Welcome back to the pages of Ask Forstrong dear readers. Wasn’t the last year fun in financial markets? When your grandchildren ask you to tell them over and over about 2022, you will regale them with stories ranging from inflationary shocks to Elon Musk’s $44 billion takeover of Twitter to the eye-watering collapse of cryptocurrencies, those scantily-regulated digital speculations — all swept away in a torrent of regret, recrimination, and allegations of fraud. 

In normal times, you would need an over-caffeinated imagination to come up with such colorful accounts. But these are not normal times. “New realities”, as we say in our shop, continue to appear regularly.

Yet, in a year full of spectacle, the biggest story by far for investors was the sudden and sustained hawkishness of worldwide central banks. With inflation running well above their 2% targets, policymakers spent the year relentlessly jacking up interest rates. Noticeably absent? Everyone’s favourite market bailout mechanism, the so-called Fed Put, where central bank-sponsored liquidity comes to the rescue to arrest any market decline. Not so this time. Instead, central banks were a wet blanket for risk assets. The American bond market took particular note, logging the worst year ever (using data dating back to 1976). 

Most investors, conditioned by decades of chronic dovishness, found themselves on the wrong side of the trade last year and even felt betrayed by bond markets that were the supposed segment of stability in balanced portfolio constructs. 

This is all new terrain. Yet, the monetary tyranny of 2022 has now rolled over into 2023. But should this be surprising? After a multi-decade battle with disinflation, especially during the 2010s, policymakers now face a far different regime. Inflation is back and, as Christine Lagarde famously declared in 2014, deflation is no longer the ogre that must be defeated decisively. 

In hindsight, the era of zero-interest rates was an aberration, rather than the start of a longer-running trend (if interest rates at 5000-year lows didn’t make the point, then negative rates, where investors paid governments for the privilege of lending them money, should have). A bizarre chapter and good riddance (see our 2023 Super Trends report for more on this). 

But with this new macro backdrop and looking ahead, the consensus forecast for 2023 is now firmly established: the global economy, which has been hitting a series of ever-higher monetary speed bumps, will finally crash into the dreaded r-word in 2023: recession. Those who dare to dream of continuing growth, or — look away — soft, velvety landings, are living in la-la land. 

To be sure, these widespread recession calls have support. Monetary tightening is usually the leading cause of recession. And, while growth has held up remarkably well in 2022, monetary policy works with — all together now! — “long and variable lags”. That means tighter financial conditions could show up in slower growth in 2023.

Veteran market watchers will also recognize the behavioural risk here too: investors can get swept along by the gusts of popular views that they themselves fanned. In other words, recession can become a self-fulfilling prophecy: if enough consumers and companies believe it, they will curtail their spending and create their own slowdown.

Recession … Or Rebound?

Where to next? Here, we serve up a bold recession forecast: it won’t happen and, even if it does, it will be benign and markets will look past mild slowdowns. 

Let’s unpack all of this. First, financial markets have a nasty habit of framing forecasts in a binary fashion. Scenario 1 or Scenario 2 will play out. But these frameworks aren’t helpful as they deter minds from other scenarios that may play out. Yet the best investors always remain open to different scenarios, actively updating their views when the evidence suggests they should.  

Today’s macro framing is that the economy will have a hard or soft landing. But both scenarios assume that inflation will serenely revert back to 2%. Mission accomplished. The world is likely to be messier than that though. A third highly-probable scenario is a mild slowdown in some regions of the world, but with inflation staying higher than target and overall global growth remaining relatively resilient. 

On the inflation front, a long slog back to 2% targets would be consistent with past inflationary episodes. The good folks at Research Affiliates have shown that when inflation soars above 8%, reverting to even 3% usually takes 6 to 20 years (with a median of over 10 years). 

On the growth front, we maintain that the market is far too bearish on global growth. Why is everyone so gloomy? Mainly because growth has disappointed for so long. The 2010s decade was a dud. That convinced many that slow growth was a permanent feature of the global economy. Unsurprisingly now, many are still stuck on secular stagnation and new normal narratives. 

