Top 5 Economic Outlooks for 2023

Predictions from the world's financial giants

Jul 05, 2023

Over the last few weeks, the largest financial institutions and asset managers in the world have publicly released their economic outlooks for the balance of the year. We read through the 100s of pages and pulled out the most important takeaways exclusively for Cap Stack readers.

We’ve specifically highlighted BlackRock, Apollo, KKR, Morgan Stanley and JP Morgan. Below you can read about where these firms agree on their outlooks, where they differ on their outlooks, followed by our detailed notes on the individual publications. Beyond the usefulness of getting perspectives from large institutions, we also like to read these predictions for entertainment purposes to observe who gets things wildly wrong.

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On to today’s article.

Overlaps:

Economic Downturn: All five firms agree on the likelihood of an economic downturn or recession. This consensus is largely driven by the tightening of monetary policy, inflationary pressures, and distress in the banking sector.
Inflation Concerns: Persistent high inflation is a mutual concern across all firms, with most expecting it to continue until at least 2024.
Non-Banking Financial Sources: There is a shared emphasis on the role of non-banking sources of funding, such as private credit and asset-backed finance. These are seen as significant in supporting firms amidst challenges in bank lending and public capital markets.
Investment Opportunities: Private equity, private credit, and real assets are considered favorable investment areas by most firms due to their lower volatility and inflation sensitivity (and because these firms are active in these areas). Distressed situations, take-privates, and carve-outs are also seen as potential investment opportunities.
Equity Market Views: All firms generally express caution about the equity market, advocating for a focus on high-quality, resilient stocks and companies with strong balance sheets. Regional diversification in equity allocations is also suggested.

Key Differences:

Market Predictions: While Apollo and JP Morgan predict a hard landing, BlackRock leans towards a soft landing. KKR has a neutral to negative view for the global economy while Morgan Stanley expects a slowdown and divergence.
Investment Strategies: The firms have different focuses in terms of investment strategies. KKR emphasizes investments in infrastructure and residential real estate. In contrast, Apollo and Morgan Stanley focus more on private credit and private equity. BlackRock underlines the importance of maintaining portfolio resilience through diversification, and JP Morgan highlights the benefits of investing in dividend-paying stocks and sectors like healthcare and utilities.
Regional Perspectives: Morgan Stanley suggests an offensive approach in Asia and defensive approaches in the U.S. and Europe, whereas JP Morgan suggests more allocation to Europe for diversification. KKR and BlackRock don't provide specific regional investment strategies.
Recovery Expectations: Morgan Stanley predicts a sluggish global economic recovery with significant regional differences. In contrast, JP Morgan sees the service sector as resilient despite manufacturing challenges and anticipates China's recovery to mirror other regions with service industry improvements.
Inflation Expectations: While most firms expect high inflation to persist, JP Morgan predicts a decrease in inflation that would allow central banks to focus more on supporting growth.

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KKR

Market Assessment: KKR believes that the S&P 500 reached its lowest point in October 2022 and expects credit prices to stabilize. They don't advocate a general risk-on or risk-off approach in the current market conditions.
Four-Stage Model: KKR refers to a model where there is a rolling recovery and rolling recession happening across four stages - contraction, early cycle, mid-cycle, and late cycle. They suggest CIOs to focus on linear deployment, portfolio diversification, and suitable hedging.
GDP Growth: They forecast a stronger GDP growth in the US and China for 2023, but lower inflation than consensus estimates for the same year. They expect higher inflation in 2024 due to the reversal of disinflationary trends from the previous decade.
Earnings and Inflation: KKR predicts a decrease in earnings per share in 2023, followed by a restrained rebound in 2024. They expect higher inflation throughout this cycle.
Labor and Energy: KKR points out a structural labor shortage in the US and predicts sustainable long-term pricing for energy and energy-related investments.
Housing and Yields: They express caution about the US housing market but don't foresee a complete collapse. They also expect higher long-term yields in the US and Germany than what the consensus forecasts suggest.
Banking Crisis and Fed Rates: KKR thinks the regional banking crisis may continue and additional banks could be under pressure if the Federal Reserve doesn't cut rates in the near term.
Expected Returns and Opportunities: Despite the current market conditions potentially leading to lower expected returns this cycle, they believe opportunities can be found in alternative lending and cash as an asset class.
Regime Change Thesis: According to KKR, the Regime Change thesis is still valid. Factors like labor shortage, geopolitics, housing demand, energy transition, and fiscal impulse are contributing to inflation. However, they warn that traditional inflation hedges may disappoint, and they don't recommend making big bets on growth versus value stocks.
Cash and Risk Allocation: KKR suggests holding more cash and allocating risk elsewhere in this climate.

