The 2023 mid-year outlook

01

Short-term pain for medium-term gain

• Recession risks have been delayed, not avoided: The surprise over the first six months of the year has not been the slowdown in economic activity. It has been the pace of the slowdown, which has been more gradual than expected, given the pace of interest rate hikes both in Australia and abroad. Rising rates are now starting to bite into economic activity. However, excess consumer savings, solid corporate fundamentals and tight labour markets have provided a greater cushion than expected.
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• A short and shallow global recession is coming: Macquarie still expects the global economy to slip into a short and shallow recession starting in 4Q23 with the US, Europe and the UK experiencing various-sized economic contractions out through mid-2024. Australia is expected to avoid the same fate as strong population growth and the recycling of unexpected commodity price gains provide support against a weaker consumer and rising unemployment. However, downside risks are building for the Australian economic outlook as the RBA remains resolute in its efforts to bring inflation back down into its target 2-3% range and it is possible that a recession is also an unintended consequence of the inflation fight.  

• Lower inflation in focus for central banks: While the resilience of economic growth is encouraging, it’s likely that slower activity and rising unemployment will be needed to bring core inflation measures back into central bank target ranges over the coming 12-18 months. Because central banks fell behind the inflation fight in 2021/22, they have been forced to raise rates at a rapid pace and without the luxury of waiting to see how policy tightening is working its way through economies. This is creating uncertainty around whether central banks have, or have not, done enough to tame inflation. Ultimately how high interest rates go will be a function of comfort around inflation, meaning economic growth will remain the collateral damage of rate hikes. At this stage, we think Australian households and businesses should not expect to see any rate relief out through 2Q24. 
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• Patience required before a new bull market starts: Bear markets are painful, can be prolonged and are usually characterised by numerous false starts that drive oscillating (and fragile) sentiment. We don’t think the equity bear market that started in 1Q22 is over yet. The rally year to date has been encouraging and illustrated a willingness to get back into risk assets. The true test will come over the next six months, as economic growth slows, and policy rates remain stuck at peak levels. Equities are driven by the combination of valuations and earnings. Without lower rates, a sustained valuation expansion phase is unlikely. Similarly, corporate profit margins are now at threat from elevated input cost inflation and weakening final demand. This is not a favourable combination for equity markets. Consequently, we think the near-term equity outlook is poor with valuations not yet cheap enough to provide a floor into rising cyclical weakness. While we do not expect equity markets to retest their 4Q22 lows, investors should remain cautious and wary of chasing the rally when macroeconomic uncertainty is elevated and the cushion for downside is thin.
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• Time to lock in peak bond yields (before recession drives them): For more than a decade, the hunt for yield has driven investors out the risk curve and into pockets of credit, real assets (such as real estate and infrastructure) and private markets. This is no longer necessary with sovereign bonds offering the highest yields since the Global Financial Crisis (GFC.) We believe there is a short window to lock in peak yields before economic risks force them lower. While cash (deposit) rates are appealing vis-a-vis bonds, the short duration nature of cash opens depositors up to reinvestment risk in the future vis-à-vis bonds, which can provide much longer dated yields. 
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• Residential property prices have bottomed even if the path forward is rocky: The Australian housing market has weathered rising interest rates much better than expected. House prices across the five major cities are picking up again despite the 400bp cash rate increase in the 12 months to July this year. Macquarie’s base case is for nationwide dwelling prices to rise, in nominal terms, ~2% over the remainder of 2023 before increasing by ~7% over 2024. Admittedly there is significant uncertainty around the short-term path of housing prices, but with policy rates approaching a peak, supply shortages likely to persist, rental availability low, and immigration running hot, we think the worst is already over even if a bit of short-term volatility remains. 
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• Wealth creation is a long game: Economic and financial market transitions take time. The economic downturn has been a slow train coming, but it will arrive. With the majority of fixed-rate mortgages taken out during the pandemic resetting over the coming four quarters, Australia is about to see prior rate hikes begin to bite much deeper into consumer behaviour. While the near-term outlook is clouded by uncertainty, Macquarie believes the downturn will be a short disruption, with the economy recovering by 2H24 and markets likely in advance of this. For now, patience is needed as the adjustment across asset markets proceeds at varying speeds. When uncertainty is high, there is always the temptation to sit on excess cash. However, over the long term, trying to time markets has proven to be a costly strategy versus being fully invested and well-diversified. 

