The stock market in 2023: it all depends on inflation
2023 is full of uncertainties. Although there is no doubt that the risk scenario has improved somewhat in recent months, it certainly remains complex.
In fact, starting in the summer months, we began to sense a somewhat more constructive tone. The first step to building a more favorable narrative was when inflation peaked in the United States, hitting its high mark in June and falling ever since. The expectation of disinflation was reinforced by the underlying US CPI, which reached its peak in September and has been decreasing for two consecutive months now. More recently, but still not convincingly, the CPI in the eurozone seems to have reached a high in October, although for the time being we only have a single lower figure, that of November.
Two factors have made disinflation possible: on the one hand, the prices of energy, basically oil and natural gas, remain at levels substantially lower than in the summer months. And on the other is the better functioning of global supply chains, which is relieving pressure on manufacturing prices, and decisively contributing to moderating CPI levels.
In response to these encouraging signs as regards inflation, investors have started to price in a less aggressive response by the central banks, which have effectively reduced the pace of interest rate increases, even if their stance remains clearly aggressive, since they want to clamp down on investor euphoria as much as possible.
Meanwhile, world economies are showing signs of greater resistance than expected, and the stagflation scenario predicted a few months ago has yet to clearly materialize. Although a situation of practical economic stagnation is expected in 2023, for the time being we have no evidence that a severe recession is coming either to Europe or the United States. On this side of the Atlantic, the drop in demand for natural gas, together with reserves that are currently at levels far higher than normal at this time of year, have warded off the risk of having to impose gas and electricity restrictions during the winter months. Similarly, the advanced indicators have recovered ground in November and December and business profits are surprisingly positive.
In the United States, the strength of the labor market and the savings accumulated during the pandemic have allowed activity to resist the strong monetary adjustment experienced by the largest economy on the planet, which exhibited a solid performance in the third quarter of the year. Although GDP will obviously grow at a slower pace in coming quarters, the Federal Reserve may well succeed in its goal of bringing inflation towards its long-term target without causing a strong economic recession.
Even in China, whose growth has been severely penalized in 2022 by successive waves of coronavirus that have kept health restrictions in place in much of the country, the zero-COVID policy is quickly being abandoned, which opens the door to a faster recovery than expected in 2023.
So given these building blocks, what can we expect from the stock market in 2023? It will depend, almost exclusively, on what inflation does. And in this regard, there are two contrasting market views: the first, which is the view we hold, posits that inflation will quickly go down and that central banks will stop raising interest rates before they cause a sudden economic downturn. In other words, they will achieve a soft landing of the economy and drive inflation towards their long-term objectives without causing a significant drop in employment levels or economic activity. In this scenario, the market would be practically guaranteed to go up in 2023.
By contrast, other analysts believe that a hard economic recession is inevitable, basing their opinion on indicators such as the inverted yield curve or the sharp fall in oil prices. These analysts believe that inflation cannot be controlled without a significant decline in employment, and thus conclude that central banks will continue raising rates in 2023. This recession scenario would cause a sharp drop in business profits and additional setbacks in equity markets.
As we pointed out, we are more confident that the first scenario will play out, and we believe that stock markets will react positively once the end of the monetary tightening cycle of the central banks is confirmed. We are also convinced that in a disinflation environment, the harsh posturing of central banks will have a waning influence on investor optimism. Similarly, we believe that the monetary adjustment process is practically complete and that there are few rate increases on the horizon. In any case, the response will be provided by the direction prices take in coming months.
