Executive summary

Managing volatility in a changing world

As 2022 draws to a close, the macro environment is radically different to the one that prevailed at the start of the year. Growth has slowed much more than anticipated. Not only did inflation fail to ease as expected, but it increased further.

Meanwhile, central banks have embarked on the most rapid pace of policy tightening in 40 years. The supply chain problems that emerged in 2021, following the initial economic recovery from COVID, extended into 2022 and broadened in unforeseen ways.

First and foremost, the Russian invasion of Ukraine in February led to sanctions and removal of supply that greatly impacted global energy markets. But the supply challenges have appeared in other areas as well. Job vacancies have soared to all-time highs in almost all regions, while labour force participation has either fallen, as in the United States and United Kingdom (reflecting a combination of both early retirement and increased long-term sickness) or failed to rise enough (Figure 1).

Figure 1. Labour supply challenges - Change in participation rate and job vacancies since end-2019

As a result, despite the growth slowdown, there has been almost no easing in labour market slack. That has kept upward pressure on wage growth, which has moved well above its long-term average across most regions through the course of 2022.

At the same time, having risen markedly in the first half of the year, underlying inflationary pressures have remained persistent through the second half of 2022. Core measures of inflation remain far above central bank targets, while headline rates reached double digits in most economies. That has led developed market central banks (except for the Bank of Japan) to raise policy rates from the effective lower bound at the start of the year into restrictive territory. Increases of 50 or 75bps per meeting became commonplace, as central banks scrambled to get on top of the inflation breakout.

That tightening in monetary policy led to a sharp tightening in overall financial conditions, as risk assets repriced to reflect the unexpected and dramatic move up in real rates. In an almost unprecedented outcome, virtually all global asset classes from government bonds to corporate credit, equities and real assets saw declines in 2022 (Figure 2).

Figure 2. 2022 was a challenging year across asset markets - YTD returns across major asset classes

The pain was felt across both developed and emerging markets. The only major asset class to see positive performance over the year were commodities, but even there it was largely restricted to energy and agriculture. The dramatic shift in cross-asset correlations was also accompanied by a significant increase in asset market volatility, most notably in bond markets, but also in foreign exchange and equities.

Looking ahead, we expect the impact of both the energy supply shock and the rapid tightening in monetary policy will push the major economies into recession.

The United Kingdom and Eurozone are expected to be at the forefront, with both expected to see a decline in output in 2022Q4, with further declines in 2023. The United States is expected to slip into recession in the second half of 2023.

In each of these cases, the recession is expected to be relatively mild given that household and corporate balance sheets are not extended. However, just how mild will depend on the severity of any further increase in energy prices in Europe and the extent to which the Federal Reserve and other central banks need to deliver even tighter policy should above-target inflation prove to be persistent.

Global growth is expected to slow to around 2½ per cent in 2023 and 2024, down from 3¼ in 2022 (Figure 3). Within that, developed market economies are expected to account for all of that slowdown, with growth of just ½ per cent expected in 2023 and 1 per cent in 2024, down from 2½ per cent in 2022. That largely reflects the impact of both the energy shock in the UK and EZ, dragging down real disposable income and spending, alongside the restrictive stance of monetary policy weighing on households and businesses.

Figure 3. Aviva Investors growth projections - Shallow recession expected in 2023

In emerging markets, growth is actually expected to be a little better in 2023, rising by around 4¼ per cent, largely reflecting an improvement in China as it exits from zero-COVID policies that have led to continued lockdowns in 2022.

Headline inflation is expected to decline in 2023, as the impact of earlier increases in energy and food prices falls out of the comparison with a year ago (Figure 4). By itself, that could account for a fall in headline inflation of 3-5 per cent in the UK and EZ and 2-3 per cent in the US.

