment for the U.S. labor market (at least on the demand side). For example, job openings peaked in March 2022 and are now gradually coming down (Display 1). However, persistent wage growth underscores a lack of a supply-side response in the labor market (Display 2).

EU Risks Higher for Wage-Price Spiral

• Compared to 2019 levels, the eurozone’s indicators for total employment, hours worked and participation rates have eclipsed those for the U.S., pointing to an extremely tight labor market.
• Despite rising industrial production, employment in industry is below pre-pandemic levels, and surveys show pressing labor shortages within the sector. More generally, a growing skills mismatch (accelerated by technological advancement) is contributing to shortages more widely.
• Labor-market rigidity in Europe discourages layoffs, as companies fear worker shortages will leave them without needed manpower when the economy eventually rebounds.
• Eurozone inflation is being driven by rising energy and food prices. Given that these components are going to be much slower to adjust vis-à-vis the U.S., the risk of a wage-price spiral is greater (i.e., the persistence of these shocks effectively results in a de-anchoring in inflation expectations).

Investment implications

• Bonds: Europe faces higher risks for inflation expectations to de-anchor. In our view, that risk puts a floor under Europe's longer-duration bond yields, and we therefore have a relative preference for U.S. duration.
• Equities: Smaller increases in unemployment (versus historical downturns) should limit severe falls in earnings growth, but decelerating inflation combined with wage pressures will likely cause margins to decline in 2023. That said, whilst inflation is likely to come down initially, creating a friendlier environment for equities, we believe the U.S. Federal Reserve has slowed the pace of tightening too early. Inflationary pressures could build later in the year, and once more negatively impact equities.

2. Energy in Transition

We expect a transitional year for energy markets in 2023, with higher oil and gas prices leading to some market rebalancing after disruptions last year. However, tight supply looks set to remain a key inflation challenge.

Oil Demand Staying Strong

• Recessionary headwinds are likely to dent oil demand in 2023, but we expect the culminating effects from Russian sanctions and gas-to-oil switching to be offsetting factors that could sustain relatively high prices.
• That OPEC cut production quotas in a tight market underscores the need for high prices to incentivise investment in future supply. Understandably, falling prices today could disincentivise such investment, resulting in a strong price rebound when economic demand eventually recovers.
• Signaling of this kind, as well as the U.S. administration’s commitment to replenish crude stocks at around $70 per barrel, should help reduce price volatility, which has been a significant hindrance to investor participation in oil markets and producers’ ability to hedge sales.
• In early 2023, we expect prices in the $90-$100 per barrel (p/b) range, but successful reopening from lockdown in China and demand normalization could push prices above $100 p/b.

Bridging the Gas Gap

• In 2023, gas markets will contend with the large supply gap left by Russia. Key pipelines in North Africa and Norway are already operating at high capacity and are unlikely to add significant supply, leaving liquefied natural gas (LNG) as the obvious short-term "fix."
• While Europe's regasification capacity is set to increase sharply in 2023, it is unlikely to fill the Russian supply gap at a time when the project pipeline for global supply is also fairly flat.
• On balance, capacity constraints will likely sustain elevated gas prices in 2023, a trend already reflected in the futures curve (Display 3).

Investment Implications

• Rates: Modelling the longer-term inflation outlook against a basket of EU energy-cost proxies with Brent crude at $90 p/b and TTF gas at €130, we calculate 5y5y inflation at 2.40 (Display 4). Nominal long-term yields might come under pressure in 2023 due to slower growth, but if buoyant energy prices persist, 10-year bund yields should be floored at 2.0%.
• European Equities: Our top-down EPS modelling suggests the downside is in line with the U.S., but EU equities may be better positioned, as our bottom-up analysis indicates that the downside is already priced into European valuations.

3. Change in China

Global supply-chain realignments, demographic change, debt deleveraging and a structural shift toward a consumption-led economy will be key trends for China in 2023. Although we see a number of challenges for China as we enter the new year, there are also signs that some of the negatives could be offset by more positive recent developments, especially in terms of the apparent alignment of COVID and economic policy, with a more pro-growth stance.

Waning Competitiveness

• China's manufacturing and trade-reliant growth model faces significant challenges in several key respects, principally related to its aging population and rising wages in manufacturing, which are causing the country to lose competitiveness. For instance, China’s median age is 40 years, compared to roughly 30 years in India, Mexico and Vietnam.¹ In addition, Chinese wages have grown five-fold over the past 15 years (USD hourly wages are now thrice Mexico's).²
• Notably, after peaking at roughly one-third of total economic output (Display 5), the manufacturing sector has seen its share of economic activity recede to 27% in 2021. Exports are also past their peak (35% in 2006), standing at just 19% in 2021.
• With competitive pressures building, China may lose market share to other countries, such as India, in high-end manufacturing, and Mexico, as U.S. companies look to nearshore operations.

