The year just past was all about inflation, but in the year ahead it will be the data and whether it supports or deflates the prospect of a global recession that will dominate markets.

In response to decade high levels of inflation, central banks have increased interest rates at the fastest pace in history. This has been a major contributing factor to the large sell off in both bonds and equities all year.

The idea behind higher rates is that it is designed to slow spending both for individuals and corporations. Slower spending will eventually lead to lower inflation. However, it is very difficult to slow inflation without economic growth also taking a hit.

Higher interest rates increase the servicing cost of debt. For individuals with debt it means lower spending, in turn creating lower profits for corporations and if severe enough, job shedding. For investors it also means equity valuations are compressed given risk-free yields through investments such as government bonds offer a real alternative to equities.

US Federal Reserve chair (Fed) Jerome Powell summed it up neatly recently in a statement: “We have always understood that restoring price stability while achieving a relatively modest increase in unemployment and a soft landing would be very challenging – we have got to get inflation behind us. I wish there were a painless way to do that. There isn’t.”

We know that central banks won’t stop until they are able to get inflation under control and that this is likely to lead to a slowdown in growth. The question remains, how much will growth slow and will it trigger a recession in 2023. The National Bureau of Economic Research (NBER) Business Cycle Dating Committee—the official recession scorekeeper—defines a recession as “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” The variables the committee typically tracks include real personal income minus government transfers, employment, various forms of real consumer spending, and industrial production.

Recently we have seen several leading indicators suggest that inflation is likely to come down, firstly freight costs have declined sharply and suggest that goods inflation should also come down. Services inflation on the other hand could be more stubborn and will largely rely on the labour market.

What is the domestic impact?

Australia’s unemployment rate currently sits at 3.4% – the lowest in almost 50 years. A tight labour market means that employers need to increase wages to attract talent, a cost which is often passed on to the consumer causing a wage growth spiral. NAB expects higher interest rates to materially weigh on consumption and GDP growth in 2023 and 2024, and while we don’t expect a recession in Australia, annual growth will likely fall below 1% and unemployment rise to 4.5%.

Eyes remain focused on the US

Looking at US financial metrics, several are suggesting a recession is likely. Other financial metrics, such the 3 month and 10-year yield curve inversion have a strong track record at predicting recessions. Additionally, US ISM Manufacturing PMI is currently at 49.00, a reading below 50 is contractionary.

Will the bulls or bears dominate?

The answer lies in whether we can avoid a recession. A question that will no doubt be debated through 2023. If we see inflation down and can avoid a recession, we could see both equities and bonds move higher, however if we do have a recession then bonds typically outperform equities, given that corporate earnings can continue to decline during a recession.

US CPI (inflation) came in at 6.5% in December, down from 7.1% in November. While this is significantly higher than the 2% inflation target it has led to speculation that the peak inflation rate is behind us. While this means we are still likely to get more rate hikes, it could signal that the Fed will not need to increase rates beyond what is currently priced into the futures market – a metric which is important to follow given that markets are forward looking.

US interest rates currently sit at 4% and the peak of interest rate expectations has gone from 5.19% down to 4.9% over the past month. This peak is expected to be realised in June 2023 according to Bloomberg’s futures market data. The decline in the peak interest rate has been a major contributor to why both bonds and equities have rallied over the last three months.

We have seen a material decline in goods inflation, however, services inflation remains resilient and is likely to be harder to break given the extremely tight labour market in the US. Unemployment in the US currently sits at 3.5%, the lowest since 1969.

The recession and equities trade-off

According to Goldman Sachs, the performance of the S&P500 following a confirmed peak in inflation depends on whether we have a recession. If we look at data dating back 1955, equities fall by an average of 15% before reaching a bottom during periods of recession. However, if a recession is avoided equities increase by 20% on average 12 months following a peak in inflation. It is important to note that these are historical averages, and while history doesn’t always repeat it can rhyme.

The reason defensive assets such as government bonds can do well once inflation has peaked is because equity holders become concerned about the potential for a slowdown in corporate earnings. Government bonds can benefit once the peak in rate hike expectations has been realised, even if growth slows or we enter recession.

For now, growth has been surprisingly strong despite the aggressive rate hikes, but the impact of rate hikes is known to be felt with long and variable lags. Looking forward we would need to keep an eye out for a confirmation if inflation has peaked over several prints. This would mean that central banks can pivot from their current higher for longer stance.

On the growth front, we are likely to experience a slow down because of the aggressive pace of rate hikes. However, the severity of the slowdown is yet to be known but will be an important consideration when deciding on investment asset allocation for 2023.
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The information contained in this article is gathered from multiple sources believed to be reliable as of the end of December 2022 and is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. JBWere Limited ABN 68 137 978 360 AFSL 341162 (JBWere) is a wholly owned subsidiary of National Australia Bank Limited ABN 12 004 044 937 AFSL and Australian Credit Licence 230686 (NAB). Before acting on this information, NAB and JBWere recommend that you consider whether it is appropriate for your circumstances. NAB and JBWere recommend that you seek independent legal, financial and taxation advice before acting on any information in this article.