As we enter 2023, the world economy is decelerating. The US is still in expansion, but higher interest rates, tighter financial conditions, and weakening property and labor markets will have a lagged, negative impact in the months ahead. The Eurozone and the UK are likely already in contraction given the combined impact of the energy crisis, inflation, and monetary tightening. And China’s recovery continues to be delayed by issues relating to COVID-19 and the property market.
Given the likelihood of a near-term deterioration in economic growth, we think further downward earnings revisions can also be expected in the months ahead.
Overall, we are looking for a 4% earnings contraction in the US, a 10% decline in Europe, and 2% growth in Asia, below consensus expectations of growth of 4%, 3%, and 7%, respectively.
But while the near-term outlook is challenging, we also think world economies will trough in 2023.
In Europe, growth should start to improve midyear as the continent’s energy crisis begins to ease after the winter, even if next winter may also pose challenges. In China, contingent upon a reopening in the middle of the year, economic growth should also improve, potentially with the help of higher infrastructure spending. In the US, a trough is likely to come later, given the strength in the economy thus far and the lagged impact of tighter monetary policy. But consumption and investment could be supported in the second half provided inflation is lower and financial conditions are looser.
What does it mean for investors?
Downward revisions to company earnings estimates mean the risk-reward is unfavorable for risky assets over the coming months. But we note that historically markets start to turn between three and nine months prior to a trough in economic activity and corporate profits.
With this in mind, a more constructive environment for risky assets should start to emerge during the year, as markets anticipate potential turning points in economic and earnings growth rates.
History also tells us that trying to anticipate a precise turning point for the market can often result in failure, and the best way for most investors to position for more favorable markets ahead is to keep a diversified portfolio, consistent with long-term investment plans.
Once a turning point arrives, markets that have already priced in most bad news and where valuations are lowest have the greatest potential for a rebound, which currently look like European and emerging market equities.
A downside scenario for markets would be a deeper and more prolonged economic contraction than expected. The Fed’s own labor market projections are consistent with a recession, and US recessions have historically had global spillover effects. In Europe, a colderthan-average winter could strain the provision of energy supplies, deepening the economic downturn. And in China, a longer-than-expected adherence to strict zero-COVID policies could further delay the recovery.
An upside scenario would be a faster and stronger reacceleration in economic growth than expected. A détente between Europe and Russia or warmer winter temperatures could alleviate the energy crisis and boost growth expectations for the region. We could see upside to China’s growth prospects if Beijing were to more quickly reopen, or roll out additional stimulus. Meanwhile, a faster-than-expected fall in inflation and lower borrowing costs could support growth in the US.
For more on how to navigate markets in 2023, see the full report Year Ahead 2023: A Year of Inflections 17 November 2022.
This content is a product of the UBS Chief Investment Office.