02

Global growth slowdown to catch up with buoyant markets 

Monetary policy tightening works with long and variables lags. Macquarie expects higher policy rates to eventually take their toll on activity levels, with a short and shallow global recession led by downturns across many key economies including Europe, UK and the US over the coming 12 months. In addition, China — which has often acted as a countercyclical ballast for the global economy — is unlikely to fulfil that role as its post-COVID reopening disappoints and it embarks on another round of stimulus. While economic growth is also expected to fall sharply in Australia (from 3.7%y/y in 2022 down to 0.8%y/y in 2024), Macquarie’s base case is that it manages to skirt recession as a slowdown in consumer spending and dwelling investment is offset by the recycling of unanticipated revenue gains from high commodity prices and strong population growth. However, the risk of recession remains contingent on where inflation and hence policy rates go from here and it remains a close call.     

It is likely that inflation will remain at uncomfortably high levels for many central banks, Australia’s included, over the coming 12-18 months. This is likely to prevent a quick reversal in policy settings as central banks attempt to extinguish the last of any inflation embers in order to prevent a flare up that would then require additional tightening. We do not expect a deep or prolonged economic downturn, but the prospect of a few more late-cycle cash rate increases over coming months does have the potential to deepen the economic downturn and even shift the consensus narrative from a ‘soft’ to a ‘hard’ economic landing should central banks push the inflation fight too far.

As we look further out into 2024/25, a lack of excesses, such as large inventory overhangs, bloated corporate balance sheets, an overleveraged consumer and/or excessive asset valuations, which all take time to correct, suggests that rising policy rates should leave little permanent scarring for the global economy as it reverts back to more normalised interest rates, inflation and economic growth levels. In addition, sentiment towards risk assets (credit, equities and real estate in particular) does not appear to have been permanently dulled and increased transparency on the rates, inflation and growth outlook should quickly bring investors back from the sidelines.

03

Regional economic outlooks: broad growth slowdown underway

US — recession ahead: The US economy has proven resilient to policy tightening through 2H22/1H23, underpinned by strong personal and government spending as well as a strong labour market. While headline inflation looks to have peaked, core inflation has been stickier as underlying trends in core goods and services have remained firm. Sticky core inflation alongside financial conditions, which have tightened but which are not particularly tight, means the Federal Reserve still has a little more to do. Macquarie is forecasting a further 25bps rate hike to 5.25%-5.50% but this will likely signal the end of the hiking cycle. However, while rates are already near peak, expectations for a 4Q23 policy reversal appear to be optimistic, with Macquarie not expecting the first rate cut until 2Q24.

While a US recession has not appeared as scheduled, Macquarie’s base case is that it will still arrive in 2H23 with negative GDP prints likely out through mid-2024. However, the downturn is expected to be both short and shallow as areas of relative strength such as corporate profits and the labour market remain supportive although consumer real income and spending growth headwinds are building. This short and shallow growth correction is consistent with leading indicators which have weakened (i.e., manufacturing) but have not collapsed (i.e., services). A gradual easing in policy settings will help lift economic growth into 2H24 although it’s unlikely that there will be much fiscal expansion relative to prior years. Overall, while the near-term outlook is for a broad-based weakening, Macquarie is optimistic that there are no long-lasting drags on the economy. 

Europe — recession underway: The Eurozone has seen a mild contraction in GDP since late 2022, with Macquarie expecting to see a more meaningful downturn staring in 3Q23. As a major exporting region, ongoing weakness in global goods demand should see further contraction in Eurozone manufacturing sector activity through the coming year, with further declines in dwelling investment as is typical of the lags from tightening monetary policy. In addition, tight credit conditions and weak business orders are likely to see further weakness in business investment as we move deeper into 2023 and beyond.

Despite the modest contraction in the economy, the labour market has been surprisingly resilient. With the labour market remaining tight and wages growth yet to peak, we are likely to see the ECB hike its deposit facility rate to a peak of 3.75% (with risks tilted towards additional hikes). Ongoing wage pressures are likely to see inflation remain sticky into 2024, with the European Central Bank (ECB) unlikely to cut rates before 2Q24. 

China — more easing to come after a soft patch: The Chinese economy rebounded strongly from 4Q22 as it reopened from its multi-year COVID lockdowns, coupled with material government stimulus to support the flailing property sector. However, the bounce has been underwhelming versus bullish expectations that China’s recovery would be a saviour for slowing developed economies.  

Unlike other countries which have seen consumer spending shift from goods to services as the economy reopens, this was more muted for China with manufacturing output also disappointing amid ongoing cautious sentiment around the property sector recovery.

