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Promotional material published by Metzler Asset Management GmbH - 21.12.2022 - Edgar Walk

Outlook 2023: The return of macroeconomic volatility

What are the financial markets pricing in for 2023?

The starting point of our outlook for this year is an assessment of the macroeconomic expectations priced into the financial markets. Market prices only move when expectations of market participants are off the mark.

According to a Bloomberg survey, financial market participants expect a moderate downturn in the global economy in 2023 – to a growth rate of 2.2 percent. In 2021, the global economy was still growing at 6.0 percent. At the same time, inflation is expected to remain high at 5.1 percent. Accordingly, the OISforwards show that further increases in the key interest rates of the central banks are anticipated – in the USA up to around 5.0 percent and in the euro zone up to around 3.25 percent. Basically, financial market participants seem to believe that monetary policy will be successful, as they expect inflation rates of around 2.0 percent again from 2024 onwards, according to inflation swaps. 

1 OIS = Overnight Indexed Swaps 

Financial market players expect a rapid decline in inflation
Actual inflation and inflation expectations according to inflation swap forward rates in %

Sources: Refinitiv Datastream, Metzler

What other scenarios are there?

The scenario priced into the financial markets is only one of four probable scenarios we have identified for 2023. Basically, there are two questions that need to be answered correctly. The first question relates to the inflation process: Will inflation return to the very low pre-pandemic levels because the two shocks "pandemic" and "war" only contributed to transitory high inflation rates? Or are there structural changes in the major economies that create persistent inflationary pressures?

If there is indeed persistent inflationary pressure, it does not automatically have to manifest itself in actual high inflation rates, as central banks can always reduce inflation at the expense of economic growth. Therefore, the second question is: How will the central banks react to this?

Scenario analysis for 2023 The overview of the four possible scenarios shows that the financial markets now expect persistent inflationary pressure, but at the same time they assume that the central banks will react perfectly.
Source: Metzler

The overview of the four possible scenarios shows that the financial markets now expect persistent inflationary pressure, but at the same time they assume that the central banks will react perfectly.

What is the inflation outlook?

We also see the scenario of persistent inflationary pressure rather than a rapid decline to previous low levels. However, if inflation were to fall sharply in 2023, contrary to our expectations, central banks would likely cut policy rates markedly again in the course of 2023, which would have a very positive impact on bond and equity markets.

The reasons for our assessment of persistent inflationary pressures are as follows:

  • Demography
  • Deglobalization
  • Decarbonization
  • High debt
  • Raw material shortages
  • Food shortages

We see the effect of demographic development as being inflationary, since the labor markets are already characterized by very low unemployment rates and ample vacancies. In addition, the baby boomers of the 1960s will retire in the coming years. Between 1980 and 2020, they provided an oversupply of labor and low real wage growth.

With increasing retirements in the coming years, labor should thus remain scarce and real wages should rise more strongly again – with corresponding pressure on companies' wage costs.

Demographics: As baby boomers retire, wage pressures should pick up again in many industrialized countries


Birth rate
(children per woman)
In addition, the baby boomers of the 1960s will retire in the coming years. With increasing retirements in the coming years, labor should thus remain scarce and real wages should rise more strongly again – with corresponding pressure on companies' wage costs.
Sources: United Nations Population Division, FactSet; as of 2021
Real hourly wages in the USA
yoy in %
Between 1980 and 2020, they provided an oversupply of labor and low real wage growth. With increasing retirements in the coming years, labor should thus remain scarce and real wages should rise more strongly again – with corresponding pressure on companies' wage costs.
Sources: United Nations Population Division, FactSet; as of February 2020

* Exclusive agriculture ** 1948 to 1980 *** 1980 until February 2020

In Japan, the ageing society has so far had a rather deflationary effect, as the elderly population in Japan has so far had an extremely high propensity to save. In Europe and the USA, however, the older population is more likely to consume and thus contribute to an inflationary environment.

Other factors that could contribute to structurally higher inflationary pressures are deglobalization, decarbonization and the scarcity of commodities.

For example, almost all companies are currently restructuring their supply chains, likely in association with higher costs and prices. Decarbonization also means greater investments in the future and thus strong demand for industrial metals, photovoltaic systems, etc. – with corresponding effects on prices. It should also not be underestimated that neither the big oil companies nor the mining companies have invested significantly in new capacities in recent years. So, there is a structural shortage of raw materials.   

Basically, we agree with most financial market players that inflation will not fall significantly below 2.0 percent on an annual average in the coming decade.

How will the central banks react?

