My New Year prediction? 2023 will be much improved, but beware the market landmines
In the light-hearted spirit of New Year predictions, this is your economic and geopolitical fate.
Enjoy the Great Disinflation of 2023 but be careful what you wish for. The real cost of borrowing will snap higher.
We will discover that the deflationary forces of the last quarter century have not completely finished with us. The global savings glut lives on, even if military rearmament (less than it seems in Europe) offers a degree of Keynesian counter-balance. China’s factory gate inflation is already negative again.
Overtightening by central banks still clinging to a broken Lakatosian model (DSGE) has already ensured that the bust in early 2023 will be deeper than necessary, and deeper than market opinion or futures contracts suggest.
Sit out the ordeal in high-grade commercial bonds and hard sovereigns if you want a quiet life. Avoid soft sub-sovereigns in the EU periphery unless you are a tactical trader.
Yields on 10-year US Treasuries and UK gilts will be below 2pc again by June. German Bunds will slice through 1pc a little later. We will not return to the mad world of negative yields on $18 trillion of global debt, but it may feel a little like that.
Global bourses will suffer one last leg down before the spring as corporate earnings buckle and more icebergs float our way from in the shadow banking nexus, now the prime source of lending thanks to the unintended consequences of regulators (do they never learn?). The financial gendarmes hobbled the banks, which pushed the QE leverage bubble off books and into opaque instruments, where it is equally dangerous.
The sell-off will clear away the equity froth still remaining from Covid money printing. The S&P 500 index will drop a further 15pc to technical support near 3,300, taking the DAX and the FTSE-100 some of the way with it.
It coils the spring for an asset boom in the second half of the year as the stars align for investor nirvana: a monetary thaw; light at the end of the tunnel in Ukraine; full economic re-opening in China after the Omicron massacre; and relief that globalisation lives on.
A chastened Xi Jinping will tone down his wolf warrior macro-Leninism because China cannot do without western investment and chip technology after all.
Emerging markets are the place to be after going nowhere for fifteen years. They are extremely cheap. The catalyst for return to fair value is in plain sight.
The Federal Reserve’s broad dollar index has rolled over after reaching an all-time high in October. The dollar is henceforth in a secular downward slide that will accelerate once the Fed does a screeching U-turn and starts to slash rates. This will alleviate the painful squeeze in the $14 trillion market for off-shore dollar debt, the prime lubricant of global commerce and investment.
But first the central banks must complete their next blunder. Having unleashed an inflation storm because they failed to heed the warning signals from an explosion of the broad M3/M4 money supply – which typically delivers its punch with a lag of one to two years – they are now making (or have made) the opposite mistake. They are tightening too hard into an enveloping recession after money growth has collapsed.
The central banks have underestimated the self-reinforcing potency of triple-decker rate rises combined with quantitative tightening, both because they have never done it before, and because their theoretical model for how QE/QT works ignores the classical quantity theory of money.
The result is already evident in America. M3 contracted at an annual rate of 4.9pc over the three months to November in nominal terms, according to the Institute of International Monetary Research. It is almost down to zero year-on-year, something that never came close to happening in the 1970s.
The Fed is not looking at this flashing red signal. It has tied its credibility – and the fortunes of the US economy – to two sets of lagging indicators: jobs and core inflation. The latter is famously distorted by the way property is measured. “Shelter” prices are deemed to be surging at a time when average US house prices are falling faster than they did after the subprime bubble. If that is inflationary, I’ll eat my hat.
The Fed’s Jay Powell is not an economist. This is good. He will recognise that an error is being made – late, but not disastrously late – rather than taking the ship down with an academic idée fixe. As Michael Hartnett from Bank of America says, when the Fed panics, Wall Street parties.
The European Central Bank will tarry longer because it is not about monetary policy at the Eurotower: it is a power struggle between the creditor North and the debtor South over the eurozone’s economic machinery. The Bundesbank is back in charge and this is going to be painful for an economic bloc already facing factory closures, with the risk of permanent deindustrialisation the longer that Putin’s war goes on.
