My 2023 Macro Outlook - Part 1
Navigating the New Normal
One of the defining questions of 2022 was how far inflation would rise and what impact it would have on global financial markets.
As it turned out, prices soared to previously unimaginable levels, with double-digit inflation becoming the new normal in some places. Even in the United States, the core Consumer Price Index (CPI) shot up to 9.1%, the largest increase in four decades.
But now, as we turn our attention to 2023, a new question presents itself:
how deep will the economic slowdown go, and what kind of impact will it have on the world's financial markets?
It is unclear what the future holds, but one thing is certain: the ongoing economic situation is likely to continue to be a significant and possibly even more impactful development than what has already occurred in 2022.
The economy in 2021 was a reflection of the massive monetary and fiscal easing in 2020.
The economy in 2023 is going to be a reflection of the massive monetary and fiscal tightening in 2022.
My base case is that we are going to experience a severe slowdown in economic activity in the first two quarters of 2023 causing huge volatility in both directions. A jump in unemployment, disappointing earnings reports and geopolitical tensions will all contribute to a highly challenging economic environment. I also believe that although the market expects an economic slowdown in 2023, the majority still underestimate the magnitude of the impact it will have on global markets.
In this series of articles, I am trying to introduce the most important elements of my macro framework which I use to navigate traditional markets and the cryptospace in 2023.
Before diving deeper into the recession issue, it's worth taking a closer look at the ongoing inflation problem.
As the data shows, following the 9.1% peak of June 2022, there has been a noticeable decline in the rate of inflation. In October and November 2022, the US Consumer Price Index came in below expectations and last week’s reading arrived as expected at 6.5%, indicating a slowdown in the increase of the cost of goods and services compared to last year.
Obviously, a relief in energy prices contributed to the decline in a great part, but even if we take the core inflation (excluding food and energy) we can see a slowdown.
While the cooling of inflation may be seen as a positive development, it's important to note that it is also a symptom of a broader economic slowdown. A decline in inflation is preceded by a decrease in economic activity, making the current recession not a surprising development.
Ultimately, this is what the FED rate hikes aim to achieve: to force the overheated economy to cool down by creating a less stimulative environment where access to money and credit is less available. What makes the task of balancing price stability and full employment (the dual mandate of the Federal Reserve and all the other central banks) challenging is that the financial system has become extremely overleveraged.
The reaction to the economic shock triggered by the pandemic in 2020 was an extreme stimulus when central banks injected huge amounts of liquidity into the system. Combined with an excessive fiscal policy of increased government spending, it certainly contributed to a rapid rise in consumer prices. But even experts can't agree on whether the roots of this historically high inflation can be found on the demand or supply side.
The supply side theory claims that C0vid lockdowns disrupted the global supply chain, resulting in less output and less trade so the same amount of money was chasing fewer available products, which led to price increases.
On the other hand, advocates of the demand shock theory argue that, while the lockdown and supply chain destruction also contributed to inflation, the main cause can be found on the demand side. They believe that the excessive stimulus (such as "helicopter money" from the government and easily available credit) throughout 2020 allowed people to extend their buying power, resulting in more money chasing the same amount of goods and services.
Additionally, there is another important contributor to the inflation issue beyond supply and demand factors: geopolitics. The escalation of tensions between Russia and Ukraine, which resulted in a military conflict on the border of the European Union, further disrupted the already fragile supply and demand equilibrium. Two major suppliers engaged in a long-lasting war: Russia, the biggest energy supplier to Europe, and Ukraine, one of the world’s top sources of agricultural products.
While the hot war between Russia and Ukraine contributed to the rise of inflation, other experts suggest that we should zoom out and take a broader perspective. From that point of view, we can see that the main driving force is not the hot war taking place in our shorter time frame, but the hot economic war between the two superpowers competing with each other, which is the dynamic that shapes the big picture and which is going to define not only the coming years but the next decades as well.
