1. Does a recession lie ahead? Always focus on the long-term picture.

If history serves as any guide, there are three different types of bear markets:

  • Structural: Triggered by structural imbalances and financial bubbles.
  • Cyclical: Typically triggered by rising interest rates, impending recessions and declines in profits.
  • Event-driven: Triggered by a one-off “shock” that either does not lead to a recession or temporarily knocks a cycle off course.

As things stand, we are likely looking at a cyclical recession in 2023.

Bear markets in a cyclical recession tend to fall by 30% to 35% on averageIcon tooltip. Since the start of 2022, the S&P 500 has declined 14.4% as at end-November, with a peak drawdown of 27% seen at one stage. As such, if this bear market sell-off conforms to historical trends, the bulk of the drawdown could already be behind us.

Markets are forward looking

Bear in mind that financial markets are forward looking.

Markets have spent the past six months pricing in the possibility of a recession ahead. If a recession becomes a reality, markets will start to ask key questions of how long and how deep the contraction will be.

Assuming the contraction is short and shallow, risk assets may start to bottom out soon after a recession starts. Historically, there is a big range. Based on recent recession examples, the S&P 500 Index can take between one month to 19 months to bottom after a recession.

Focus on the long-term picture

One thing is clear looking at how the S&P 500 and MSCI World indices performed during recessions. Staying invested amid market volatility tends to pay off over the long term.

Stock market losses incurred upon a recession may seem extraordinarily large in the short-term. However, these periods tend to be brief when viewed from a longer-term perspective, as markets stage large rebounds from their bottom until the next recession (Figure 6).

As such, while there are periods of volatility and pain, the time-tested trend is one of rising stock markets over a multi-year and multi-decade horizon. Therefore, we always advise investors to adopt a long-term approach to investing, stay invested through volatility, buy on dips, invest in tranches during downturns, and most importantly, avoid timing the market.

With more clarity by mid-2023, investors could gradually seek out capital appreciation opportunities with greater confidence in the latter half of the year.

Figure 6

*Recovery off the low indicates the bottom from the past recession into next peak before the next recession.
Source: Bloomberg (30 November 2022)

2. What will central banks’ (particularly the Fed’s) policy paths look like?

More monetary policy tightening looks likely from major central banks in the near-term.

The Fed’s moves will likely affect what other central banks do, with the exceptions being the Bank of Japan (BOJ), which has kept policy unchanged, and the People’s Bank of China (PBoC), which has cut key policy rates.

The Fed has done a lot in a short timeframe, essentially front-loading aggressive monetary tightening with 425 bps of tightening over the course of 2022, pushing the Fed Funds Target Rate (FFTR) to 4.25% - 4.50%, the highest since November 2007. With the Fed still focusing on fighting inflation, it expects interest rates to rise to 5.1% in 2023.

The Fed has a communication challenge as it tries to walk the tight rope of balancing potential economic risks and its mandate of controlling inflation. While it has signaled a higher peak in the FFTR, the Federal Open Market Committee (FOMC)Icon tooltip has also shifted down to smaller rate hike increments.

This suggests the Fed may be shifting to a “slower for longer” approach of raising interest rates in smaller increments, but for longer. Interestingly, the idea of a “Fed pivot” has changed dramatically over the past few months, akin to the repeated shifting of its goal posts.

The “Fed pivot” was once used to signal a reversal to rate cuts sometime in 2H 2023, before it became a policy pause instead. Now, the idea of a “pivot” is smaller rate hikes.

All things considered, there could be more volatility ahead as investors engage in the dangerous game of deciphering the Fed’s intentions.

Financial markets are expecting a terminal FFTR of 4.90%. Our house view calls for another 50 bps rate hike in February 2023, followed by a smaller 25 bps hike in March 2023. We are forecasting rates to peak at a range of 5.00% - 5.25% by the end of 1Q 2023. Thereafter, we expect a pause to the rate hike cycle for the rest of the year.

Figure 7

Source: Macrobond, UOB Global Economics & Markets Research (16 December 2022)

While we expect inflation to moderate in 2023 due to high base effects, peaking commodity prices, and a re-adjustment to the demand and supply equilibrium, it will still likely average above the long-term objective of 2% for global central banks.

This means that although the Fed may hit the pause button next year, rate cuts may not be on the cards unless an economic or financial crisis arises. While this is not an optimal scenario for a financial market recovery, the Fed slowing its rate hike pace offers hope that we are closer to the end of the rate hike cycle than we are to the middle. This should allow risk assets to stabilise.

For Emerging Market central banks, the likelihood of a policy pause is higher since many started their rate hike cycle much earlier at the tail-end of 2021.

