A weaker economy/ stronger financial markets?

2022 was a difficult year, both for the global economy and for the financial markets. 

The UK stock market was helped, however, by its large exposure to commodity producers, defensive consumer staples and its low exposure to expensive technology companies. The continued decline in sterling also helped, given that circa 75% of the FTSE All-Share’s revenues come from outside the UK. The fall in the pound has helped flatter international stock market returns somewhat when translated back into sterling. Nevertheless, the UK stock market has not been blind to the risks of the economic outlook.

The U.S. economy is forecast to expand in 2023

However, the boost from net exports is likely to reverse over the short-term because the Federal Reserve Board’s real broad dollar index, a trade-weighted measure of the dollar against a basket of currencies, was at a 37-year high in October, and global economic growth, particularly in Europe and China, is weakening. The Federal Reserve’s commitment to restore price stability, while necessary, could cause the U.S. economy to slow.

Sharp decline in the yen against the dollar

Japanese stocks, which held up well in local currency terms, have been magnified by the sharp decline in the yen against the dollar, boosting the local currency value of their foreign earnings. One might also look at the return of value stocks and argue that they aren’t pricing in much recession risk. However, value returns have been supported by the outperformance of more defensive sectors such as healthcare, consumer staples and utilities, along with the strong returns for energy stocks. Some cyclical value stocks have fallen a long way already. 

Crude oil prices have decreased over recent months and European natural gas prices are now at pre-Ukraine war levels. Product shortages have continued to ease and surveys have revealed a further improvement in suppliers’ delivery times and this is helping to reduce work backlogs.  

Impact of high inflation and rising interest rates

The impacts of high inflation and rising interest rates continue to be felt across the globe but particularly in Europe, where the energy crisis weighs heavily on real incomes. The outlook for China has brightened as their government has taken the first steps back from its previous zero-COVID policy to a living with COVID strategy and although that may initially present short-term challenges, it is seen as a positive move in the longer term and should immediately help ease supply chain issues.

Although inflation remains high, a marked downturn trend is expected during the course of this year.

The UK is most likely already in one of the most anticipated recessions of all time. Quarter 3 (July, August and September) last year showed that the UK economy decreased in size. Although there was also a decrease in October, there was an increase for the month of November (largely seen as a World Cup boost) but the data as a whole, for Quarter 4 (at the time of writing this article) has not yet been released and is widely expected to be negative, confirming that the U.K. is, indeed already in recession.  The general consensus is that although this could confirm a technical recession, it may be a mild one - this does not mean that it won’t hurt.

In conclusion, the balance of risks facing the global economy in the short-term are decidedly weighted to the downside. Still, forecasts and financial market indicators are not fool proof. The strength of labour markets generally point to a resilience that stands in stark contrast to weakness in other areas of the economy. 2022 will mainly be remembered as a year when markets priced-in the impact of higher inflation and rising interest rates.

On the plus side, with markets already starting to anticipate a decline in inflation and a peak in interest rates, 2023 is likely to be a tougher year for the economy but could well be a better year for the financial markets overall.