After a nightmarish 2022, shell-shocked investors have losses to recoup and plenty to ponder. There are asset-class allocations to be made, industries to favour or shun and every economic variable under the sun to forecast. Professional money managers have the extra headache of working out how to stop nervous clients racing for the exits. But one question dominates the rest, and it is the impossible one that looms over every crash. Is the worst over?
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Economically, there is a clear answer: this year will be grim. Kristalina Georgieva, head of the imf, warned on January 1st that a third of the global economy is likely to fall into recession in 2023. Downturns have probably already begun in the euro zone and Britain. In a recent poll of economists carried out by the University of Chicago and the Financial Times, 85% thought America would follow before the year is out.
This does not guarantee another bloodbath—it could even mean the opposite. In theory, markets are forward-looking, and fears of recession stalked the world for much of 2022. Such a widely held consensus should be baked into today’s prices, meaning even a marginally better outlook would buoy prices. Indeed, analysts at JPMorgan Asset Management use the strength of agreement that there will be a recession to argue that stock prices will in fact end 2023 higher than they started. They are not alone in their optimism. Goldman Sachs’s researchers think share prices will fall in the near term, but recover by the end of the year. Deutsche Bank’s bullish lot reckon the s&p 500 index of large American firms will end the year 17% higher than it now stands.
If this year offers a repeat of 2022, with heavy losses for both stocks and bonds, it will be an unusual one. Stock prices mostly go up. They rarely decline two years in a row. The s&p 500 last did so two decades ago during the bursting of the dotcom bubble. Last year’s bond rout was on account of the Federal Reserve raising rates at its fastest pace since the 1980s, which is unlikely to be repeated.
Even so, there are reasons to believe more pain lies ahead. The first is that shares, relative to their underlying earnings, remain expensive by historical standards. Despite last year’s plunge, the price-to-earnings ratio for “growth” stocks, those of companies promising big future profits, has fallen back only to where it was in 2019. This was its highest since the global financial crisis of 2007-09, a level which was reached after a decade-long bull market. True, “value” stocks, those with a low price compared with the firm’s book assets, look more attractive. But as recession sets in, both types are vulnerable to earnings downgrades that are, for the most part, yet to materialise.
Moreover, today’s valuations were reached during an unusual period: one in which central banks pumped endless liquidity into the market via quantitative easing (qe). By buying government bonds with newly created money, the Fed and others depressed yields and nudged investors to seek returns in riskier assets, like stocks. Now these qe programmes are being kicked into reverse. One consequence is that governments will rely much more on private investors to hold their debt. In the fiscal year of 2022-23, America’s Treasury may need to borrow almost twice as much from investors as it did during each of the two years preceding the covid-19 pandemic, and four times the average in the five years before that. Even without central banks raising short-term interest rates, this glut could drive bond prices down and yields up. Just as in 2022, stocks would therefore be left looking less attractive by comparison.
The final reason for gloom is a divergence between economists and investors. Although wonks are betting on a recession, many punters still hope one can be avoided. Markets expect the Fed’s benchmark rate to hit a peak of below 5% in the first half of this year, before declining. The central bank’s governors disagree. They project that the interest rate will end the year above 5%.
Thus investors are betting either that inflation will fall to target more quickly than the Fed expects, or that the monetary guardians do not have the heart to inflict the pain it would take to get it down. There is, of course, a chance they will be proved right. But markets spent much of 2022 underestimating the Fed’s hawkishness, only to be put in their place by Jerome Powell, the central bank’s governor, at meeting after meeting. If the pattern repeats, 2023 will be another miserable year for investors. ■
Read more from Buttonwood, our columnist on financial markets:
India’s stockmarkets are roaring. They also have serious faults (Dec 20th)
For bond investors, every country is an emerging market now (Dec 8th)
Has private equity avoided the asset-price crash? (Dec 1st)
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