The government has already responded to softening activity although it appears its decision makers are taking a more targeted and measured approach to additional reflation supports. Macquarie expects the recovery to regain momentum from 3Q23 as a new round of monetary, fiscal and property easing measures are announced to stabilise the economy in the coming months. If the government is to achieve its 5% growth target in 2023, then the relatively subdued consumer will need to be supported by additional stimulus packages. Near-term softening trends aside, Macquarie expects GDP growth to accelerate from 3.0% in 2022 up to 5.7% in 2023.

04

Australian economic outlook: still (relatively) lucky…

Australia’s macroeconomic outlook has now converged on other major developed economies, with sticky core inflation driving a higher-than-expected peak in the cash rate and consequently a slightly deeper economic downturn than Macquarie was expecting coming into 2023.

Macquarie still thinks Australia will avoid a recession (unlike the global economy and many other developed economies such as Canada, Europe, New Zealand, the UK and US), with positive contributions coming from a rebound in population growth and moderate fiscal support, as larger-than-expected commodity price gains are recycled. However, this is now a close call as the RBA appears resolute in its fight against inflation.

The bad news is that recession or not, Australia is about to enter its weakest economic growth period since the GFC, with annual growth projected to fall from 3.7% in 2022 down to 1.3% in 2023 and to only 0.8% in 2024. Like many other economies, Australia has been cushioned from rate hikes by a large pot of excess savings built up throughout the global pandemic, as well as a resilient jobs market which has seen unemployment fall to 50-year lows. However, household incomes are now bearing the brunt of rate hikes, with consumer spending already slowing sharply and the household savings rate back below pre pandemic levels. This means that for many households and businesses, conditions will feel recessionary as cost-of-living pressures persist, the labour market weakens, and the RBA continues its hawkish policy stance.

Longer term, it is important for the Reserve Bank of Australia (RBA) to restore price stability/policy credibility and for now, economic growth will be the collateral damage. Either we reset now and weather the pain of tight policy conditions, or we muddle through a period of higher inflation and growth uncertainty. For the RBA, the choice is clear, with some short-term pain necessary for long-term gain. Fortunately, Australia should weather rising policy rates better than most of its developed market peers given the cushion likely to be provided by strong population growth, rising housing prices and relatively steady government spending.

05

Spotlight on Australian housing

The price correction is over, but the upswing remains uncertain. The Australian housing market appears to have weathered rising rates better than expected on both the depth of the correction and the duration. House prices across the five major cities are picking up again, despite the 400bp increase in the cash rate over the 12 months to July this year.

A combination of factors have likely contributed to the surprise turnaround. 

1. The RBA has flagged that only a few more interest rate rises are likely. 
2. The rental market is extremely tight - raising the relative attractiveness of ownership. 
3. Household formation has fallen to its lowest ever level (raising housing demand). 
4. The volume of properties listed for sale is at historically low levels.
5. Government initiatives designed to encourage home ownership, for example, the introduction of the option for first home buyers to pay land tax over stamp duty in NSW.

Macquarie’s base case is for nationwide dwelling prices to rise, in nominal terms, ~2% over the remainder of 2023 before increasing by ~7% over 2024.  This implies that we have now seen the worst for house prices and that recent price declines will be largely recouped by the middle of 2024.

Despite the recent bounce and expectations for prices to recover into the back end of 2023 and beyond, there remain some headwinds that will linger for a while longer. In particular, inflation is still well above the RBA’s target band and the path back to 2-3% may need further tightening. State government supports have also toned down more recently, including in NSW and Victoria, which could add to the headwinds if accompanied by further interest rate hikes. By mid-2024, Macquarie is forecasting the RBA to begin lower rates although this is contingent on the inflationary backdrop. However, with the prospect of lower borrowing rates coupled with supply shortfalls and improving demand as consumer confidence returns, we think the medium-term price outlook is positive with the worst now in the rear vision mirror.  

06

Diversification to counter uncertainty

Coming into 2023, the consensus was equity markets would resume their downward path as rising interest rates began to slow economic growth and falling profit margins weighed on corporate earnings growth. Despite the emergence of a number of unexpected headwinds such as US bank defaults, debt ceiling negotiations and rising services inflation, equity markets have climbed a wall of worry to post strong gains.

We think the rally in equities has been driven by better-than-expected economic and earnings growth across most developed economies throughout the first half of the year, as well as the reopening of China, which has seen the timing of a global recession pushed back into the second half of the year. 

While it has been painful for investors who have been sitting on the sidelines waiting for a more opportune time to deploy excess cash and re-enter equity markets, we think rising policy rates are finally starting to bite into economic activity. Entering a global recession, even if short and shallow, is strong reason to remain cautious on the near-term investment outlook. 