Moving Beyond Debt-Fueled Growth

• China's debt-fueled investment growth owes much to the high savings rate, which has suppressed household consumption. In 2021, investment contributed to 43% of GDP against 38.5% for household expenditure. Despite record rises in private debt to GDP (Display 6), investment’s contribution to growth has been falling.
• Property sector weakness is structural, reflecting dwindling demand from an aging population and peaking urbanisation. Plus, household wealth is excessively tied to property, leading to a negative feedback loop between falling property prices and consumption.
• The Chinese government understands the need for urgent change that decreases wealth and income inequality while expanding the middle-class to rebalance the economy toward a consumption-led growth model, hence the "common prosperity" agenda.

Reasons for Optimism

• In late 2022, we saw a reversal in the path being followed by Chinese policy-makers, with a softening of China’s zero COVID stance and a reprioritisation of economic growth, rather than more ideology-led economic management. Domestic regulatory reset concerning internet/platform companies and delisting risk for U.S.-listed Chinese companies is abating, while restrictive property measures are being eased, though the government’s overarching principle on housing remains intact.
• Structural problems, such as deteriorating demographics and property sector weakness, will not disappear. Nevertheless, these reversals in certain areas of policy, coupled with excess household savings as a driver for consumption recovery post-reopening, could have a significant positive impact on the Chinese economy and assets in the next three to six months.

Investment Implications

• Transmission from GDP growth to equity earnings has weakened over time and may decline further ahead, given weak GDP forecasts and the persistence of other challenges in the economy.
• Short-term risk premiums may narrow in response to relaxation in lockdown rules and property sector support. However, China’s path to reopening is likely to be bumpy, and the best-case scenario for the property market is stabilisation, not normalcy.
• Long-term risk premiums are likely to remain elevated, given the uncertainty related to China’s rebalancing, which will be a time-consuming and likely disruptive process.

As we expect the medium-term outlook for China to improve, positions that provide broad emerging market exposure, with indirect China exposure, look attractive as we head into 2023. They enable us to potentially benefit from positive EM trends while mitigating the impact of uncertainties over the pace and smoothness of China’s post-COVID reopening. They also help to capture the positive knock-on impact the reopening would have on China’s trading partners, particularly among Asian emerging markets.

ESG View

Focus Sharpens on Inequality

• While climate change is an ever-present component of ESG integration, we foresee inequality as a growing challenge for 2023. Inequality has come under increased investor scrutiny since the COVID-19 outbreak and is now moving further up the agenda following the spike in the cost of living in 2022. We believe engagement can be a powerful tool to address this.

Conclusion

After a period of profound disruption, economic rebalancing may prove a tricky act in 2023. Policymakers must carefully weigh their options, as they attempt to suppress inflation without harming the economy and financial markets. Labor market and energy challenges will not facilitate a smooth walk across the tightrope for Europe, but until recently, the region has appeared to be more sure-footed than China. How long that relative advantage persists is increasingly questionable, in light of recent positive developments in China. The U.S. economy, more flexible and energy independent, has a slight advantage in unwinding its imbalances.

In the short term, we believe more benign inflation figures will encourage the U.S. Federal Reserve to pause tightening too early, which should initially create a friendlier environment for equities, but may subsequently lead to inflationary pressures building during 2023. This could make central bank inflation goals—such as the Fed’s increasingly questionable 2% target—unattainable without further tightening, putting downward pressure on risk assets.

Overall, we expect fixed income assets to outperform equities in the first half of 2023. Ultimately, the range of potential macro scenarios is wide and dependent on how central banks proceed, particularly the U.S. Federal Reserve. We expect to see a shallow recession and moderate but still largely restrictive monetary policy. In our view, the paths to rebalancing, and not simply the macro outcomes alone, will matter for markets in 2023. Staying nimble and adjusting investment positions as events unfold will remain key.

Appendix

Asset Class Views

U.S. Equities — Negative

We see more downside for U.S. earnings under most macro scenarios. They range from 5%-10% in our base case of an extremely shallow recession to 15%+ in case of a deeper recession. Valuations at 17.5x NTM EPS do not reflect the elevated recession risk adequately and cannot be justified by the recent small decline in UST yields. From a valuation perspective, U.S. equities face 10%+ downside after the recent November rally. At the very least, we look for a retest of the October lows in 2023 at around 3,600 and, in case a recession becomes inevitable, would expect the S&P 500 to bottom nearer 3,200-3,300.

