In this week’s update - Will inflation begin to fall and interest rates top out from here? Will growth get a lift from the reopening of China after covid lockdowns? Will the US$ continue to weaken?
Continue reading for our predictions for 2023.
Russia: For Putin to survive, he has to diversify trade from West to East, quickly. Trade primarily constitutes energy (Oil & Gas) – which means selling it at vast discounts to the spot price. This switch is not an overnight process. The “Power of Siberia” pipeline (carrying gas exports to China) will not reach capacity until 2025 (=38bcm). A second pipeline is planned via Mongolia but will only boost gas to a total of 48bcm (38bcm + 10bcm) by 2025. It won’t reach capacity until 2030 (total of 88bcm). That’s some 3y to 8y from now. Meanwhile, he has to balance high/rising inflation at home (exacerbated by military drafting that sucks more labour out of the economy) with the inability to fund growth through investment due to high borrowing costs. His woes are now spreading internally while externally Ukrainian forces keep advancing. It’s down to the West + Ukraine to see whether they offer him a “Golden Bridge Exit” (Sun Tzu – a Chinese general, military strategist, writer and philosopher - wrote that when an army surrounds its enemies, it is prudent to “leave an opening”. Such a strategy is often referred to as building a “Golden Bridge” allowing one's enemy to avoid certain defeat through escape). I think we will see a start to this process. The West is already beginning to show signs of concern at how Ukraine is taking out Russian positions, inside Russia, using drones and other sophisticated hardware and the implications this has on a severe, Russian counter-retaliation. At some point, the West will have to make the first move – Putin certainly won’t. His plan “B”, if such reports are true, is to escape to Argentina or Venezuela if all else fails.
Iran: The revolt led by Iranian women will either result in the leadership relaxing its grip (highly unlikely) or being toppled. I think the Clerics are on their way out. If true, it will change the balance of power in the region considerably with Iran becoming cautiously “West-leaning”. This would be a game-changer! If it transpires so, I hope the West doesn’t mess it up by pandering to surrounding, Middle Eastern nations.
China: The country is facing its biggest challenge ever as it eases Covid restrictions knowing full well that things really will get worse first before they start to improve. Frankly, it makes the goings-on, in the country’s property sector, look like a side show. Property is not the main risk to the economy – the easing of covid restrictions is. Between excessive & harsh lockdowns, digital tracking, questionable vaccine efficacy and poor vaccine distribution, the country is on the backfoot and has had to acquiesce to protesters (mostly the youth amongst whom unemployment is highest) as memories of Tiananmen remain vivid in the minds of Politburo members. It will be a choppy Q1 as infections spread fast and deaths rise…..but I believe the authorities will pull through and the big, economic reopening will start. This is going to boost growth, especially the terms of trade, in the region by quite some margin. It will also boost demand for commodities – not to the extent we witnessed post 2008 but nevertheless still meaningful.
US: Despite saying he will run, Trump’s days are over. He is being investigated for all sorts of wrongdoings and investigators seem to be circling. I think we will finally see an outcome to this reality show resulting in his departure…..paving the way for a fresh face to take over. For now, the Democrats have come through remarkably well. Even though they lost their majority in the House of Reps to the Republicans, the latter is too divided to be a real obstacle. The economy is holding up far better than expected. Inflation is turning while wage growth accelerates.
Europe: It’s all about the gas! Europe has to focus its efforts on reducing its dependence on Russian oil and gas – and if they can do it in less time than it takes for the Russians to transition away from the West to the East, Europe’s economy will gain significant traction. They have already done a remarkable job replenishing gas stockpiles to get through this Winter. I have no doubt they will do even better ahead of next winter. So unless Mr. Putin has a secret polar vortex weapon at his disposal, I think Europe is now starting to win the energy (gas) war.
Inflation: Headline inflation has turned an important corner. Almost every week I used to find myself commenting on how inflation was going up. Now, it’s starting to point the other way. The main driver has been the big decline in energy costs which, together with food, constitutes the headline rate. However, core inflation (ex-food & energy) is a different story and will remain persistent and in the midrange single digit levels. The latter will be the Central Banks’ (CBs) new fight. Overall, I find the inflation projections still too optimistic – both by magnitude as well as timeline. There are serious questions to be asked over target rates of 2% to 3%. Wage growth is gaining momentum and labour markets remain astonishingly tight. If CBs can find a reasonable balance between core inflation and wage growth, that is a further boost for growth – when spending power, in real terms, turns from negative to positive brought about by core inflation undershooting wage inflation - growth gets a shot in the arm. Inflation at levels of 5% to 6% helps erode the value of debt – it all assists with the debt mountain.