3. Will the stock-bond correlation stay positive or revert to its negative trend?

Over the past two decades, stocks and bonds have been negatively correlated. This means stock prices tended to rise when bond prices fell, and vice-versa.

This allowed investors to build resilient multi-asset portfolios by diversifying across stocks and bonds. However, the stock-bond correlation turned positive in 2022 for the first time since the late 1990s, meaning both stocks and bonds fell, leaving investors with no place to hide from the market storm.

Figure 8

Stock-bond correlations calculated on a rolling 24-month basis using the S&P 500 and Bloomberg US Aggregate Treasury Total Return Indices.
Source: JPMorgan Asset Management, Bloomberg (30 November 2022)

If we only consider the trend over the past two decades, a return to a negative correlation trend would appear likely over 2023, especially once inflation declines and central banks ease off from their tightening cycles. Moreover, if a recession occurs, this would benefit safe haven assets such as bonds.

If so, a mixed asset portfolio should see a positive return for the full year 2023.

It is however interesting to note that over the past 150 years, the stock-bond correlation has been fairly dynamic, flitting between negative and positive correlations. Key factors influencing correlations are rising inflation and interest rates. For example, during periods of high inflation, such as in the 1970s, 1980s, and early 1990s, stocks and bonds were positively correlated.

Hence, if inflation stays elevated in 2023, leading to continued rounds of aggressive monetary policy tightening, the correlation may remain positive.

4. With China's abrupt COVID shift, will headwinds in China lessen?

The fear after the 20th Chinese Communist Party (CCP) Congress in October was that China would focus more on ideology and less on the economy.

Recent developments offer hope that this may not necessarily be the case, and suggest that President Xi’s attention is slowly turning towards supporting the economy after consolidating his power.

China’s three headwinds have been long-standing, namely its zero-COVID strategy, property sector crisis, and souring bilateral relations with the US. Recent policy developments for all three have however been positive, with the risk of a further decline in market confidence seemingly forcing Beijing’s hand.

Firstly, China has made an abrupt shift away from zero-COVID, with Beijing looking at reducing the economic and social impact of prior stringent pandemic restrictions.

That said, China’s COVID re-opening will invariably face setbacks along the way, and we have seen a big wave of infections across the country after restrictions were eased. The situation may continue to worsen across winter, and it remains to be seen how this affects factory production, supply chains and domestic consumption.

Secondly, a 16-point support plan for China’s ailing property sector indicates a growing acknowledgement of the sector’s impact on broader economic growth.

Finally, US President Joe Biden and Chinese President Xi Jinping held an amicable meeting at the G20 Summit in November 2022, providing hope that bilateral tensions will soften. The early completion of audit checks by the Public Company Accounting Oversight Board (PCAOB)Icon tooltip has also fueled hope of a lower risk of delisting for US-listed Chinese companies facing audit issues.

2023 GDP target

It remains to be seen whether China will announce a lower 2023 GDP target or even a definitive target. Clarity will come in the early part of 2023, around the March National People’s Congress (NPC).

If there are further positive developments in all three headwinds mentioned above, the market’s current 2023 China GDP projections will be on the low side, and there could be upward revisions ahead.

It has been reported that senior Chinese officials are debating a 2023 GDP target of around 5%, while China’s Politburo said it will use “targeted and forceful” monetary policy as it aims for an “overall improvement” in the economy in 2023.

Property sector support

Given how China’s property sector drives around 26% of the country’s GDPIcon tooltip Beijing cannot afford a continued slump. Homebuyers boycotting mortgage payments could lead to social unrest, while surging loan defaults by developers could cascade into a banking crisis.

To address this, China recently issued a 16-point plan to support its ailing property sector, with measures ranging from addressing developers’ liquidity crisis to loosening downpayment requirements for homebuyers. Overall, the new policies are much more comprehensive than prior piecemeal steps.

Furthermore, the joint statement by the PBoC and the China Banking and Insurance Regulatory Commission (CBIRC) mentioned the “stable and healthy development” of the property sector, while PBoC Governor Yi Gang said he hoped the real estate market will have a “soft landing”.

Despite this, Chinese developers still face a mountain of looming debt maturities, with at least USD292 billion of onshore and offshore borrowings due by end-2023Icon tooltip, which means systemic risk cannot be ruled out.

Shift away from zero-COVID

The biggest policy shift comes from China’s abrupt roll-back of zero-COVID. While it has triggered a surge in infections, the hope is that this will eventually lead to herd immunity, and a sustainable recovery in domestic consumption and business sentiment. However, the path ahead is not straightforward.

