The biggest risk of 2022 was inflation and all stock market indices were impacted by it. It’s almost time to start a new year and look at what the biggest possible risks are for 2023.
The Bank of America poll
According to the bank’s latest survey, the biggest risk for 2023 will remain inflation, followed by the risk of a deep global recession.
Inflation was the main issue for 2022. However, I think that for next year, the risks are going to be the consequences of inflation more than inflation itself. This is why I am going to highlight 5 major risks for 2023.
1. The risk of a recession
Here are the recession probabilities by country for 2023:
Even if the probabilities of recession give important signals for 2023, it remains underestimated within the financial markets.
When I say that the risk of recession is underestimated, it is because we can see that the positioning of operators remains very high on the markets. Moreover, there is a significant gap between the positioning and the sentiment of individuals. Operators are anticipating a recession but have no fear of it.
Here is a graph with the positioning of operators still very high compared to the past:
This significant difference may be due to the fact that operators associate recession=pivot and therefore that central banks will be present to limit the damage. However, a pivot is not necessarily bullrun significant and does not limit possible losses in the event of a recession.
If a recession were to occur during 2023, a correction in profits should be expected. This is not yet priced in the markets as we had a bear market mainly because of the bond/rates market in 2022 and not because of an earnings correction.
Anticipating a recession remains the simplest, but defining its amplitude is the most difficult. Especially since the situation is very different from what we used to have. First, we have labor shortage issues, and second, we have supply chain issues. Therefore, the recession may not cause unemployment as high as in the past either.
2. The risk of an overly restrictive monetary policy
As the FED relies heavily on real and past data, it does not anticipate the consequences and the damage that monetary policy may entail. Therefore, there are obviously chances that it will be more restrictive than it should be. Moreover, it is rather rare for a central bank to be restrictive during an economic slowdown. However, it wants to preserve high rates in 2023 since its main mandate remains price stability to control inflation. However, as the level of growth for 2023 is weak, it could be too restrictive if it is based only on inflation data. Moreover, services inflation, which remains the most resilient, declines when the recession is already underway when the labor market is affected.
If this is the case, this should have an impact on corporate results since until then, growth was able to absorb some of the increases without affecting profits.
In terms of growth forecasts and unemployment forecasts, here is the latest news from the FED:
3. China and the risk of zero covid policy
The zero covid policy has had very important consequences for Chinese growth. But the question remains whether there is a possible way out of the exit from the zero covid policy.
It is known that China has been easing the zero covid policy recently, but this can also have negative impacts. The number of cases could explode very quickly because there is no herd immunity. Therefore, if hospitals become overstretched, it could also slow growth and exacerbate supply chain issues for US companies.
Moreover, when we look at the “China credit impulse”, we can see that despite a reduction in the zero covid policy recently, the level of the indicator remains close to 0% despite a test towards 17.8%. In the past, before a resumption of acceleration in global growth, the indicator was around 40%. Therefore, China cannot revive the economy globally just yet. This may therefore also have a major role for overall growth next year.
4. Liquidity risk – Bond market
We know that the bond market is more important than the stock market. All of the central banks of the world’s largest economies, such as the ECB or the FED, are maintaining significant restrictive policies. The Bank of Japan also comes at the end of 2022 to go hawkish (restrictive) for the first time in years. After a long period of accommodative policy, it joins the two other major central banks.
How can this create liquidity problems?
For years, the Japanese have headed outside the country to find better yields. This implies that Japan was an important liquidity provider. Going forward, with the BOJ (Bank of Japan) becoming more hawkish, one of the biggest exporters of liquidity is likely to preserve cash in Japan. As Japan is the biggest buyer of US bonds, but also of several bonds in Europe, this can have an impact on the stability of bond market liquidity.
Moreover, in terms of instability, we had a first glimpse with the Bank of England and the QT program (quantitative tightening). The QT program consists of not renewing maturities in order to withdraw liquidity from the financial system. This system also makes it possible to maintain high rates. In England, they had to intervene quickly to buy back bonds in order to avoid a tragedy on pension funds (lots of bonds in pension funds).
The QT continues in the US, but if we remove the Japanese buyers, this may limit an important source of liquidity since it is the main buyer. As for the ECB, it should implement the QT in March 2023.
As the decisions of all central banks have an impact on global liquidity, the currency market, inflation, growth, it is important to closely monitor the risks that may arise. It is an environment more conducive to a liquidity hole since the central banks are connected to each other.
5. A more serious event in the crypto ecosystem
The bad news has multiplied quite a bit in the crypto universe. Some of these more popular events include the Terra Luna case, Celsius and more recently the FTX case.
It was also Binance’s turn to be in the spotlight recently. Concerns about the company relate to evidence of reserves. And the doubt grew after Binance’s auditing firm terminated its services.
It is quite normal that after the FTX case, investors become more reluctant and lose confidence, and act more punctually under emotions. In the meantime, another auditing company has taken over and reported that everything is correct. However, other financial and accounting experts have pointed to other failings.
As nothing is ever certain and everything depends on the trust we place in it, it is here that we can say that once again, the biggest collateral remains credibility. Therefore, as we are in an economic slowdown with less available liquidity, the risk is still present for 2023. It is also a test because if a company such as Binance manages to overcome this flawlessly, it will just strengthen the credibility given to it. If not, it will create a bigger and more serious negative domino effect in the crypto universe.
The notion of “tail risk” or extreme risk
Already, initially, the notion of “tail risk” is used in financial jargon to talk about potential extreme risks. More technically, it is the possibility of an investment to move by more than three standard deviations, this translates into a variation beyond the normal distribution. This kind of movement can happen when a rare event may happen or underestimated. More specifically, extreme risk follows an event.
How to reduce the consequences of an extreme risk?
One of the first arguments for dealing with a rare event of extreme risk remains portfolio hedging. As this is something rare, the implications on yields can be painful. This is why there are ways to hedge a portfolio, via options for example. Futures or an inverse ETF can also be used. There are downsides to hedging a wallet as well, primarily the cost. As these are rare events, actively hedging a portfolio can also have an impact on the forward yield. This is why it is better to hedge a portfolio when the financial conditions of the environment are less accommodating, such as when monetary policy is restrictive with a fairly pronounced economic slowdown at the same time.
Conclusion
In financial markets, there will always be risks present. This is why raising awareness makes it possible to take the necessary precautions. That said, there are environments that are more conducive to risk such as when monetary policy is restrictive. This can affect both inflation, liquidity and growth. This can give less advantageous financial conditions, and all the more so if at the same time there is a slowdown in growth.
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