Rates: Central Banks are now pretty much on the curve! They have done it in rapid time considering the panic began in Q4 2021 and was then followed by the Ukraine invasion in Feb this year. From here on, it’s all about tweaking rates in line with the performance of the economy. The Fed announcement on Wednesday was actually very clear to my mind – they are saying we are not out of the woods yet (core inflation) but will act accordingly based on newsflow. CBs have done what they can to reduce liquidity and dampen consumer demand – without sacrificing employment. They are only too aware of the risk of tightening too much and collapsing the labour market. It’s all about finding the right balance. With the latest increase in the Fed Funds Rate of +0.50%, the range is now 4.25% to 4.50%. I think the worst of the hikes is over. As one headline I saw read: “+0.50% is the new +0.75%”. GS is forecasting 3 more hikes next @ 0.25%. I can only see that happening if we get a stronger-than-expected growth rebound. We won’t know the answer to that till end of Q3. For now, my view is we avoid a recession.
Growth: There has been an uplift in growth forecasts for 2022 just based on the last 60 days. It’s no coincidence this ties in with a drop in headline inflation. A Goldman Sachs (GS) ELI (Effective Lockdown Index) for China has it at close to its 2022 high. As this unwinds and the economy reopens, this will create a large growth effect which will spill over into the surrounding region. That benefits Europe, especially Germany, given exports to the region as a whole. This in turn impacts the rest of Europe. That’s effectively how the transmission mechanism works. The unknown is whether this reopening in China will be inflationary or deflationary. In 2008, it was deflationary and lasted years. Now, the cost of doing business in China has risen – it’s one of the reasons why manufacturers, including Chinese companies themselves, are spreading their manufacturing plants in the wider Asian region. Relative costs have changed.
Summary: The risks to the above are huge. What if Putin does go nuclear? What if covid easing in China backfires and results in mass uprisings? What if energy costs go through the roof reigniting headline inflation again? What if CBs get it wrong and initiate excessive tightening of financial conditions through interest rates resulting in unemployment rising and default rates escalating? On balance, I think the risks are skewed to market upside, not downside i.e. I don’t see anything just yet to suggest any one or more of the above risks will get out of hand.
Back in July, GS forecast the drag from covid restrictions on the world economy was around 1.5% to 1.75% of global GDP. About two-thirds of this was attributable to China. This has not been factored into revised forecasts for 2023 – That’s a lot……and it’s not a simple case of saying “just add an extra 1% onto next year’s GDP forecast”. That’s not how the transmission mechanism works. There is a multiplier effect that kicks in. Currently, the 2023 consensus IMF/Bloomberg growth forecast is +1.7% (US +0.4% EU -0.1%, Japan +1.3%, UK -1.0%, Canada +0.5%, China +4.8%, India +5.7%, Brazil +0.8, Russia -3.0%). By contrast, GS has global growth at 2.0% with vastly better forecasts for the US (+1.3%), Canada (+1.1%), China (+5.2%), Brazil (+1.2%) and Russia (-1.3%). The direction of their forecasts make a lot more sense to me – if growth pickups up, it’s Risk On. You would expect the Emerging Market nations to do better and also commodity nations (like Canada).
So, in a nutshell:
Declining headline inflation
Persistent core inflation (which will create volatility as it will take time for markets to adapt to this psychology)
Healthy wage growth that comes to match core inflation (amongst skilled workers and specific sectors it will beat core inflation)
Interest Rates top out from here
Growth gets a lift from China reopening, wages globally, a revival amongst exporting nations and a lift in commodity prices
FX: Risk On = a weaker (NOT weak!) US$ in favour of €, EM and Commodity FX. So if you’re a non-US$ investor, think about diversifying your FX risk through an international portfolio that invests in a mixture of US$ and non-US$ underlying positions.
The risk to growth is to the UPSIDE, not the downside.
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