Figure 4. Aviva Investors CPI inflation projections - Declining in 2023, but risks to the upside

However, that view is conditioned on an assumption that oil and gas prices broadly follow the path shown by futures markets. There remains upside risk to that outlook. In Europe, the severity of the cold this winter, alongside the ability to procure gas or diversify to other energy forms in 2023 will be key to avoiding another ramp up in wholesale natural gas prices heading into next winter. Moreover, with sanctions on Russian oil expected to be tightened going into 2023 along with OPEC cutting output, there is likely to be more supply removed from the market. That could push prices higher, even with the expected slowing in global growth.

Fiscal policy may be utilised further to cushion future increases in energy prices, however, there will be limits to how long such a policy can be maintained.

We expect core inflation, which has been in the range of 5-6 per cent during the second half of 2022 in the US, UK and EZ, to also decline through 2023. In terms of core goods, the easing in global supply chain pressures should see inflation of traded goods ease further.

For core services, the negative impact on real income and spending of higher energy prices, as well as the restrictive stance of monetary policy weighing on demand and ultimately working its way through to a loosening in the labour market and weakened pricing power.

However, we expect that process will be quite slow, with core inflation likely to remain above the central bank targets of 2 per cent throughout 2023. Indeed, the risks are also tilted to the upside here, with incoming information on likely wage settlements in the UK and EZ for 2023 significantly higher than in 2022, reflecting a degree of success on the part of employees in reacting to the decline in real wages experience this year.

In the United States, where wage bargaining is more decentralised, recent outcomes show no sign of slowing in wage growth, which remains in the 5-6 per cent annualised range.

While we see the risks to inflation tilted to the upside again in 2023, the range of possible outcomes is wide. Uncertainty about inflation is likely the greatest we have seen in 40 years. We have seen some of the largest forecast errors ever this year from official bodies (Figure 5).

Figure 5. Central bank inflation forecast errors have been unusually large in 2022

Those errors reflect the shocks that have impacted inflation, in particular, from the supply- side.We expect a range of structural factors could result in both a sustained tailwind to inflation and increased likelihood of positive inflation shocks. Changes due to the political shift towards deglobalisation, the drive to decarbonisation and changing demographics could all work to increase economic and policy uncertainty, resulting in greater variability and higher average level of policy rates.

As such, we expect central banks to continue to adopt a risk management approach to setting policy rates, with the primary focus on bringing inflation down to target over a horizon that doesn’t create too much economic pain.

In our central projection, we expect the Federal Reserve, ECB and Bank of England to reach the peak of the tightening cycle by the end of 2023 Q2, with rates of around 5 per cent, 3 per cent and 4 per cent, respectively.

We expect the Bank of Japan will adjust its policy of yield curve control (YCC) in 2023 Q2, as multi-decade higher inflation feeds into moderately higher wage growth and higher inflation expectations. We expect the PBOC will continue to run easier policy through 2023 to help encourage the post- COVID recovery in China.

We prefer to be broadly neutral in equities. Equity markets have de-rated through 2022, reflecting the move higher in real rates. Looking to 2023, we expect to see downward revisions to earnings expectations in coming quarters, reflecting the shallow economic recession, to weigh on markets (Figure 6).

Figure 6. Asset allocation

Only once there is a clear downshift in inflation do we expect to see risk assets perform better. We have a mild preference for the UK over Europe given the relative exposure to energy and resources.

We have a preference to be modestly underweight duration, with upside inflation risks outweighing the downside recession risks. However, the peak in policy rates is likely approaching, requiring a nimbler approach to duration in 2023.

We prefer to be neutral in credit, where we think the recent rally in spreads makes high-yield less attractive going into recession. On investment grade, the all-in yield on short-dated paper does make it relatively attractive, but is competing with attractive risk-free cash returns.

Finally, we prefer to be long the US dollar going into 2023, reflecting the weakening global growth environment and the strength of underlying inflation in the United States, but think that the longer-term dollar trendcould eventually everse as growth prospects improve in late 2023.