1.The persistence of inflation, which will determine how tight financial conditions need to be.

2.The scale of economic slowdown in the US and other developed markets.

3.The leverage of earnings to that downturn.

4.Whether markets have already priced in the downturn.

5.How China’s economy performs as it exits covid-zero

6.Can the RBA engineer a soft landing in Australia.

 

Initial signs on the first three issues are positive. The first datapoints of the year suggest that inflation is lower than consensus expectations, which in turns requires less tightening, a milder downturn and a small hit to earnings. Headline and core inflation for November came in weaker than expected with headline inflation at 7.1% YoY now well down from the 9.1% YoY peak seen mid-year. While the slowdown is concentrated in goods inflation, it leads services inflation at major turning points. CPI rents are still rising rapidly but should fall this year following the fall in rents for new leases now occurring and the breadth of rapid price rises has collapsed with only 51% of CPI components now seeing monthly annualised inflation above 3%. Services inflation ex housing remains the Fed’s main concern now, but it’s already slowing and likely to slow further reflecting the lead from goods inflation and as the labour market slows through next year.

 

This supports markets in the near term. So too does the current outlook for China.

 

The consensus view has been for markets to re-test equity low points in the first quarter as earnings revisions turn negative. As a result, investor positioning has been cautious, with the market braced for a poor reporting season. Ironically, this may lead to the market holding up better than expected.

 

Near term liquidity may also be supportive. The US Treasury has been running down its cash position as it nears its debt ceiling. In the near term, this offsets some of the effect of quantitative tightening.

 

That said, it is hard to see a sustained market move materially higher. The Fed is likely to rein in any substantially easing of total financial conditions – which includes equity markets. The economic downturn is still also likely, with earnings set to fall. A market multiple of 17x in the US does not provide much of a buffer to this.

 

If 2023 sees easing inflation pressures, central banks are likely to get off the brakes and economic growth may be stronger than feared. This along with improved valuations should make for better returns in 2023. There are likely to be bumps on the way, particularly regarding recession risks, and this could involve a retest of 2022 lows or new lows in shares before the upswing resumes.

 

Global shares are expected to return around 7%. The post mid-term election year normally results in above average gains in US shares, but US shares are likely to remain a relative underperformer compared to non-US shares reflecting still higher price to earnings multiples (17.5 times forward earnings in the US versus 12 times forward earnings for non-US shares). The $US is also likely to weaken which should benefit emerging and Asian shares.

 

Australian shares are likely to outperform again, helped by stronger economic growth than in other developed countries and ultimately stronger growth in China supporting commodity prices and as investors continue to like the grossed-up dividend yield of around 5.5%. Expect the ASX 200 to end 2023 at around 7,600.

 

Bonds are likely to provide returns around running yield or a bit more, as inflation slows and central banks become less hawkish.

 

Unlisted commercial property and infrastructure are expected to see slower returns, reflecting the lagged impact of weaker share markets and higher bond yields (on valuations).

 

Australian home prices are likely to fall further as rate hikes continue to impact, resulting in a top to bottom fall of 15-20%, but with prices expected to bottom around the September quarter, ahead of gains late in the year as the RBA moves toward rate cuts.

 

Cash and bank deposits are expected to provide returns of around 3%, reflecting the back up in interest rates through 2022.