KKR Asset Allocation Strategy

Japan's Equity Market: Bullish due to attractive pricing, improving corporate governance, and an opening economy.
Collateral-Based Cash Flows: Overweight cash flows linked to nominal GDP, asset-based finance, real estate credit, and infrastructure.
Cash: Overweight due to rising yields.
Higher Quality Liquid Credit: Favor due to attractive returns and reduced default risk.
Flexible Capital to Preferred Securities: Consider debt-like instruments with equity upside.
Middle-Income Consumer: Positive outlook due to improving finances and supportive home values.
Non-Correlated Assets: Favor over traditional long/short hedge funds.
Short the USD: Due to trading at a premium and relative tightening in other economies.
Underweight Regional Banks: Expect challenges due to losses from duration and commercial real estate credit.
European Cyclicals: Bearish due to stronger euro, decarbonization, and de-globalization.
Turkey: Cautious due to high inflation and unorthodox monetary policy.
Businesses with High Staff Turnover: Emphasize worker tenure and aligned incentives.

Key Themes

Buy Simplicity: Favor high-quality liquid and private credit, mortgages, small and mid-cap stocks, and undervalued sectors.
Real Assets: Favor collateral-based cash flows.
Automation/Digitalization: Anticipate increased focus due to labor shortages.
Worker Retraining: Expect more opportunities as formal education becomes scarcer.
Resiliency: Focus on redundancy and resilience in various sectors.
Energy Transition: Consider as a significant investment theme.

Economic Outlooks

USA: Expect varied conditions across regions, growth to slow, and inflation to remain above Fed's target.
Europe: Expect slow but positive growth, inflation concerns, and deceleration in manufacturing sector.
China: Expect a lowered GDP forecast due to property sector issues and a consumption-led recovery.

Capital Markets

S&P 500: Expect decline in earnings per share (EPS) in 2023, rebound in 2024, and modest upside from current trading levels.
Interest Rates: Expect rate hikes in the U.S. and Europe, and easing and rate cuts in China.
Oil: Expect downward revision in oil price forecasts due to increased Russian crude production.

Takeaways from FAQ

Value across asset classes: Small-cap stocks, foreign stocks, credit investments, real assets, and cash offer good value.
'Credit' sleeve of portfolio: Advise moving up in capital structure, favor high-quality CLOs, and see opportunities in high-yield debt market.
Inflation and Real Assets: New inflation hedges outperforming traditional ones.
Health of the global consumer: Global consumers are in better shape than appreciated.
Commercial Real Estate loans: Challenging outlook but market is more resilient compared to the Global Financial Crisis.
Longer-term issues: Concerns about inflation, demographic shifts, geopolitical tensions, and environmental issues.

KKR Summary

KKR's Global Macro, Balance Sheet, and Risk team (GBR) believes that a new regime for investing has begun, marked by several unique factors. These include supply-side shocks like tight labor markets, heightened geopolitics, and the energy transition, leading to more volatile and higher inflation. Another significant factor is increased fiscal spending in major global economies, contributing to the current economic cycle.

Despite monetary tightening, its impact on consumers is being mitigated by excess savings from the pandemic, limited variable mortgages, and a stable unemployment rate. The team offers several action items for investors, such as favoring credit over equities, investing in collateral-based cash flows, considering private equity and infrastructure markets, and exploring non-USA assets.

The team warns of potential pitfalls to avoid, including caution regarding office real estate in the United States, housing in China, and segments tied to manufacturing in Europe. The biggest risk is the need for further rate increases by central banks to control inflation. Despite potential headwinds, the team remains generally constructive on risk assets, emphasizing that the time to reduce risk has passed.

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BlackRock

Stocks outperformed expectations in the first half of the year, with the S&P 500 delivering double-digit returns.
Elevated inflation and the Federal Reserve's rate-hiking campaign have not dampened market performance.
Technology shares, especially in the IT, telecom services, and consumer discretionary sectors, drove market performance.
Investor caution is apparent, demonstrated by outflows from U.S. equity funds and inflows into money market funds.
The recent banking crisis and the ongoing inverted yield curve signal recession concerns.
There is potential for sidelined cash to be deployed into the market.
As the market focus shifts from macro factors to stock-specific dynamics, opportunities may arise for active stock pickers.
Defensive sectors like healthcare and well-priced cyclicals are seen as potential areas of interest.
The return of alpha, or excess returns above the market average, is anticipated as stock differentiation increases in the post-COVID era.
This environment of higher valuations, inflation, and interest rates is likely to benefit skilled managers, who are expected to play a larger role in generating alpha and contributing to investors' overall returns.