Basically, there are three ways a central bank could respond to the current inflationary environment: soft, perfect, or over-hard. If the central banks succeed in causing only a moderate downturn with the help of the expected interest rate hikes, but one that is sufficient to break the inflation dynamic and bring inflation back down to 2.0 percent, this would be the "perfect" reaction to the current environment. Equity markets would then likely perform well in 2023, as valuations are now much lower than at the start of 2022, while also allowing for solid positive corporate earnings growth. The bond markets would also have performance potential, as central banks would cut key interest rates again in 2024.

However, we believe central banks are more likely to react too harshly to the current inflation environment. There are three reasons for this:

  1. return to high real interest rates
  2. pace of the rise in interest rates
  3. synchronization of the rise in interest rates worldwide

A look at the real yield on a 5-year inflation-linked government bond in the USA, the country of the world's reserve currency, shows a dramatic reversal in yields. As recently as last year, real yield was trading at around -2.0 percent, while this year it even peaked at just under +2.0 percent. In mid-December it was still trading at around +1.4 percent. In the euro zone, too, real yield on 7-year inflation-linked Bunds rose markedly from around -1.75 percent at its lowest point to around +0.1 percent in mid-December.

Dramatic rise in real yields in the USA
in %

Sources: Refinitiv Datastream, Metzler; as of December 13, 2022

At the same time, the strongest increase in key interest rates within one year in the USA and the euro zone since the 1970s is looming. This is thus a completely unexpected interest rate shock that hits record high debt levels and presumably many "zombie" companies that have only been able to survive because of low interest rates in recent years.

For example, private sector debt in the USA has risen from about 100 percent of GDP in the 1970s to over 150 percent of GDP. Globally, private debt has also risen to comparably high levels. There is thus a threat of a noticeable increase in credit defaults, which is likely to reinforce the recessionary tendencies in the USA and Europe.

Finally, simulations by the OECD and the ECB show that a globally synchronous cycle of key interest rate hikes could have non-linear effects. Especially since central banks worldwide are raising key interest rates in very large steps of 50 or even 75 basis points. The ECB's analyses show that the negative effect on economic growth in a globally synchronous rate hike cycle could be three times as strong as in a normal rate hike cycle. Thus, key interest rate increases abroad dampen European exports and also contribute to deteriorating financing conditions.

Record number of central banks are raising key interest rates at the same time – non-linear braking effects are likely
Number of key interest rate changes of select central banks*
The ECB's analyses show that the negative effect on eco-nomic growth in a globally synchronous rate hike cycle could be three times as strong as in a normal rate hike cycle.
Sources: Bank for International Settlements, World Bank, Metzler

* 37 countries plus euro area, three-month moving average ** As of August 31, 2022

Are there any signs in the real economy of "over-hard" central banks?

The thesis of "over-hard" central banks has so far been based more on theoretical considerations. Therefore, the question arises whether there are already any signs of this in the real economy. At present, we see several reasons that speak for recessionary tendencies because of the over-tight monetary policy in the major economies.

First, banks in the USA and the euro zone massively tightened credit standards for corporate customers in early October. This means that the key interest rate hikes have resulted in a restricted supply of credit, as is usually to be expected when key interest rates are raised. What is surprising, however, is the extent of the tightening, which has reached levels comparable to past recessions.

Banks tighten credit standards noticeably in response to monetary policy
Tightening of banks' credit standards compared to those of companies (balance of respondents)

Sources: Refinitiv Datastream, Metzler; as at October 31, 2022

Second, the inverse yield curves signal increased recession risks. In my interpretation, the 10-year government bond yield reflects the equilibrium interest rate, which neither stimulates nor slows down the economy. If the central bank raises the key interest rate above the yield on 10-year government bonds, it is deliberately putting the brakes on the economy.

Thirdly, interest rate-sensitive sectors are always the first to be affected by a change in the monetary environment. In the USA, for example, we can already see that demand for residential real estate has really collapsed because of interest rate hikes. According to the University of Michigan's consumer survey, the willingness to buy has never been this low.

The residential property market is early cyclical. This means that the rest of the economy usually follows the residential property market with a time lag of up to one year.

USA: Buyers' strike in the real estate market
Index values

Sources: Refinitiv Datastream, Metzler; as of November 30, 2022

In the euro zone, on the other hand, the stance of monetary policy is more likely to be observed based on the real M1 money supply. Due to key interest rate hikes, money supply growth has already slowed down noticeably. Moreover, high inflation is eating up the money supply necessary for solid economic growth. The real money supply is thus also signalling a noticeable slowdown in growth in the coming months.

