Most investors will be glad to have seen the end of 2022. The past year has been challenging for almost all asset classes but it has been the synchronised falls in equities and fixed income has made the year most difficult to navigate. While there are reasons for optimism in 2023, the paradigm shift that occurred in 2022 persists. Bond yields and interest rates rising from sub 0% to 3-4% fundamentally changes the way investors, businesses and consumers approach decisions. A zero cost of money did lead to bubbles in some areas of the market, with the falls last year most acute in those areas that rose rapidly in 2021. Without a return to extremely low interest rates, it is unlikely that there will be a snap back in those assets. Nevertheless, the relentless increase in interest rates and bond yields does appear to be easing and could allow the market breathing space to consolidate.
While inflation remains high globally, the early signs that the pace of rising prices is slowing is allowing investors to look ahead to the implications on monetary policy and asset prices. There have been increasing signs that inflation has peaked in key economies and a number of significant inflationary drivers are beginning to weaken or reverse. The main constituents of the closely watched US CPI include, energy, food, services, goods and shelter (housing). Within these, there are notable reversals already happening or likely to occur in the near future, particularly in energy, food and shelter. Energy prices are clearly declining, with crude oil and natural gas prices having peaked earlier in the year. This will become a significant negative driver early next year. Food pricing trends are less clear although the cost of production and prices are heavily influenced by the cost of energy, with a lag. There have already been declines in commodity food prices, for example, wheat prices are over 40% down from their peak and flat year on year. Finally, shelter, which is predominately influenced by rental prices, is now negative month on month as rental prices in key cities fall outright. As rental contracts are generally negotiated over at least a 12 month agreement, the impact on the headline inflation figure will be moderated and extended.
Resultingly, anticipation of a recession during 2023 has led many market participants to believe that it is unlikely the Federal Reserve will be willing to increase interest rates much further as inflation falls and unemployment begins to rise. Short term interest rate expectations and bond yields have moderated, positively influencing equities and other asset prices already, overcoming the weakening outlook for economic growth and company earnings.
The two key risks to this recently more positive outlook are the stubbornly resilient US labour market, and the potential for further external supply shocks. Firstly, although the jobs market is showing some signs of loosening, it is still tight in absolute terms as vacancies outnumber jobseekers and employees retain significant bargaining power. Monetary policy rate setters and observers will be keen to see this weakness continue as it lessens the risk of second round inflationary effects. Secondly, supply shocks by their nature are difficult to predict, however, energy and food markets as well as global supply chains remain fragile and would be very vulnerable to further shocks if they were to occur, exacerbating the price response.
Looking forward, over the course of 2023, we expect that inflation will fall rapidly at a global level. This will particularly be seen during the second quarter as the price spikes in many commodities seen in the corresponding period in 2022 have their maximum effect on the annual figure. As inflation declines to its target rate, policy makers can take a more relaxed view and may even begin to consider rate cuts before the year is out. While a weakening economic outlook may prove to be positive for investors in government bonds, the outlook for equities and other risk assets in this environment is less clear. Earnings expectations are already beginning to weaken and an outright recession may cause a more significant hit, removing some valuation support from the market. With this fine balance between potential monetary policy support later in the year and weakness in earnings, we retain a neutral equity outlook at the start of the year.