At this stage, we don’t see any strong need to be aggressively deploying excess cash into risk assets given central banks are not yet finished their rate hike cycles and the prospect of rate cuts (to provide downside support for risk assets in the event of economic disappointment) does not appear imminent. In fact, Macquarie is not expecting the US Federal Reserve to begin cutting rates until 2Q24 with a similar timetable expected for the RBA.  

Historically equity markets have always fallen during periods of recession. While history is not a rule, we think markets remain overly optimistic in their willingness to look through the growth slowdown. It is possible that central banks still have to raise rates further than expected, leave rates at  peak levels for longer than expected and/or that the economic downturn proves deeper and more prolonged than expected. 

Despite making progress in raising rates and lowering inflation, there remains a lot of unknowns in assessing the path forward. As a result, we think investors should avoid positioning too heavily for one outcome over another. During periods of elevated economic and financial market uncertainty, investors should ensure that portfolios are fully diversified rather than positioned defensively. This is because a diversified portfolio is built to perform under a range of outcomes while a defensively positioned portfolio generally delivers performance under only one outcome (being bearish). 

Finally, it is difficult to time markets so, while a degree of cautiousness is advised, we don’t think sitting on large amounts of uninvested capital is the best approach. Rather, and despite some downside risk, we think averaging into risk assets to take advantage of lower valuations and rising return expectations is better than trying to time the bottom.

07

Investment views for 2H23 and beyond

Economies and financial markets are in a period of transition which is not yet complete.  Unfortunately, a return to the ultra-loose policy settings that existed for the decade post the GFC is unlikely with inflation taking time to revert back into target ranges. This drives the following asset class outlooks:

1. The near-term risk/reward outlook for equities is poor. However, we don’t think a correction will be deep or prolonged given markets are already some way off early 2022 highs. In addition, while we are concerned that the near-term risk-reward looks weak, corporate fundamentals are solid, and this should help provide some downside protection for markets which are trading on cheaper (but not cheap) valuation levels. We came into 2023 with the view that global equity markets lows were set in 2H22. We maintain this view, despite the potential for another leg lower as economic growth risks intensify. We don’t think the bear market is over just yet and investors should avoid getting caught up in the euphoria that has enveloped markets in recent months.
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3. Australia has not been and will not be a safe haven equity market in 2023. Australian equities were a safe haven through 2022 as they benefited from less extreme valuations, a strong tailwind from energy and miners and a falling Australian dollar. But this was a 2022 story, and they have already lagged their global peers as these positive tailwinds have reversed in 1H23. While Australian equities still offer a world-leading dividend yield backed  by solid corporate fundamentals, the potential for stickier inflation and hence higher policy rates versus peers, means Australia is not likely to remain a safe haven during a period of upcoming economic weakness and also if/when markets rebound. 
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5. Sovereign bonds are appealing for yield and to hedge rising economic growth risks. We think long bond yields have already peaked and are likely to fall further as economic growth slows in 2H23. We think investors should be locking in peak bond yields which are now comparable, if not in excess of cash deposit rates. Bonds also provide strong protection against equity market weakness, rising as equities fall.
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7. Credit offers attractive returns, but be wary as not all credit is created equal. We expect a modest default rate cycle where levels rise back to the average rather than hit prior peaks. Even so, spreads are likely to widen further. Quality (investment grade over high yield) will be a differentiating factor in a backdrop when risk aversion remains high and economic growth slows. It is likely that investors are pulled into the attractive credit returns but be wary of stepping down the quality spectrum in order to assess these gains. 
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9. We like the long-term outlook for private markets (both debt and equity) but this asset class is not immune to the valuation adjustment seen across public markets in the short term. Cyclical demand for real assets (infrastructure, transportation, clean energy and selected real estate) will add to already strong structural demand across both private and public markets through 2023. We think this should become an ever-increasing part of diversified portfolios with long-term objectives. 

In summary

As we look out through year end 2023, investors should remain reasonably optimistic despite the prospect of slowing economic growth, limited interest rate relief and a period of potentially weaker equity market returns. Economies and markets are going through a transition from zero rates back to more normalised levels with these transitions taking time and accompanied by elevated uncertainty and volatility. 

While these transitions are disruptive, investors should not fear a return to normal, but they should understand that when uncertainty is high, and the number of outcomes large, it pays to be well-diversified. Wealth creation is about achieving long-term goals. We think the near term is likely to see a short stumble, in a reset to what should be attractive medium-to-long term returns for most asset classes.