Investors will likely want to speculate on the re-opening play, with many hoping for a repeat of the boost to consumption and travel-related stocks seen after March 2020. However, we caution that this time may be different, as we do not envisage a quick economic rebound mirroring 2020. Instead, potential waves of infections may mean a slower rebound in consumption and travel spending, and possibly hobble broader economic activity and supply chains.

Closer sectorial focus is needed. While Chinese big-tech companies may struggle with divesting more of their non-core businesses and domestic consumption remains lacklustre, other parts of China’s Tech sector may see a respite. President Xi has signalled a focus on building domestic cutting-edge capabilities as the US moves to restrict high-tech semiconductor technology.

Energy security also ranks high on the CCP’s priorities in the midterm, with Beijing unlikely to risk a repeat of 2022’s brief power shortages triggered by heatwaves and drought. As such, the high-tech and green industries may be big beneficiaries of Beijing’s policy priorities.

Sentiment in Chinese markets may start to improve

We may see teething issues in China’s COVID re-opening journey. However, if policy developments continue to be positive, the outlook for China’s economy and Chinese financial markets could improve more materially in 2H 2023.

If this is the case, China’s GDP growth may improve to 5.2% in 2023 (higher than the projected 2.8% in 2022).

The risk to this upbeat scenario is if policy developments disappoint.

5. What are the triggers to look for to determine a sustainable market recovery?

A conclusive turnaround for broader risk sentiment will depend on:

  • Moderation in inflation
  • Pause in monetary policy tightening
  • Peak in US dollar (USD) strength
  • Bottoming in economic activity
  • Bottoming in asset valuations

Once these conditions are met, we could see a sustainable market recovery.

Inflation needs to moderate

For a sustainable market recovery to happen, it is crucial that inflation eases further. When this happens, the squeeze on global household disposable incomes will abate. It will also mean that companies face less upward pressure on input and wage costs, allowing them to focus on expansion plans once again.

As such, investors should keep a close eye on both headline and core consumer price index (CPI) data, while staying mindful that central banks are acutely focusing on core CPI and wage trends.

Pause in monetary policy

A decline in core inflationary pressures will also allow global central banks to pause their rate hike cycles. A key reason behind 2022’s financial market tumble was aggressive central bank tightening to combat runaway inflation. If price pressures ease and central banks back away from rate hikes, one big headwind for financial assets will be removed.

In this scenario, we will see global bond yields peak and trend lower, while broad USD strength should also abate. For Asian risk assets, capital inflows may gather pace once the USD starts to weaken.

A peak in USD strength

From late September 2022, we have seen USD strength start to abate and enter a consolidation phase, even before the noticeable pullback that started in early November.

Indeed, the USD Index has now broken below the shorter-term trend line from early 2022, undermining the previously bullish picture (Figure 9).

Figure 9

Source: Bloomberg (30 November 2022)

The downturn was triggered by a weaker-than-expected US October CPI report, and helped by the Fed raising interest rates in smaller increments. This is a good signal, as a reversal of USD strength should boost stock market sentiment, as evidenced by the negative correlation between the USD and equities.

Figure 10: Correlation between the USD and S&P500 and MSCI World indices

For Asian risk assets, a weaker USD is an important pre-requisite for capital outflows to end, and for fund flows to return to the region. A weaker USD will also help diffuse the high imported inflation faced by many Emerging Market economies, and reduce the stress on countries with a large proportion of sovereign debt issued in the USD. Lastly, a weaker Dollar also reduces the pressure on Emerging Market countries to run down their foreign exchange reserves to support their local currencies.

A bottoming in economic activity

Another key trigger required is for economic activity to bottom out. Watch for higher frequency data such as Purchasing Managers’ Indices (PMI) and corporate guidance updates, followed by lagging indicators such as trade, employment data, and GDP reports.

Still, note that when economic data confirm a bottom, financial markets would already have rallied in anticipation, so these are more of confirmatory signals of a sustainable market rally, rather than leading indicators.

A bottoming in asset valuations

A definitive market recovery traditionally happens after investor capitulation, where fear takes centre stage and panic selling ensues without consideration for valuations. Once this capitulation is complete, the rationale is that there is no one left looking to sell; hence the market can find a bottom. This is difficult to call in real-time, and will only be apparent in hindsight a few weeks or months down the road.

What investors should focus on instead are historical valuation trends, such as forward price-to-earnings (P/E) ratios and price-to-book (P/B) ratios. A lower P/E ratio indicates better value. A P/B ratio below one indicates that a stock is trading for less than the value of its assets.

Figure 11

Source: Bloomberg (30 November 2022)

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Managing Editor
  • Winston Lim, CFA
    Singapore and Regional Head,
    Deposits and Wealth Management
    Personal Financial Services
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