Why equity and bond investors can expect better returns in 2023

We may be near the end of the interest rate cycle after the Fed’s aggressive ‘front-loading’ of rises
As imbalances created by the pandemic and disruptions caused by the war in Ukraine recede, lower inflation can be expected

Chris Iggo

Published: 1:30am, 11 Aug 2022

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What happens to US interest rates from here on is important to investors everywhere – through the influence they have on the US economy, on global rates and the dollar. There are reasons to believe we may be near the end of the interest rate cycle after the most aggressive “front-loading” of rate rises for many decades.

The US Federal Reserve has increased rates by 225 basis points since March. The suggestion is that there could be one or more moves to come but evidence is beginning to mount that the US economy is slowing. Markets are now pricing in that the Fed will be cutting rates by the end of 2023 in response to the US being in a recession. Indeed, official data suggests a recession may have already begun, with real gross domestic product growth being negative in both the first and second quarters.

Inflation data is key to the outlook. Consumer price inflation reached 9.1 per cent in June. This, of course, is a manifestation of the global cost-of-living crisis driven by higher food and energy prices. Even without monetary tightening, higher inflation was likely to slow global growth as consumer real income growth turns negative and businesses face higher costs and pressure on profit margins.

In its recent forecasts, the International Monetary Fund revised its global growth outlook to 3.2 per cent for this year and 2.9 per cent for 2023 – down 0.4 and 0.7 percentage points from April. For many advanced countries, the 2023 forecast is low enough to suggest one or two quarters of negative growth – the traditional benchmark for a recession. High energy prices are the single most important cause of this gloomier outlook.

For Asia, the growth outlook is better. Inflation has risen in the region because of the spike in global energy prices. However, in many Asian countries, headline inflation rates are less than in the US or Europe and consensus forecasts suggest this will continue in 2023.

While there has been some increase in regional interest rates, lower average inflation than in the US and a peak in rate expectations in the advanced economies should allow rates to come down again in 2023.

This is reflected in the growth outlook. The IMF forecasts that the Asean-5 economies will grow at rates above 5 per cent this year and next, that India will see only a moderate deceleration to just above 6 per cent and China will record stronger GDP growth in 2023 at 4.6 per cent relative to an estimated 3.3 per cent this year.

The US outlook is still key. Consumers are bearing the brunt of the cost-of-living crisis and now face higher debt-servicing costs because of the Fed’s tighter stance. If markets are right in calling a peak in rates by the end of next year, and inflation starts to recede, there should be some respite for American families in 2023.

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US Federal Reserve authorises another big rate hike in bid to curb inflation

After all, the labour market has remained strong. In recent weeks, there have been signs of things improving on the inflation front, as well. Fuel prices have been falling since peaking in mid-June. Global commodity prices have dropped too, with the UN’s Global Food Price index falling by 9 per cent in July.

Typically, seasonal patterns see less inflation in the second half of the year. If US consumer price inflation can drop to, say, 7 per cent or below by the year-end, the Fed would be justified in pausing or even ending its rate hiking policy.

Financial markets have already anticipated this. Based on money market pricing, the Fed funds rate is expected to peak at around 3.5 per cent by the end of this year and fall back towards 3 per cent in 2023.

This narrative of inflation and interest rates both peaking has driven a much better performance by global markets since mid-June.

From China to the US, spending on healthcare and housing must rise

The US Treasury 10-year bond yield, the benchmark for fixed-income markets, has dropped by 80 basis points since June. This has contributed to improved sentiment in equity markets as well. The S&P 500 index has risen 11 per cent in total return terms since bond yields peaked, with the technology heavy Nasdaq Composite index up 17 per cent.

Central banks everywhere face the challenge of high inflation and slowing growth. This situation is a result of pandemic-related supply issues, and the policy response fuelling a strong recovery. The war in Ukraine has only added to the disruptions.

As the pandemic recedes, so will such imbalances. The world is also working to find solutions to the reliance on Russian energy. Both point to lower inflation going forward. Central banks need to talk tough – in some cases, they have acted tough, but the peak in interest rates is probably in sight. That means better returns for both bond and equity investors in 2023.

Chris Iggo is chief investment officer for core investments at AXA Investment Managers