Dear Investors,
Expect the unexpected in 2023 and keep the Fed’s path top of mind.
2023 might have in store for investors, considering what the Fed may or may not do.
Real investment advice thinks there are three potential paths the Fed might follow in 2023.
The three paths determine the level of overnight interest rates and, more importantly, liquidity for the financial markets.
Liquidity has a heavy influence on stock returns.
Consumer spending patterns are now normalizing again.
In the U.S. and Europe, goods prices have already stopped rising relative to other prices – in the U.S. they’ve started falling quite rapidly – and Blackrock expect that to continue.
That means overall core inflation will come down materially from its current highs.
The unprecedented influx of liquidity that drove asset prices higher in 2020 and 2021 is quickly leaving the market.
The lag effect of higher interest rates and fading liquidity will likely play a prominent role in determining stock prices in 2023.
It’s possible that inflation could come down closer to 2% than Blackrock expect.
Goods prices could fall faster than expected and companies might not have the pricing power to pass on higher wage costs.
While this could be better news for inflation, it would be bad news for profitability.
What does this mean for investors? Falling inflation increases conviction that central banks have regained some control and will be able to stop hiking at some point.
Falling inflation has spurred market hopes that it is already on its way to target without a recession, and yet central banks will still start an easing cycle.
But getting inflation down close to target will require higher rates and recession.
The core inflation ride could be a rollercoaster
The smoothness of the ride depends on how quickly spending patterns revert and goods prices fall.
If U.S. relative goods prices fall at a pace that would get them back to their pre-pandemic trend by the end of 2024, Blackrock estimate core goods would take 0.1-0.2 percentage points off total core inflation in the second half of 2023 versus adding 2 percentage points at their peak in 2022 – meaning core inflation dropping down towards 3%.
But if the reversal of the spending mix and drop in goods prices were to be as rapid as in recent months, they estimate core goods inflation could end up taking off 1 percentage point from overall core inflation by the end of 2023, dragging it below 3%.
Where inflation settles once the adjustment is complete depends on what happens to wages and services inflation. That remains stubbornly high (see chart above).
Unless that changes, overall core inflation is not likely to settle back at the Federal Reserve’s 2% target.
The reversal of goods prices means getting inflation down from its June 2022 peak of 9.1% to around 4% will be the easy bit.
Getting it to settle below 3% will likely be much harder.