Eurozone Equities — Neutral

Valuations de-rating has been strong enough to partially offset the upcoming downside from EPS, but ongoing headwinds from the energy crisis will likely prevent valuations from converging back to historical medians, spelling a low-to mid-single digits residual downside for eurozone equities. While valuations and factors such as a higher dividend yield support the region versus peers, more visibility on the implications of the energy crisis is needed for significant relative upside in the region. Therefore, we expect performance to remain under pressure until later in the year when uncertainty over the energy crisis outcomes is reduced.

U.K. Equities — Neutral

While valuations for U.K. equities look historically cheap, both on an absolute and relative basis, we remain cautious on the asset class, as we see a number of challenges heading into 2023. Margins are likely to come under significant pressure due to high energy prices, as well as a tight labor market, which is facing structural supply shortages. These factors make the risk of a wage-price spiral higher than in Europe and will keep pressure on rates and, consequently, on risk premiums. Following the latest change in leadership, the U.K. government seems to be focusing on fiscal discipline, reducing the potential support from fiscal stimulus for equities.

Japanese Equities — Neutral

Japan's delayed post-COVID recovery, return of foreign tourists, fiscal spending and corporate capex outlays should provide support to the economy and help avoid a recession in 2023. However, FX translation tail winds, which supported positive earnings revisions and Japanese equity outperformance, have likely peaked. Absolute and relative valuations have also become less attractive versus rest-of-world equities. We favor an unhedged exposure to Japanese equities, as it is likely to be supported by a stronger yen in 2023.

Asia ex Japan Equities — Neutral

Within Asia ex Japan, we are turning incrementally positive on Chinese equities, as domestic and external headwinds abate. China's changing attitude, from zero-COVID policy to reopening, is encouraging, as accumulated household savings should support economic recovery via the consumption channel. The worst of domestic regulation against internet/platform companies is likely behind, while restrictive measures for the property market are being eased to support the economy. Valuations remain undemanding, with forward P/E still below 5Y, 10Y and since-inception (2005) medians.

EM Equities — Positive

Peak inflation in the U.S. and EM suggests that central banks are nearing the end of their tightening cycle. An environment in which the USD peaks, with positive FX implications for EM balance of payments, and many emerging markets central banks, rate cuts would appear supportive for EM assets broadly. China's reopening could potentially be another positive catalyst that could have positive knock-on impact on its Asian trading partners. Therefore, we enter 2023 with a positive view on emerging markets equities.

Latin America (LatAm) Equities — Neutral

LatAm is likely to continue facing global recessionary fears, fiscal concerns and domestic political headwinds in the first half of 2023, with some positive news from China reopening. In Brazil, Lula's new cabinet will start its new term with a slightly more prudent fiscal policy than initially proposed. In the latter part of the year, the outlook for the region looks more benign, with Latin America likely to enter a monetary policy-easing phase earlier than DMs and other EM peers, allowing valuations to re-rate higher. Coupled with declining U.S. inflation, rates and a peak in the USD, these developments should be positive for the LatAm region.

Sector Views

U.S. and European Energy — Positive

Higher oil and gas prices should continue to support energy equities in 2023. Combined with lower breakeven oil price levels for most companies, this should help the sector offer a very high cash flow yield, with companies continuing to prioritise shareholder returns to aggressive investment policies, which ought to keep the energy market tight and prices higher. Valuations have failed to re-rate despite significant EPS upside, leaving the sector still screening as cheap, but we could see some re-rating in 2023, as investors acknowledge a different outlook for energy markets compared to a more “typical” slowdown.

European Banks — Positive

We are positive on European banks, as they offer an attractive dividend, even in the case of recession. Multiples remain depressed and are not reflective of a changing interest rate regime, which should support net interest income. Sector balance sheets also enter this recession in good shape, while cost of risk is already priced at levels consistent with a deep recession.

U.S. Health Care — Positive

We are positive on U.S. health care, as the sector remains relatively less sensitive to the macro cycle, displaying relatively stable margins even during recessions. Compared to other defensive sectors, such as consumer staples and utilities, U.S. health care has also performed well in the initial stages of a recovery, likely due to its biotech allocation. While valuations are not cheap, the sector is cheaper than other defensives versus the S&P 500.

U.S. Rates — Neutral

While 10Y UST yields should trade with a slight downside bias over 2023 (due to growth concerns), we do not expect an aggressive duration rally, even in a scenario that sees the U.S. economy slip into recession. In such an event, the Fed would likely be careful not to cut the fed funds rate excessively, but rather only toward neutral (2.5%), given uncertainties around where inflation will ultimately settle, which could be higher than 2%. In our base case, with fed fund rates at the end of 2023 close to current pricing, we see the risk/reward for U.S. yields as balanced moving into 2023.

