Investing outlook 2023: Sticky inflation, volatility and liquidity withdrawals

As central banks continue to navigate the twin threats of rising inflation and a slowing global economy, investment management firm T Rowe Price is predicting more risks and market volatility in 2023.

Samy Muaddi, Portfolio Manager of the Emerging Market Debt Strategy, said that while the macroeconomic backdrop is dim with lingering liquidity concerns in the short term, strong valuations not seen in a decade are supportive of a contrarian view in some sectors of fixed income.

Sebastien Page, Chief Investment Officer and Head of Global Multi-Asset, the division that manages about 30 percent of T. Rowe Price’s US$1.28 trillion in assets under management, said the team is defensively positioned given sticky inflation, a potential economic growth shock, and liquidity withdrawals by some market participants.

However, the gloomy consensus is being reflected in some asset classes, presenting opportunities for investors who stay focused on the long term, said Page.

“There is an abundance of doom and gloom in global economies and financial markets, leading many investors to remain prudently defensive moving into 2023. However, the bad news is starting to seep into the pricing of some asset classes and select valuations are compelling. There is little sense in waiting for a market bottom, which are nearly impossible to predict,” said Page.

“Our Asset Allocation committee is combining some defensive positions in cash (relative to our strategic weights in stocks and bonds), with selective risk-on tilts where valuations are compelling, including in actively managed small cap stocks and high yield bonds.”

“I believe we are getting closer to a contrarian ‘buy risk’ moment, but we’re not quite there yet. An important risk on the horizon is that fixed income liquidity is deteriorating. If we get a liquidity shock, the key question will be whether the Fed can keep one foot on the brake and one on the accelerator and make it work,” said Page.

Below are the key outlook observations from T.Rowe Price:

Global economy

• In 2022, for the first time in 20 years, global central banks are more focused on containing inflation than in maintaining or encouraging economic growth.
• Monetary policy tightening has ramped up globally with 274 interest rate hikes announced since the beginning of the year compared with 117 hikes in last year and nine in 2020. Qualitative tightening will gather pace next year.

The monetary policy cliff is daunting.

• Central banks will remain resolute in containing inflation, but they tread a difficult line with the global economy slowing and possibly entering a recession.
• The Fed is between a rock and hard place. Its key challenge is how to navigate a soft landing without appearing to be dovish on inflation.

Global equities

• Rising inflation and monetary tightening globally, coupled with higher bond yields, have been the key factors driving down equity markets, with most major indices near or at bear market levels.
• After entering the year with valuations near 20-year highs, most major equity benchmarks are trading below their 20-year averages.
• The market is likely to remain volatile until the virulence of inflation becomes clear. The severity of any recession will be a key driver of market performance next year.
• Longer-term, interest rates and inflation are likely to remain higher than levels we have seen over the past decade as de-globalization, onshoring, and increasing geopolitical risks create structural changes in the global economy.

The next decade of equity market leadership, following the last ten years of dominance by growth companies, is likely to be broader and may favor companies with shorter-duration cash flows, including value stocks.

Global fixed income

• The challenging macroeconomic environment and fading monetary support is disconnected from strong credit fundamentals leading to high realized interest rate volatility and a decreased appetite for risk taking in global fixed income.
• While US rates remain biased to the upside in the near-term as the Fed fights sticky inflation, the subsequent negative impact on economic growth should provide an attractive entry point to add duration.
• Our investment teams are seeing opportunities not seen in ten years in many sectors, including historically attractive yields in securitized credit, global high yield, and emerging market debt. Liquidity conditions however are unlikely to improve near term.
• Emerging market debt has experienced a historic level of differentiation between firmly anchored countries well positioned for the current environment and certain frontier markets that are navigating a period of debt distress.

Asset allocation

• Risks remain elevated moving into 2023 given sticky inflation, the possibility of recession with associated earnings deterioration, and liquidity withdrawals by some market participants. The T. Rowe Price multi-asset team has adopted a somewhat defensive stance, slightly underweighting stocks versus bonds.
• However, the team has examined 18 different sell-offs when the stock market was down 15% or more. Historically, if investors had leaned in and started adding to risk at that point, their returns a year forward would have been quite strong.
• In equities, the team is slightly underweighting U.S. and European equities. It is overweighting emerging markets, Japan, international versus U.S. stocks, and U.S. small-capitalization stocks versus their large-cap counterparts.
• In fixed income, the team is slightly underweight US and other developed market investment grade bonds. The team favors emerging markets, floating rate loans, and global high yield.