Contrary to the mainstream narrative, the stage may be set for an economic hard landing in the coming year.
According to a new report from Robeco, the methods that central banks are using to prevent a cyclical downturn are “flawed,” primarily due to the lagging response of monetary policies to real-life scenarios, including inflation, housing, and the real economy. “To regain their credibility, they now risk tightening monetary policy excessively into 2023, inadvertently creating downside risks to the consensus soft-landing scenario,” the report stated.
Even with the increased tightening of the past year, central bankers are still likely to maintain a tighter monetary stance, at least until the data shows that their policies have indeed curtailed inflation and shifted the economic trajectory.
“While an inversion of the yield curve shows the market believes central banks are able to cool inflation, the magnitude of inversion currently observed in the U.S. Treasury curve reflects this risk of excess tightening and suggests the ISM [manufacturing index] could drop below 45 in 2023,” the report stated. “This implies that risks are tilted to the downside for the 2023 consensus of U.S. annual real GDP growth of 0.8 percent.”
But bad news may actually be good news. While the Dutch asset manager expects 2023 to be a recession year, it could also serve as a turning point for long-term returns once three major peaks are reached: peak inflation, peak rates, and a peak dollar.
“The last leg of a steep climb toward the peak can prove treacherous, and markets tend to overshoot here,” the report stated. “That implies short-term pain as exhaustion and capitulation take hold, following an already dismal performance across the multi-asset spectrum. While cash levels among retail investors are historically elevated and professional investors are moving toward a consensus of a U.S. recession in 2023, we haven’t seen full capitulation in risky assets yet.”
According to the firm, that kind of capitulation will signal the last leg of the bear market cycle — akin to the one witnessed during the era of quantitative easing — and create a dislocation in assets and opportunities that could result in sustainable gains due to the risk-reward payoff. “As policymakers maintain their hard line into 2023 and global growth deteriorates further, we expect markets [to finally] factor in all the bad news,” the report stated. “That’s when the longer-term opportunities will start to emerge.”
Robeco expects central bankers to show “higher sensitivity” to decreased real activity as a result of their tightening policies, which in turn will slow the pace of rate hikes, solidify the bull market for sovereign bonds, and generate a better outlook for the 60/40 portfolio.
Emerging market equities, which tend to outperform in a dollar bear market, may also present an attractive opportunity. “Emerging markets are attractively valued versus their developed counterparts,” the report stated. “In addition, the downturn in the earnings cycle in emerging markets is already more mature than developed market equities, in part because emerging market central banks have preempted developed market central banks in combating inflation.”