As we feared, the ‘challenges of normalisation’ are indeed substantial. Underlying inflation pressures from fiscal and monetary loosening after the pandemic, aggravated by the Ukraine conflict, proved much more severe than central banks had assumed, prompting sharp rises in official interest rates.

Whereas in the past central-bank orthodoxy would have led policymakers to tighten in advance of an inflationary episode – ‘getting ahead of the curve’ – a period of low inflation in the 2010s predisposed them this time to being more tolerant of price pressures. Now, they are clearly chasing the curve, leading to an abrupt reversal away from super-loose monetary stances.

Policy tightening sparked another ‘taper tantrum’ in both bonds and equities. As a function of an inflation shock occurring at a time when bonds had been pushed to severely overvalued levels by ultra-loose central-bank policies, equities and fixed income declined together to a degree not witnessed since 1969. The impact on financial assets has been particularly severe because of the excessive asset-price inflation in the post Global Financial Crisis (GFC) ‘zero rates’ period, which culminated in the response to the COVID shock.

Although much tighter liquidity conditions have greatly improved valuations and hence prospective longer-term asset returns, they have not yet materially slowed economic growth, the employment outlook or earnings expectations. That will come in 2023. Having held up surprisingly well, especially in the US, corporate earnings are finally being impacted. In time, central banks can pivot from worrying about inflation to worrying about growth. But not yet. In the interregnum, we can expect volatility to remain elevated and further financial-asset de-rating. We have yet to the reach the culmination of policy tightening that began in 2021, but it is drawing nearer – hence the title of this year’s Outlook.

For longer-term investors, periods of culmination present opportunities to acquire assets at good prices. Investor positioning is thoroughly cleansed; excesses are exposed; and positive risk asymmetry (i.e., when potential upside outweighs potential downside) is restored. 2023 could prove to be one such occasion.

As tightening feeds through to the real economy, interest rates should peak and inflation should eventually fall back sharply. COVID-related supply-chain problems have receded, causing goods prices to start to decline; consumers are resisting price increases; many commodity forward curves are already persistently backwardated (jam today costs more than jam tomorrow); and, importantly, key central banks, with a few dishonourable exceptions, are showing determination to prevent inflation expectations becoming unanchored. Just as investors were surprised by the duration and strength of the inflationary spike, they may be surprised by how quickly it eventually fades.

Defensive bond valuations are finally at, or approaching, attractive levels after many years of persistent overvaluation. They look more attractive because a recession is the price of a return to a moderate level of interest rates. One risk, of course, is that, against a backdrop of growing and by now surely excessive financialisation – a variously described term but by which we mean here that the financial sector is increasingly dominating economies – the US Federal Reserve (Fed) over-tightens and by so doing causes more severe economic damage, domestically and particularly internationally.

A rampant US dollar has been the direct consequence of the Fed’s response to US economic overheating, in the context of an energy crisis in Europe and Japan. Dollar dominance has signalled a sharp tightening of international liquidity, the greenback’s degree of strength reminiscent of the Reagan bull market of the mid-1980s. Of course, it could rise further. But there is a high probability that as the economy loses momentum, US interest-rate expectations will finally recede, resulting in a cyclical US dollar peak.

Policymakers in China have been bucking the trend. They were the first to tighten to address overheating in 2021, particular in the domestic property market, and have been easing credit conditions just as the US and other countries have been doing the opposite. The combination of earlier tightening and rigid adherence to a zero- COVID policy led to much weaker growth in 2022 than forecast. However, this is set to change in 2023. Efforts to stabilise the property sector and boost growth via higher spending on infrastructure should start to engender a moderate recovery, which should be reinforced by an eventual easing of COVID restrictions. China still faces significant and largely self-inflicted medium- to longer-term structural growth challenges, but the cyclical picture could brighten considerably.

Elsewhere among the major economic blocs, economic recoveries will more probably be a feature of 2024 than 2023. Short of a systemic crisis, interest rates are more likely to level off than pivot. Having got it so wrong, central banks (led by the Fed) will be reluctant to declare victory against inflation prematurely and will focus on lagging indicators such as unemployment to guide monetary policy – which in any event will take time to impact real economies. A risk is that they continue to fight yesterday’s battle – the post-COVID spike in inflation – and keep official rates too high. This notwithstanding, markets will eventually anticipate economic stabilisation and eventual recovery.

Finally, the Ukraine crisis is likely to recede as a material influence on commodity prices, either through exhaustion and stalemate or a conclusive outcome on the battlefield. Should this be the case, energy prices are likely to continue to subside, removing the most serious headwind for European economies in particular. Of course, the geopolitical consequences of the crisis could continue to be felt for much longer. DM/BM