Yet a large economic contraction similar to 2000 or 2008 is unlikely. The decade after 2008 was an extended period of private sector deleveraging, cleansing of excesses and overall financial system repair. Today, we simply do not have the same economic and financial imbalances in the major world economic regions (i.e. America, Europe and Asia) as we had prior to those periods. 

The obvious follow up question then is, where will growth come from? Here, we run the risk of sounding like a broken record but we will repeat it again: the pandemic was a moment of economic reset (where the world shut down and re-opened) and policy breakthrough (where fiscal stimulus finally arrived). 

The net result has been heightened global demand. And rising demand has finally convinced executives that capital is worth outlaying — a sign that individual businesses are buying into their own prospects (even as they remain gloomy on the world economy and higher rates). In fact, pandemic shortages have quietly kickstarted a robust recovery in capital investment. This was the key missing ingredient in the post-2008 recovery and is crucial for that virtuous cycle of growing capacity, productivity and, ultimately, higher growth. All this should eventually lead to stronger earnings and, crucially, sustainably higher interest rates.

What’s more, a revival in demand is also taking hold simply because the world has underinvested in the real economy for years, whether it is on energy, infrastructure, or defense. This is far different from the “capital light” digitized spending of the last decade, which didn’t make a meaningful contribution to overall growth. 

Today, an aging population needs more healthcare services. The West needs to spend more on defense to counter threats from Russia and others. Climate change and the need for energy security will boost state investment in renewables. And heightened geopolitical tensions are leading policymakers to spend more on industrial policy. 

The final overlooked growth observation is that several dynamics could turn positive in the coming months. Forget about a warmer winter in Europe (and the associated lower gas prices) or even the likely peaking out of interest rate cycles around the globe, the world’s second largest economy, China, is now in full-blown, nostril-flared re-opening. The Economist calculates that the country has been in lockdown for 1,016 days (fully opening this week). Households now sit on a record amount of cash. Meanwhile, Beijing is now clearly committed to supporting a robust growth cycle, steadily easing monetary and fiscal policy, along with loosening credit conditions in the all-important property sector. 

How do you say “pent-up demand” with hyperbole? Expect a rerun of the surge in economic activity that the West had upon re-opening in early 2021. Adding it all up, global growth, even as Europe and America slow, will be powered by a surging China and will accelerate in the second half of 2023. 

The final point relates to investor sentiment. It is as gloomy as it gets, as we pointed out in our October 2022 article, “Pivotal Moments: Are Markets Forming A Bottom?” At 2022 year-end, Bloomberg News gathered more than 500 forecasts from Wall Street strategists. Finding a bullish one was near impossible, and the average forecast calls for a decline in the S&P 500 in 2023 (the first time the aggregate prediction has been negative since 1999). Analysts are even more pessimistic, recently downgrading the earnings per share estimates at the 2nd-greatest pace since 2010.  Bloomberg concludes: “this is the most anticipated recession of all time.”

All this means that if recession does arrive, will anyone be surprised? Hardly. Recession would be “known news” and already discounted. Conversely, if recession does not arrive, or even if the slowdown is shallow, a large positive surprise will unfold. As soon as markets get a whiff of impending recovery, they will rapidly re-price a higher growth outlook.

Investment Implications

During the 2010s, markets were busy pricing in a low growth, low inflation backdrop. That meant technology, growth stocks and all things America steadily outperformed.  The reverse will happen in the 2020s. Higher inflation and interest rates have changed the calculus. When investors can earn a nearly 6% coupon from a plain vanilla corporate bond (or when investors can buy a variety of international stocks on single-digit earnings multiples with double-digit dividend yields!), speculative technology stocks start to lose their edge. 

And, once a financial bubble bursts, markets tend to stay depressed for a long time. The US Growth index declined more than 60% between March 2000 and October 2002, with the NASDAQ taking 14 years to reclaim is previous high. That means more pain lies ahead for all the winners of the 2010s. 

Elsewhere, new bull markets are beginning. The US dollar has broken its long-term uptrend and international currencies are now outperforming. Markets outside of the United States are showing new uptrends. And value stocks, aggressively de-rated after a decade of depressed prices, are stealthily outperforming.

Rather than trying to pinpoint the exact timing of any recession, a better strategy for investors will be to start aligning portfolios with the new macro fundamentals. They are here to stay — recession or not.