This year has been a challenge. From higher interest rates to geopolitical shocks, there was no lack of events that tested the market’s resilience.
Next year will likely see some of this year’s trends continue.
Interest rates are going higher, albeit at a slower pace.
The war in Ukraine continues.
Inflation remains historically high.
However, there are plausible scenarios that could deliver a positive surprise.
Inflation Could Fall Faster than Anticipated
When prices started rising fast this year, investors were shocked.
So were the heads of the global central banks. Their brutal hiking policies looked like emergency situations, completely unforeseen.
Between January and December, the federal funds rate jumped from almost zero to over 4%.
The Fed hiked interest rates in response to rampant inflation. Back in June, it crossed 9% on an annual basis.
The latest data from the Federal Reserve Bank of Cleveland shows that inflation in December (updated on December 23) will be 6.7%. That’s the headline CPI number.
But the number that the Fed uses to guide its interest-rate decisions is also cooling. Personal consumption expenditures, or PCE, are up 5.2% annually as of December 23. In November, they increased by 5.5% annually.
It looks like the rate of inflation is slowing down. Bloomberg forecasts that in 2023 it will moderate to 3.5%.
Bloomberg also reports that inflation could slow down even more if China’s reopening falters.
It may happen because of high rates of covid stressing the country’s healthcare system and resulting in multiple shutdowns across the economy.
China’s government reversed its lockdown policy quickly and without proper preparation for what could potentially be the biggest wave of covid in the country.
It may walk back from its decision to reopen after seeing the disastrous consequences of its policy change. The Economist projects up to 1.5 million deaths if the virus keeps spreading.
If it happens, China’s economy will not be able to function fully. It will also consume fewer commodities, such as oil.
A slower-than-expected reopening may drive inflation to low single digits faster than the market anticipates.
This would be bad for China’s economy, but good news for the rest of the world. (And China’s population, which is suffering from the uncontrolled spread of covid.)
Lower inflation will allow global central banks to slow down or pause their rate hikes altogether.
This is the biggest catalyst that every investor will likely feel the effects of next year.
And it may happen sooner rather than later.
Europe Could Avoid a Recession
If inflation falls and interest rate growth moderates, Europe could avoid a recession next year.
Right now, markets estimate the probability of a recession in Europe at 80%, the highest since mid-2020.
However, the EU has managed to continue growing in the third quarter of this year, ahead of analyst expectations. Government support and better functioning supply chains were among the most important reasons.
The market expects the European Union’s economy to contract by about 0.5% in the fourth quarter and 0.4% in the first quarter of 2023.
Both drops, if they happen, will likely be mild. And a recovery could start as soon as the second quarter of next year.
But if inflation falls faster than expected, Europe could be in a position to dodge the recession altogether.
Much like this year, all eyes will be on incoming inflation numbers.
We are seeing signs that inflation is slowing down. If this trend continues, there is hope that next year will finally start delivering investors some long-anticipated good news.
Thank you for your loyal readership,
The Financial Star team