Inflation has peaked, here comes recession
It has been a turbulent year for investors and the world at large. The war in Ukraine and an energy crisis were unexpected blows to a world economy recovering from a global pandemic and facing a struggle with high inflation. As the year closes, inflation, central banks and recession fears are the main market drivers.
Inflation, while still high, is believed to have peaked. And while central banks are continuing to hike rates – with recent 50 basis-point increases in the US and Europe – these jumps are smaller than what was seen earlier. Similar or smaller rate hikes are expected to continue in the first part of 2023, but most of the heavy lifting is now over.
With inflation in retreat, recession fears are rising. Recession is a not an unexpected consequence of central banks trying to rein in inflation and put the brakes on growth. The US is expected to see a sharp decline in growth in 2023, while the effects in Europe are already underway. Europe’s recession is expected to be more severe, given the impact of the energy crisis.
Against this background, the ABN AMRO Investment Committee made no change to the asset allocation. It continues to reflect an underweight in equities, a neutral stance towards bonds and an overweight in cash.
Stocks face earnings pressure
The effects of inflation are now hurting consumer spending in both the US and Europe, denting retail sales, demand and, in turn, hurting corporate profits. With economic recession expected in both the US and Europe, we now also expect a corporate earnings recession as well, although the exact timing is uncertain. Quarterly earnings results have been better than expected, but the outlook is dimming. More analysts are revising expectations downward than upward.
We expect negative earnings growth in Europe and the US in 2023. This is a more negative view than consensus estimates, given that we do not believe that recession risks have been priced-in. We therefore retain our preference for an underweight equities position. In terms of regions, we favour the US over Europe and take a neutral stance toward emerging markets. In this environment, we prefer more defensive sectors, such as consumer staples and health care.
Safe government bonds preferred
Although painful for investors during 2022, core government bonds became increasingly attractive as yields rose. Bond markets will continue to find relief as inflation decelerates in 2023 and central banks stop hiking interest rates. Given that we are entering a recession, however, lower quality (higher-return) bonds will be under pressure. We therefore continue to prefer higher-quality bond segments, such as core government bonds and investment-grade credits.
Outlook somewhat brighter for 2023
This month marks the two-year anniversary of the development of a successful covid vaccine. It was a monumental advance that changed the course of a pandemic. It enabled economies to open up after being locked down, giving a significant boost to equity markets in 2021. But the forceful recovery also ignited inflation, which was not as temporary as central banks first expected. Instead, central bankers delayed forceful action and, as a result, they will need to continue to raise rates into 2023.
It has been a tumultuous and, at times, uneasy, progression back to normal. Nonetheless, we believe that 2023 will be a better year for investors than 2022. We expect both the Federal Reserve and the European Central Bank to stop hiking rates early in 2023, with a muted recovery by the end of the year. Our current asset allocation (underweight equities, neutral bonds and overweight cash), is in line with our outlook, and positions us opportunistically for what lies ahead.
For more information on our view for 2023, see the ABN AMRO Investment Outlook, “From inflation to recession.”
Richard de Groot, Chair, ABN AMRO Investment Committee