Growth will likely weaken, but we see a path to a better economic outcome and stronger-than-expected equity returns.
Our 2023 outlook anticipates weaker economic growth and stronger markets. Although we believe a historic global central bank tightening cycle will rein in inflation, recessions are likely in the United States and Europe. Growth will continue to be challenged in China and Latin America.
Given that macroeconomic backdrop, we’re focusing on core fixed income as a valuable portfolio ballast. Within equities, we broadly prefer quality and cash flow generation.
At the same time, we do see a path to a better economic outcome that could lead to stronger-than-expected performance for risk assets such as equities and high yield bonds. A mix of three factors could get us to this better place:
- A benign inflation outcome
- Resilient consumers and businesses
- Global white swans (i.e., positive geopolitical developments that would improve investor sentiment)
We focus here on the U.S. outlook.
A benign inflation outcome
Many data points signal that inflation is past its peak. Durable goods prices are decelerating rapidly, as are import prices and producer input prices. U.S. crude oil and gasoline prices are at their lowest levels of the year.
The most recent U.S. Consumer Price Index data showed a 20-basis-point month-on-month gain in core inflation—the slowest pace of the year. Shelter inflation, which accounted for much of that move, lags the real-time private data that is signaling a significant deceleration in market rent increases.
Rental inflation set to decelerate
This chart illustrates CPI Owner’s Equivalent Rent (OER) vs market rents per the Apartment List Rent Index. CPI Owner’s Equivalent Rent: Started at 3.4% in February of 2018 and remained relatively flat through 2018. It moved up a bit to 3.65% in June of 2019, then back down to 3% in December of 2019 before falling further to 1.52% in January of 2021. It jumped to 5.1% in December of 2021 and continued to move up to 5.65% in May of 2022. It hit 8.45% in September of 2022, and 8.76% in October of 2022. Apartment List Index: Started at 2.39% in January of 2018 and moved to 5.32% in June of 2018, before falling to 1.36% in November of 2018. In March of 2020 it rose to 4.4% before falling to -9.59% by July of 2020. It inflected higher and hit 28% in September 2021, before falling back to 6.87% in March of 2022. It moved up to 9.25% in July of 2022, then fell to 0.05% in September 2022 and 0.02% in October 2022.
Critically, this deceleration in inflation has coincided with only a slight rebalancing in the labor market. The quits rate and the job openings rate (which are good measures for the intensity of labor demand) have fallen from peak levels. But non-farm payrolls data suggest that hiring is continuing at a relatively brisk pace of about 250,000–300,000 jobs per month. The widely followed unemployment rate hovers near historical lows.
In short, an economic “soft landing” looks possible if inflation can continue falling faster than the labor market deteriorates.
Resilient consumers and businesses
So far, cracks in the economy have been limited to interest-rate-sensitive sectors such as real estate and financial activity, and to businesses that expanded to meet pandemic-era demands that proved to be transitory.
Overall though, the U.S. economy looks to be in decent shape. Consumer spending could accelerate modestly as a slowing pace of inflation leads to a recovery in real income. Higher U.S. mortgage rates have crushed marginal activity. However, more than 90% of new mortgages are fixed, so the actual cost of borrowing for many households has not changed even as rates have risen. The quits rate may be past its peak, but it’s still a signal that workers are feeling confident about their ability to find new jobs.
Corporate debt levels seem manageable, as companies are largely locked into lower rates. Profit margins have proved more resilient than expected, given elevated inflation and wages. Throughout 2022, businesses have had to contend with shifts in consumer spending. Demand for goods and apparel weakened relative to the demand for in-person services that were largely shuttered at the height of the COVID-19 era. In general, businesses have adjusted fairly well. And in the coming months and quarters, inventory and pricing swings could become less drastic.
Despite higher inflation and wages, profit margins have proved more resilient than expected
This chart shows nonfinancial corporate profits as a % of gross value added (4-quarter moving average) from 1960 to 2022. It began at 10% and rose to 13% by December 1966. It dipped to 9% in December 1970 and rose to 14% by March 1980. It then fell to a series low of 6% in March 1987, then rose to 11% in March 1997 and 18% in December 2006. It dipped to 13% in June 2009 then rose to a series high of 20% in December 2012. It dipped then rose again to 20% in June 2022.
Finally, a slower pace of monetary policy tightening (and perhaps even a pause in rate hikes) could give CEOs the confidence they need to borrow money to invest in new plants or make acquisitions. Consumers and businesses may acclimate to a higher interest rate environment more successfully than many expect.
Global white swans in Ukraine and China
The war in Ukraine and China’s property downturn and COVID lockdowns have cast a pall on economic and market outlooks. They have also led to a much stronger U.S. dollar, which is itself a headwind to global growth.
A positive shift on any of these fronts would likely ease friction for the global economy, resulting in a weaker dollar. And the change would almost certainly lead to better investor sentiment.
The U.S. dollar looks very overvalued
This chart shows the J.P. Morgan Real Broad Effective FX Rate Index from 1994 to 2022. It began at 104 and dipped to 95 by May 2008. It rose sharply to 129 in February 2002 then fell to a series low of 92 by July 2011. It rose to 120 by January 2017, then fell to 108 by April 2018 and rose back to 124 by March 2020. It dipped then rose to 129 by November 2022.
Still, even if Russia and Ukraine were to negotiate a settlement, Europe will still need to make significant changes to its energy infrastructure, which could take many years.
In China, a policy pivot toward reopening the economy, embracing Western mRNA vaccines, boosting the property sector or issuing more market-friendly rhetoric could jumpstart markets, given current, depressed sentiment and investors’ limited exposure to Chinese markets.
Investment implications
Some combination of these factors—a benign inflation outcome, continued resilience of consumers and businesses, and global white swans—could have profound implications for markets. It could potentially lead to outperformance of risk assets (such as stocks and high yield bonds) over “safe havens” such as core fixed income or gold.
The U.S. dollar would likely weaken further. European and Chinese stocks could lead a global equity rally. U.S. small- and mid-cap companies might well outperform large caps, given their lower valuations and higher sensitivity to economic growth.
Even though core bonds would probably underperform risk assets, lower inflation and a less aggressive stance from central banks would likely lead to lower yields and solid performance from investment grade fixed income.
So, while our base case scenario for 2023 sees weakening growth across the global economy, if we have learned anything from the last three years, it’s to expect the unexpected. A positive economic outcome certainly fits that bill for 2023.
Your J.P. Morgan team is here to help you understand our 2023 outlook—our base case and our best case for the economy and markets—in the context of your financial plan.
