3 scenarios that could surprise markets in 2023

Global Investment Strategy Group

Our Top Market Takeaways for 9 January, 2022.

Market Update

New year, same vibe

It may be a new year, but U.S. financial markets still have the same vibe. Last week, the S&P 500 oscillated within the same range it has been in since the middle of December. It moved up on hints that inflation is receding, and down on data points that suggest a stubbornly strong labor market. Under the surface, sectors that do better when economic growth is strong (e.g., financials, industrials and materials) performed well, while mega-cap technology and energy stocks lagged.

Outside the U.S., the vibes do seem to be shifting. In December, China rapidly removed many COVID restrictions. Markets are excited. Offshore Chinese stocks have rallied nearly 50% from the late October lows, with the latest ~10% coming in just the first few trading days of 2023. Post-COVID normalization should provide a boost to the Chinese (and global) economy through 2023.

European markets are likewise off to a relatively strong start, gaining over 4% in as many days. This continues a run of impressive performance. Over the last six months, European equities are up 16%. The S&P 500 is up almost 2% over the same period. Despite the cost-of-living crisis driven by the war in Ukraine and the resulting food and energy shortages, economic activity has been better than anticipated, and the warm winter has alleviated the natural gas shortages. In fact, natural gas prices are back down to where they started in 2022.

Heading into this year, many feared that the three major economic blocks of the U.S., Europe and China would all be dealing with stagnant to recessionary economic growth. Recession risk looms in the U.S. and Europe, but growth has been stronger than expected and the latter has seen a rapid improvement in energy supplies. Reopening in China has also happened much more quickly than many expected and stands to be a positive for economic activity.

Spotlight

What could surprise us in 2023

In December, we released our outlook for 2023. There, you can find why we believe that even as growth weakens throughout 2023, markets will probably have a better year than they did in 2022. We also discuss how we are managing portfolios through continued turbulence, and where we think investors can find opportunity.

But what might surprise? Here are three scenarios we think are realistic, but which aren’t part of our base case.

1. Do you believe in miracles? China and Europe will materially outperform. China’s surprise reopening after three years of stringent COVID containment policies will not only provide a tailwind to domestic Chinese economic growth, but also to many global companies that are also exposed to spending by Chinese households. Luxury players and travel are two areas that immediately come to mind. There are also signs that the onerous regulatory environment that deflated public company valuations is starting to shift. In December, U.S. authorities announced they will have full access to audits of Chinese companies that trade on U.S. exchanges. This removes the risk that those companies would have to de-list, which has been a clear overhang.

Europe, meanwhile, now has a surplus of natural gas after a keen focus on building storage over the autumn, the rapid construction of LNG import facilities in Germany, and a very mild winter. China is the third-largest source of revenue for European companies, so economic reopening should provide an earnings tailwind. Finally, the end of negative interest rate policy in the region should encourage capital that fled due to paltry yields to return, and could help boost European bank earnings. A weaker dollar provides another tailwind for investors that think of their wealth in U.S. dollar terms. Oh, and mega-cap tech, which we believe will underperform in the next cycle, is much less represented in European indices.

In 2023, Chinese and European assets could outperform their U.S. peers to the tune of 15%–20%.

2. Forget a hard landing or soft landing. We won’t have any landing at all in 2023. Many outlooks we have seen expect equity markets to have a tough first half of 2023, as they anticipate a U.S. recession (a hard landing) by the second half of the year. Those that are more sanguine believe the Federal Reserve can stop hiking rates because price inflation and the labor market will settle in a much more balanced place without too much economic damage (a soft landing). But there is a case to be made for no landing at all.

Despite headlines that big tech firms are planning to reduce their workforces, the broad U.S. labor market has shown no signs of weakness. Initial jobless claims are still remarkably stable at very low levels, and survey data suggests that most of those who have been fired from tech jobs have been finding new work relatively quickly. The quits rate, which is a good indicator of how comfortable workers feel about their prospects for finding a new job, actually rose last month. 

This strength in the U.S. labor market comes at a time when price inflation is falling. This means that real income for workers is rising, which could support more spending, which would encourage companies to continue hiring. Of course, this would keep upward pressure on wages, and would incentivize the Fed to keep hiking rates through the balance of the year.

In 2023, we may not see the end of the tightening cycle for the Fed or a recession in the U.S.

3. Wall Street: don’t call it a comeback. The industries that felt the impacts of higher rates most acutely last year were finance and real estate. Initial public offerings, high yield debt issuance, mergers and acquisitions, mortgage applications and home sales all collapsed at their fastest rate since the Global Financial Crisis. Of course, the Fed is probably to blame. Higher financing costs are meant to slow down activity, but the rate of change in interest rates also had a material impact. Businesses, bankers and prospective homeowners all paused to see where the ceiling on interest rates was before borrowing and dealmaking.

Even though rates globally will likely remain at a higher level in 2023, their stability should help spur more activity in interest-rate-sensitive sectors. Take mortgage rates for example: over the last five years in the U.S., they have been about ~180 basis points (bps) above the 10-year Treasury rate. Last year, they were ~270 bps above the 10-year U.S. Treasury rate. A similar story can also be found true in Europe and the UK. As rate volatility comes down, so too should mortgage rates, which could breathe some life into the housing market.

As for the rest of Wall Street, there are deals that need to get done. The technology, media and telecom space needs to restructure after a painful year. Could Alphabet spin off YouTube? What is the long-term plan that Disney has for Hulu and ESPN? Could a Hulu/Peacock merger and spinoff make sense? Why does Amazon have a retail and a cloud computing business under the same roof? Warren Buffett always seems to be looking for a deal. Could a company like Textron, which makes Cessna airplanes and E-Z-Go golf carts, make sense? Peloton still has a loyal following and a large user base. Could a large company like Nike or Apple use it as a catalyst to build out a connected fitness platform?

In 2023, lower volatility in markets could lead to a recovery in mortgage activity, M&A, and IPO and debt issuance.

No matter what surprises 2023 might have in store, your J.P. Morgan team is here to help guide your financial plan. 

All market and economic data as of January 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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