Apollo

Current Economic State

The US economy has experienced a downturn in the past six months, with negative Gross Domestic Product (GDP) growth expected over the next nine months.
High inflation of approximately 5% persists and is expected to continue until 2024, led by the Federal Reserve's tightening of monetary policy.
Silicon Valley Bank's collapse puts pressure on regional banks to tighten lending standards and reduce credit availability.

Projections and Predictions

A recession is imminent, with a 60% chance of a hard landing.
There is ongoing debate between a potential soft landing or a hard landing.
- Soft landing arguments: The impact on the commercial real estate sector will be smaller than the 2008 financial crisis, and the US banking sector's share of lending has decreased.
- Hard landing arguments: The ongoing banking turmoil will have larger macro effects than anticipated, and high inflation and labor shortages will lead to higher interest rates.

State of the Capital Market

Equity and bond investors have different outlooks; equity investors do not seem to anticipate a steep recession due to strong earnings, while the high-yield market indicates a harder landing.
Bond issuance and lending markets are showing signs of recovery but remain below historical averages.

Non-Banking Financial Sources

Due to challenges in bank lending and public capital markets, non-banking sources of funding, like private credit and asset-backed finance, are likely to be significant in supporting firms.

Potential Investment Opportunities

In the current economic environment, it is advised to consider investments in asset classes with lower volatility and inflation sensitivity, such as private equity, private credit, and real assets.
High interest rates and the demand for finance may pressure many companies to restructure their balance sheets, offering opportunities for private-equity investors.
Opportunities also exist in distressed situations, take-privates, and carve-outs.

Looking Ahead

For the remainder of 2023 and beyond, investors should consider their asset allocations.
In the likely scenario of a hard landing, asset classes with lower volatility and inflation sensitivity, such as private equity, private credit, and real assets, become more appealing.
Providing capital, especially debt and equity financing, can benefit investors in an environment where regional banks are under pressure and primary high-yield issuance is facing challenges.

Morgan Stanley

Outlook

The global economy is expected to slow down and become more divergent in the second half of 2023 due to persistent inflation and tight monetary policies by central banks. This challenging environment will require investors to seek opportunities that yield more than the risk-free rate of return. Varying strategies by region are recommended, with a focus on offensive approaches in Asia and defensive approaches in the United States and Europe.

Investment Opportunities

According to Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley Research, equities and high-yield bonds in developing markets pose higher risks. However, underappreciated opportunities can still be found, such as agency mortgage-backed securities. Despite their valuations approaching levels seen during the 2008 financial crisis, they are considered less risky due to more conservative lending standards. Additionally, declining US government bond yields make these securities attractive for investors.

Regional Differences

The global economic recovery will be sluggish, but significant regional differences will shape investment opportunities. Asia is expected to experience stronger growth, lower inflation, and easier policies compared to the US and Europe.

Key Points

US and European equities may underperform: Company earnings are anticipated to fall short of expectations in the latter half of the year. Morgan Stanley has lowered its 2023 S&P earnings forecast and expects a rebound in 2024.
Sector-level investments offer opportunities: Defensive stocks like consumer staples are favored over cyclicals such as consumer discretionary and technology stocks in the US. However, technology stocks in Japan, emerging markets, and Europe are expected to have upside potential. Healthcare is recommended across all regions.
Japan and emerging market (EM) equities appear attractive: Favorable conditions, including stronger growth, lower inflation, easier policies, and reasonable valuations, may lead to double-digit returns in these markets over the next 12 months.
Strong US dollar: The US dollar is expected to remain strong as investors seek its defensive qualities and positive carry, historically showing a negative correlation to equities.
Normalizing commodities: After a breakout year in 2022, commodity markets are anticipated to return to more normal conditions. Slower economic growth typically leads to decreased demand for base materials and energy, resulting in flat prices for most commodities.
Selective bond investments: Long-duration government bonds in the US, UK, and Germany could perform well due to attractive real yields, despite high inflation and poor carry. Investment-grade bonds may also provide positive returns in developed markets with soft economic growth.

Market Insights

The outlook for 2023 suggests that it has been a better year for markets than initially expected, with economies performing relatively well. While manufacturing has faced challenges due to weaker demand and rising costs, the service sector has remained resilient. Factors such as a strong labor market, pent-up savings, and the desire to compensate for missed experiences during the pandemic have outweighed the impact of higher costs and interest rates.