Eurozone Rates — Negative

We expect rates in the eurozone to remain higher than pre-COVID. Firstly, this reflects a regime of higher energy prices in 2023, which we expect as a consequence of global energy flows being rerouted following the Russian invasion of Ukraine and the ongoing energy transition trends. Additionally, the post-COVID eurozone labor market remains very tight, limiting the hit to consumption from inflation and the downside in yields even as we move into a recession. Yields may be under pressure in the first half of 2023, as growth weakens, subsequently moving higher towards 2.5%. Peripheral spreads should be more supported than in previous periods of distress due to ECB policies, but they still look vulnerable to some slower but controlled widening, as financial conditions tighten.

Developed Market Credit — Overweight EUR IG and Underweight U.S. HY

Given elevated recession risks, we prefer higher-quality IG credit over HY in the U.S. and eurozone. Overall, IG has suffered from unfavorable technical factors compared to HY, such as elevated gross supply and rising stars affecting the overall credit quality of the index. IG valuations have reset meaningfully, with spreads discounting more recession risks than HY, especially in Europe. USD HY offers little premium should default rates reverse their post-COVID benign trend and rise towards longer-term averages. We are overweight in EUR IG and underweight USD HY, while having a neutral view on EUR HY and USD IG.

EM Sovereign HC Debt — Positive

EM sovereign spreads have widened significantly (above the 95th percentile), making valuations cheaper and durations longer relative to other fixed income peers, while also displaying the highest yield. With inflation in EM expected to roll over and a less hawkish Fed, we expect a positive spillover effect on risk sentiment, and lower bond and market volatility. Thirty-six percent of the JP Morgan Emerging Markets Bond Index (EMBI) Global Diversified Index is composed of oil exporters, which should find support from higher oil prices. Within the EM index, high yielders could face a choppy macro environment during the first half of the year, plagued by the risk of a U.S. recession, leading to volatile spreads. That said, the second half of the year ought to provide some general reprieve to spreads, if recessionary risk stabilises.

EM Corporate Debt — Neutral

Among emerging market debt assets, EM corporate has the highest risk exposure to Asia/China, which faces uncertainty from China's bumpy COVID reopening and structural property market overhang. The shorter-duration profile for EM corporate also means the sector would not benefit as much from bond yields rolling over, as the global tightening cycle peaks.

EM Local Debt — Neutral

Inflation in EM is peaking and expected to roll over next year, with central banks near the end of their tightening cycle and some expected to cut rates in the second half of the year. This is positive for assets with higher real carry and duration. On the FX front, volatility is likely to remain in EM currencies as long as concern over U.S. recession lingers. However, there is potential for EM currencies to rebound, if growth concerns dissipate and global risk sentiment improves. While we are neutral on EM local debt on aggregate, we are selectively overweight on short-duration Brazilian and Mexican bonds on the back of higher nominal and real yields, peaking inflation and rate cuts.

EUR-USD — Positive

As we move into 2023, we have trimmed our USD exposure. EUR is likely to appreciate more sustainably, as equity markets bottom out and global growth picks up—a China reopening could be a positive catalyst for the EUR, while weakening U.S. growth and falling inflation turn into a headwind for the USD. Rising USD hedging costs are also likely to reduce eurozone investor outflows into U.S. fixed income. The USD remains very expensive versus historical levels, making it more vulnerable to sell-offs compared to other assets that have already moved off from their respective peak valuations.

JPY-USD — Positive

We are positive JPY against the USD moving into 2023. While still at a relatively low level, Japan's inflation should continue moving higher in 1H 2023 due to lagged effects from higher input costs, driven by the weak JPY experienced in 2022. At the same time, U.S. inflation has likely peaked and started to roll over. The probability of the Fed becoming more dovish in 2023 is non-negligible, with a slowing U.S. economy, but the probability for the BoJ to become even more dovish is close to zero, skewing outcomes for JPY to the upside.

Investment Research

Ewa Turek
Vice President, Head of Research

Eric Zhang, FIA
Executive Director, Head Tactical Positioning

Umar Malik, CFA
Research Analyst

Christopher Chia, CFA
Research Analyst

Timmy Lim
Research Analyst

Florian Regnery, CFA
Research Analyst

Portfolio Specialists

Christian Goldsmith
Managing Director

Laura Biancato
Executive Director

Sabrina Lund
Vice President

¹ U.S. Census Bureau. As at December 16, 2022.

² China National Bureau of Statistics (NBS), Mexican National Institute of Geography & Statistics, Vietnamese General Statistics Office. As at December 16, 2022.