by Craig Burelle, Senior Macro Strategies Research Analyst, Loomis Sayles
Editor’s Note: Every year, Loomis Sayles features outlooks from our sector teams — teams composed of traders, analysts, strategists and portfolio managers immersed in their respective sectors of the fixed income market. We asked each sector team three questions that drill into key themes in their respective sectors. We will publish views from each sector team over the next few weeks.
To set the stage, we’re starting with Craig Burelle, Senior Macro Strategies Analyst, and his views on the macro backdrop in 2023.
1. There has been a lot of talk about an approaching recession, yet the markets seem to be pricing a soft landing. What do you think is behind that disconnect? What are your views on a potential downturn?
Market behavior, particularly in equity markets, tends to look for the upside. And with signs that US inflation has peaked, labor market resilience and positive corporate earnings growth, there are reasons to be optimistic. Ultimately, however, we expect the lagged effect of monetary policy to prevail and put downward pressure on earnings and economic growth.
The global economic cycle appears to be transitioning from late expansion to downturn. We’ve noted a marked deterioration in some key fundamentals, including the outlook for corporate credit, pricing power and profit margins. In our view, the transition won’t be complete until employment or profits roll over. On the employment side, corporations have been adding jobs, but we are on the lookout for a shift in hiring patterns. On the profits side, we believe pricing power could be the final nail in the coffin if costs continue eating into margins.
2. Central banks have been working overtime to lower inflation. Now that US core PCE seems to be coming down, is the worst of inflation behind us? How might inflation influence central bank policy in 2023?
While we see indications that inflation has peaked, we don’t think the battle is over. In our view, inflation won’t get under control globally until economic growth slows and labor markets weaken. China’s economic reopening is a new wild card that seems likely to drive commodity prices higher.
We believe inflation pressures are likely to keep central bankers uncomfortable throughout the first half of 2023. The European Central Bank and the Bank of Japan recently surprised markets with hawkish moves. We expect the Federal Reserve to deliver a rate hike in February 2023, but it may pause thereafter if inflation continues sliding. We doubt the Fed will pivot toward rate cuts until it sees a recession, consistent downside inflation surprises and evidence of labor market slack.
In our view, the first half of 2023 will be a delicate dance where central banks work to lower inflation and avoid a downturn. If a downturn begins, excessive inflation could limit central banks’ monetary and fiscal response. We do not anticipate a strong policy response to downturn, particularly if one begins in mid-2023.
3. Where are you looking for opportunities in this environment?
A weakening global economy is likely to usher in more volatility in 2023, particularly in the first two quarters of 2023. We have a cautious but opportunistic view of risk assets, particularly in the corporate sector, and will look to invest when disconnects between market value and fair value emerge.
We will also be watching for opportunities in non-US-dollar assets in particular if the Fed pauses its rapid tightening cycle. A pause would take some upward pressure off the US dollar, especially if other developed market central banks continue their hiking cycles.
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