Outlook Overview: You Can Go Your Own Way

• Divergence is also a key theme and hence our Outlook title for March. Economies can go their own way with the U.S. dominated by the lagged impact of monetary policy and China driven by the reopening. Europe also has monetary policy tightening feedthrough and the prospect of gas and utility prices being much lower than mid-2022. We still look for a borderline recession in the U.S., a three quarter recession in EZ and 5.8% growth in China in 2023.U.S. and EZ headline inflation has peaked and we see the prospect of more downside surprises in EZ than the U.S. China CPI inflation will likely remain controlled. For the Ukraine war the balance of risks has now switched to a frozen conflict rather than the war dragging on into 2024. Meanwhile, Japan will likely increase the 10yr yield cap further to 0.75% in autumn 2023, though we do not see the BOJ abandoning QE with yield curve control.
• EM countries will show more resilience than DM countries in 2023, both as currencies have not been destabilized by 2022 USD strength and EM policy tightening is close to finished. Ongoing post COVID recovery tailwinds remain into early 2023, as reopening was later than the U.S./Europe. Some scope does exist selectively for rate cuts to start in late 2023 (e.g. Brazil).
• For 2024, we see scope for ECB rate cuts to arrive before the Fed, as we feel that the ECB has brought rates too high with core inflation likely to fall back and wage inflation better controlled than the U.S.Fed easing will likely not arrive until 2024, as the Fed keeps policy restrictive to ensure that core PCE inflation comes back towards target. Most other DM countries (except Japan) and EM countries (ex-Turkey) will likely also see 2024 rate cuts, as inflation comes under better control.

Risks: More aggressive Fed tightening to 6% plus would cause a U.S. recession and a deeper selloff in U.S. equities with a delay in the market recovery until 2024.Such a policy shock would initially hurt government bonds as well, but yields would then pivot to hopes of aggressive easing in 2024. The other key risk is that the U.S. imposes major sanctions on China for supplying lethal weapons to Russia, which would hurt the global growth outlook – we see this as a modest probability risk.

Figure 1: Economic Scenarios

Source: Continuum Economics

Market Implications

• Government bonds: March’s yield decline means that rate peaks/2024 rate cuts are largely discounted at the long-end, though the short end still has scope for yield to decline once official rates peak and central bank communications eventually prepare for rate cuts. The key theme is thus yield curve steepening. We prefer short-end of the curves in the remainder of 2023 and into 2024.10yr yields in major market will see modest negative total returns in the remainder of 2023.
• Equities: U.S. equities are overvalued relative to real yields and too optimistic about the Fed cutting rates in 2023.This can prompt a mid-year dip, which will likely be amplified by a crisis over the U.S. debt ceiling. Scope exists to 3800 potentially 3500, before recovery hopes kick in and we see a recovery of the S&P500 to 4200 by end 2023 before 4700 for end 2024. DM equity market will likely follow the U.S. and EM to outperform – especially Brazil and China (Figure 2). 
• FX: The USD will continue to decline versus DM currencies, as overvaluation is reversed. For most currencies this will be at a slow pace, as yield differentials will slow the decline in the USD. We see EUR/USD at 1.12 and USD/JPY 120 for end 2023. EM currencies are more mixed, though we see appreciation of the Brazilian real.
• Commodities: Oil demand is being underestimated due to China reopening and the ongoing rebound in global tourism. With OPEC+ likely to only increase production quota by 0.5mln b/d, we see WTI to $85 by end 2023. 

Figure 2: Asset Allocation for 9 Months to end-2023

Source: Continuum Economics. Note: Asset views in absolute total returns from levels on March 27 (e.g., 0 = -5 to +5%, +1 = 5-10%, +2 = 10% plus).

Figure 3: Key Events and Critical Uncertainties