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As 2023 approaches, the drag of tighter monetary policy is intensifying, yet central banks continue to advance. The new dot plots show the median year-end 2023 projection for the fed funds rate at 5.1% before being cut to 4.1% in 2024 — a higher level than previously indicated. However, investors don't seem to be buying the Fed's hawkish dot plot and are justified in their skepticism. At the end of last year, the Fed expected the upper limit of its fund's rate to be 1% at the end of 2022, but it ended up at 4.50%. The Fed predicts that the rate will be +5.00% a year from now. If it underestimated rates, then is it guilty of overestimating them now?
Global Growth Outlook
The substantial increase in borrowing costs in the United States is already depressing housing activity, and the strength in the U.S. dollar likely weighs on U.S. corporate profit margins. There are also growing signs that credit conditions are becoming tighter. Moreover, the problems in the emerging markets, the U.K. pension fund industry, and the U.S. cryptocurrency market are all interconnected and indicate that tightening financial conditions can create stress that could have broader macroeconomic implications.
Equity market outlook
In 2023 fundamentals are expected to deteriorate due to tightening financial conditions and more restrictive monetary policy. Historically, during the past eight cycles, the Fed hiked until the Fed Funds Rate was greater than the CPI, meaning there is more room for hikes.
The economy will likely enter a mild recession, with the labor market contracting and the unemployment rate rising.
Consumers who had saved money during lockdowns have largely used up their post-COVID excess cash, and are now facing negative wealth effects from declines in housing, bonds, equities, and other investments. This negative trend is likely to continue next year as consumers and businesses reduce discretionary spending and capital investments.
It is also possible that markets will shift from their current "bad news is good" mindset, where soft economic data is seen as signaling a shift in monetary policy by the Federal Reserve, to a "bad news is bad" scenario, where fears of a significant decline in profits and job losses lead to further market losses.
Overall, the outlook for equities is bleak in the first half of 2023, but there might be a rebound in the latter half of the year. Weaker demand, lower pricing power, margin compression, and tighter financial conditions will weigh on equities, but the transition from inflation to disinflation and a shift in central bank policy toward growth will support a recovery in risk assets in the latter half. In addition, low valuations may also attract investors and boost equity markets in the second half of 2023.
Higher yields - a gift to investors long starved of income in bonds.
Rising interest rates, widening spreads across sectors, and market volatility have stressed fixed-income total returns with an intensity that few expected, making it one of the most challenging years for fixed-income investors in recent history. While headwinds are expected to continue in the near term, long-term investors will have opportunities in 2023. Widespread sell-offs and volatility have created attractive buying opportunities, and higher yields have made bonds more appealing to investors who were starving for yield for years.
The forecast for inflation and interest rates will remain crucial in 2023 as investors attempt to predict where rates will peak and when the Fed might "pivot" toward monetary easing.
Unfortunately, Central bank policy rates cannot resolve production constraints; they can only affect demand in their economies. This leaves them with a difficult choice: either bring inflation back to their 2% targets by reducing demand to levels that the economy can comfortably handle or accept higher levels of inflation. For now, they are opting for the first option. There are signs of an economic slowdown, but as the negative effects become more pronounced, we expect central banks to stop raising rates even if inflation is not on track to reach 2%.
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