Market expectations have shifted towards a scenario where the economy avoids a recession and inflation falls back to target levels. Inflation is anticipated to decrease quickly, allowing central banks to focus on supporting growth instead of driving a recession. However, some concerns remain, and the likelihood of a recession is still considered probable. The mid-year outlook emphasizes the importance of portfolio diversification against recession and inflation risks, adopting a relatively defensive approach to stock allocation, and considering dominant secular themes in a shifting economic landscape.

The economic toll of recent banking stresses is also a concern. While swift liquidity support and takeovers have prevented a further escalation, the perception of market complacency regarding banking troubles may be misplaced. Bank lending surveys indicate that corporate lending standards have tightened, which historically has been accompanied by a recession. Balance sheet constraints and a bleak outlook for real estate suggest that risk tolerance at banks will remain low in the near term.

The behavior of the labor market is another uncertainty. While firms have cut back on investment plans, employment intentions have remained relatively robust, potentially due to challenges in finding staff post-pandemic. However, it is uncertain if this trend will continue, and a significant rise in unemployment may still be forthcoming. Central banks face a difficult balancing act, needing the labor market to weaken to drive down inflation but reluctant to be the cause of rising unemployment, especially in the run-up to national elections.

Inflation is expected to cool on a headline basis, with base effects and dropping energy and food prices benefiting Europe. However, core inflation is not projected to quickly return to target levels. Buoyant demand for services, a tight labor market, and ongoing wage pressures are likely to keep upward pressure on costs and prices until a recession occurs. The long-term concern is that goods price inflation may not remain as low and stable as in the past due to higher input costs and reduced disinflationary effects from globalization.

The energy situation in Europe is more favorable than anticipated, with storage tanks at high capacity and falling gas prices driving down inflation and reviving consumer confidence. The prospects for energy problems next winter are considered less likely unless there are severe temperature conditions. Efforts are also underway to establish domestic renewable energy solutions.

China's recovery has shown similar patterns to other regions, with improvements in the service industry and more muted investment activity. Real estate challenges and limited financial buffers have affected private sector confidence. While growth expectations for China may fall short, it is premature to discount the entire year. Moderate government debt levels provide room for fiscal stimulus, and low inflation allows the People's Bank of China to cut policy rates to support households and businesses.

Equity Allocations Resilience

The current stock market rally is due to the rising hopes of a positive economic scenario.
Investors should focus on high-quality companies, strong dividend payers, and regional diversification to enhance the resilience of equity allocations.
Quality is important as markets tend to reward companies with strong balance sheets and experienced management teams, especially during uncertain times.
Including dividend-paying stocks can help buffer against volatility. Sectors like healthcare and utilities often offer strong dividend opportunities.
It's risky to concentrate portfolios in a single equity region. Diversifying by allocating more to Europe could be beneficial.
Tech stocks may not perform well during a US recession due to a potential pullback in spending.

Portfolio Diversification

In 2022, stocks and bonds both experienced significant losses due to inflation reaching 40-year highs.
Given the likelihood of persistent above-target inflation, investors should consider diversifying their portfolios to include alternative assets like timber, infrastructure, real estate, and hedge funds.
Relying solely on the negative correlation between stocks and bonds may not be sufficient for portfolio diversification in the face of inflation volatility.

Secular Investment Themes

Factors such as climate change, pandemic impact, and geopolitical events have led to scarcity in various areas.
Scarcity in clean energy, materials, food and water, and labor are creating investment opportunities in renewable energy, efficiency, electrification, sustainable transport, construction, domestic processing and recycling of critical minerals, sustainable agriculture, water management, reforestation, and services for older populations.

Central Scenarios and Risks

Central Scenario: Moderate inflation and mild recessions are expected. Central banks may pause their hiking cycles with modest rate cuts anticipated in 2024. Equities may face challenges with higher quality stocks outperforming.
Downside Scenarios
1. Growth and inflation decline simultaneously prompting central bank support leading to deeper recessions.
2. Sticky inflation prevents central banks from intervening due to persistent price pressures. Bonds fail as diversifiers, equities experience negative total returns, and USD strengthens against cyclical currencies.
Upside Scenario: Resilient growth and cooling inflation could create a favorable environment. Stocks might see positive earnings expectations and rebounding valuations.

Disclaimer: We are not financial advisors. This content is for educational purposes only and merely cites our own personal opinions. All analysis, including valuation, debt, liquidity, etc. is illustrative in nature and subject to revision.

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