Euro zone: High inflation and ECB rate hikes weigh on the overall economy
in % yoy
Euro zone: High inflation and ECB rate hikes weigh on the overall economy
Source: Refinitiv Datastream, Metzler; as of October 31, 2022

In China, we expect economic growth of only 3.0 percent next year. The wave of infections currently building up is likely to continue to weigh on growth until spring of 2023. In addition, the crisis in the real estate market will continue to dampen growth for two to three more years. Finally, the demographic trend reversal should not be underestimated: in 2023, the number of workers could decline noticeably.

So, what does Metzler Asset Management expect for 2023?

Recessions are inevitable in all three major economies. We therefore expect the global economy to grow by only 1.3 percent in 2023, compared to 2.2 percent in the Bloomberg Consensus. Noticeable increases in credit defaults are likely to be one reason why recessions are deeper than generally expected.

Accordingly, we expect central banks to raise the key interest rate less than expected – and even see opportunities for key rate cuts in the second half of the year. Therefore, we also see opportunities for falling government bond yields in the course of 2023. We see the yield on 10-year Bunds fluctuating between 1.75 and 2.0 percent.

For the equity market, we expect a difficult first half of the year due to falling corporate profits in a recessionary environment. Typically, corporate profits decline by 10 to 15 percent in a recession. In the second half of the year, however, we see recovery tendencies on the international stock markets due to the anticipated turnaround in monetary policy.

After an "annus horribilis" in 2022 for European small cap stocks, there is a good chance for a countermovement in 2023 and for a return to the long-term upward trend compared to European large caps. European small caps tend to outperform large caps in upswings and booms. Therefore, the expected economic turnaround in the course of 2023 could also initiate a trend reversal in the relative performance of small caps.

European small caps face countermovement
Relative performance of the two total return indices
Nach einem „Annus Horribilis“ 2022 für europäische Small Cap-Aktien bestehen 2023 gute Chancen für eine Gegenbewegung und für eine Rückkehr zum langfristigen Aufwärtstrend gegenüber europäischen Large Caps.
Sources: Refinitiv Datastream, Metzler; as of November 30, 2022

How does Metzler Asset Management assess the medium-term prospects?

The expectation of a recession implies that neither the euro zone nor the US economy can withstand higher interest rates due to high debt levels. Thus, the more the central banks raise the key interest rate, the greater the risks are to financial market stability.

According to our assessment, there is no key interest rate that can balance the necessary level to fight inflation and at the same time ensure financial market stability. Therefore, central banks are forced to use the policy rate in a pendulum motion. If inflation rises, the central banks must raise the key interest rate so that inflation does not get out of control. However, this increases the risks of recession due to a noticeable rise in loan defaults. The central banks must then lower the key interest rate again quickly so that a major debt crisis does not arise.

The consequence of key interest rate cuts, however, is that inflation picks up again. Overall, this chain of thought suggests that significantly higher macroeconomic volatility is to be expected in the future. High macroeconomic volatility is also likely to mask the fact that the average inflation rate over the coming decade is more likely to be 4.0 percent than 2.0 percent.

"Back to normal?" – The long phase of low volatility business cycles could be over
Real US gross domestic product yoy in %
„Back to normal?” – die lange Phase schwankungsarmer Konjunkturzyklen könnte vorbei sein
Sources: FactSet, Metzler; as of Q3 2022

* Phase of reduced economic fluctuations since the mid-1980s

Conclusion: Economics

  • Persistent inflationary pressure in the coming years
  • Overly harsh central bank reaction in 2023 in response to high inflation in 2022
  • Central banks underestimate the risks to financial stability
  • An interest rate shock meets high debt levels and a large number of "zombie" companies
  • Recessions are therefore inevitable in all three major economies in 2023
  • Loan defaults will increase
  • Central banks will ease monetary policy again in 2023
  • Economic recovery and rising inflation again in
  • Central banks will tighten monetary policy again in 2024 or 2025
  • The result: high long-term volatility of interest rates, inflation and economic data

Conclusion: Financial markets

  • Recession and declining inflation are a good environment for government bonds
  • Corporate bonds offer above-average risk premiums
  • End of recessions and turnaround in monetary policy in the course of the year open up opportunities on the stock market
  • European small caps on the verge of a countermovement – with upside opportunities
Edgar Walk, Chefvolkswirt Metzler Asset Management
Edgar Walk

Chief Economist , Metzler Asset Management

Edgar Walk joined Metzler in 2000. As Chief Economist in the asset management division, he is responsible for formulating our global economic outlook. Due to his close cooperation with the portfolio management, he focuses on capital market themes as well as on global economic analyses. Mr. Walk holds a master’s degree in economics from the University of Tübingen in Germany and spent a semester at the University of Doshisha in Kyoto, Japan. In addition, he completed the program “Advanced Studies in International Economic Policy Research“ at the Institute of World Economy in Kiel, Germany.

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