Zoltan Pozsar claims that inflation did not start with the war in Ukraine and that the biggest driver of inflationary forces can not be related solely to the ongoing crisis. Still, the war accelerated those inflationary forces that have been working in the background for a while. Most importantly, if the war and zero-Covid policies are here to stay for a longer period, the mainstream thesis about inflation being cyclical and driven mainly by the business cycle and central bank stimulus could turn out to be completely false.
According to Pozsar, most of the market participants expect that inflation is about to peak and that the FED is about to switch its policy from tightening to easing again.
The problem is that the supply-side issues (geopolitical tensions, shift in trade dynamics) are more severe and deeper than the demand-side problem (which central bank policy tries to address with the easing and tightening process).
So if we can assume that the current inflation is mainly driven by the economic war and the ongoing fundamental changes in the world order and not only by the stimulus that has been injected into the financial system to tackle the C0vid aftermath, we can also assume that we are not at peak “FED hawkishness” (central bank policy will not take/can’t take a U-turn soon as the market expects).
But then what can happen to inflation?
It can jump even higher,
it can decline to the desired level of 2%
or it can stay elevated for some time.
Given the enormous pace and amount of interest rate hikes and the reduction of the FED balance sheet, we can rule out option #1 for now —but it doesn’t mean that inflation can not jump back to or above the 2022 summer levels in the future.
Option #2 would be the dream case, the so-called soft landing narrative: inflation would take a slow but steady decline accompanied by a mild recession. To achieve this, the FED should navigate the economic machine with the precision of a Formula-1 driver: following the optimal path, applying the brakes precisely and of course sitting in the best car. Unfortunately, the economic machine is not even close to an F1 car and not even to a regular one. We should imagine it as a huge cargo ship.
Option #3 is that inflation will do decrease but not to the desired level of 2%, instead, it will stay elevated for some time. The background of this outcome relies on the thesis that today’s inflation is a structural phenomenon which can be seen as a byproduct of the changing world order where geopolitical and socioeconomic shifts have disrupted the system that made the low-inflation environment possible over the last decades.
Historically, recessions always contribute to the rapid decline of inflation which forces central banks to stop their rate-hiking operation and instead cut rates to prevent the economy from falling into a depression. This would be the FED pivot case, which is being considered by the mainstream as a positive bullish signal for equity markets and crypto as well.
My very personal view on this matter is that a FED pivot caused by a severe recession is NOT bullish for risk assets. Although a less restrictive FED policy would certainly provide a more favourable environment for crypto, I still see other roadblocks on the road leading out of this extremely challenging environment. Timing the market has never been more challenging than today.
The general narrative is that the extreme pace of rate hiking will cause a deep recession sending inflation even below the 2% target which will force the FED to stimulate the economy again by cutting interest rates. The logic says that lower interest rates are good for risk assets and crypto, so digital assets could benefit from the crash of the economy. The truth is that even if the FED will have to lower interest rates, we won’t see that near-zero interest rate environment again in the near future and financial conditions will remain tight for a while —which is NOT the favourable environment for crypto and other asset classes without a decent cash flow.
The crypto bull case is a V-shape recovery like we had during the C0vid crisis. But we have to understand that such a bullish economy would immediately re-inflate prices, causing a second extremely inflationary cycle which would force central banks to implement even higher interest rates for longer. Instead, the economy would need an L-shape recovery, resulting in a period of lower growth and higher inflation.
The markets are still looking past this dilemma and will probably not react until the crisis is deeply upon us (as it happened before the C0vid shock too).
Investing is more of an art than a science. We can not predict the future —not even quantum computers can. The only way we can navigate today’s unpredictable market is by being prepared for all possible outcomes and scenarios.
And this can best be achieved by having a well-diversified portfolio:
Emerging Markets such as Latin America and India can provide investment opportunities due to the lack of investment during Covid and other factors.
There are certain areas of commodities that have been underinvested in, that are less growth sensitive.
I favour equities that generate the cash to support their growth over equities that need liquidity to grow in value (no crypto in Q1-Q2).
Cash is still king.
From 2023 onwards, wealth preservation will be much less about buy-and-hold and much more about macro risk management.