The ECB will keep tightening into the energy storm as it did in 2008 and 2011 until the ground crumbles beneath their feet. German producer price inflation fell 4.2pc in October (month on month) and a further 3.9pc in November. Real M1 money in the eurozone is contracting hard. But Bundesbank wants to scorch the earth and slow salt in the ground for Catharginian certainty.
The Japanese will run down their vast holdings of Spanish and French debt because the Bank of Japan’s “pivot” at home means that returns on domestic bonds are now higher (adjusted for currency hedge costs). The reverse flow is already nudging up eurozone borrowing costs. Wait for the reverse tsunami.
The Meloni honeymoon for Italy cannot last. Once the risk spread on Italian 10-year debt breaches 250 basis points, slow contagion will spread to Club Med, the Baltics, and overstretched ERM peggers such as Romania. Markets will then focus their attention on the ECB’s putative anti-spread tool and conclude that it can be used only in extremis.
The Bundesbank will find reasons to ensure that it is not deployed, demanding instead that Giorgia Meloni ratify the EU bail-out fund (ESM), which she refuses to do because the instrument entails enforced austerity if ever used – and a Cypriot-style seizure of bank deposits? – under colonial commissars from Brussels. This will be the political fight of 2023.
France has put off all its problems by subsidising everything – from diesel to condoms – and suppressing every price signal that it does not like. But this is the year that Emmanual Macron has to admit that “whatever it takes” is no longer affordable. His valiant attempt to raise the pension age above 62, the sine qua non of French fiscal viability, will set off a late winter of discontent - or a Gilets Jaunes II in gallic vernacular.
Thank goodness for the Bank of England and monetary sovereignty. Threadneedle Street does heed the money supply – up to a point – and will stop tightening sooner than peers. This will mitigate some of the damage. Sterling will therefore weaken. The usual suspects will weaponise this as an indictment of Brexit, and the usual fools will believe them.
The UK’s recession will not be the worst in the G7 this year as the financial press keeps telling us. The by-now familiar Brit-bashing from the Parisian OECD – it’s in the water at Rue André Pascal – will again prove to be overdone, partly because of open-door immigration.
The final tally by late 2023 is that the UK economy will have grown by roughly the same as the eurozone Big Four since the onset of the pandemic, as it has since the Referendum. Better relative performance this year will not make the slightest difference to the Brexit debate. Kitchen-sinking every ill on Brexit will continue, and go largely unchallenged – Julian Jessop notwithstanding.
Vladmir Putin may spoil the recovery in the second half by adding an oil crisis to the gas crisis (in remission, but not cured), hoping to foment a political uprising against Europe’s wobbling governments before the attrition of the war finishes him.
He lacks the fleet of shadow tankers required to outflank the G7 price cap on his oil exports. It is tempting for him to deprive the world of three million barrels a day and drive Brent to $200, calculating that he can get back on price more than what he loses on volume.
He will not do so long as the Chinese are staying holed up in their homes trying to avoid Xi Jinping’s dynamic maximum Covid policy, or lying on hospital floors having caught the virus. The opportunity arises only as China bursts back to full life and adds two million barrels a day to world demand.
He certainly wants to think that is his plan. My presumption is that he won’t dare. It hurts most of the world. He cannot afford to irritate China and India any further, or lose further sympathy in the global South.
My other presumption – low conviction, as hedge funds say – is that the outlines of a settlement in Ukraine will emerge after the Rasputita spring thaw, squalid though it may be. It will end in partition along the lines of the 38th parallel in Korea, or rather the 17th parallel in Vietnam, which proved only to be a holding line before the next war. It won’t be durable peace, but it will be rocket fuel for asset markets.
Annus mirabilis? Not quite, but no catastrophe either. Happy New Year.
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