The silver lining is that high inflation should moderate relatively quickly. That will create an opportunity for policymakers to reduce rates. He thinks the Fed will cut before year end and the ECB and Bank of England next year. But central bankers can’t do that if inflation is significantly above target. So, he believes that it’s important that the recession doesn’t come too early, and disinflation plays out.

The coming recession scenario will be more like the early 1990s recession, he said, with the central scenario being a 1 to 2 per cent drawdown in GDP. He expects the macro scenario in emerging markets to look a lot better than in developed markets.

Market implications
His central scenario is for recession in western economies, and a difficult, choppy outlook for markets. He believes that the recession is not going to be big enough to really purge all inflation pressures out of the system. “As a result, this points to a regime of somewhat higher inflation and interest rates over time,” he continued.

Consequently, he takes a cautious overall view on risk and cyclicality in portfolios. Interest rate exposure is appealing – particularly the Treasury curve – the front end and mid part of the curve. And he sees some value in European bonds too. In credit, he is selective, with a focus on higher quality credits in investment grade over speculative grade credits. He is cautious on developed market stocks.

Emerging markets
“The combination of Fed cuts, a reliable weakening of the dollar, and relative growth and inflation seems to point to emerging markets as the appropriate asset allocation tilt. Fed easing and the turn in the liquidity cycle created a strong inflow into emerging markets in the early 1990s. We could see a similar trend unfold again,” he continued.

Emerging market assets also exhibit lower country correlations. Financial stability worries seem less pronounced right now, offering investors opportunities to improve portfolio diversification and return potential. He favors emerging market stocks and local currency EM debt, and wants exposure to the EM growth premium through risk premium and EM FX.

China and India
In China, he believes that domestic demand should remain supported by high household savings, a property sector which is bottoming out, and government efforts to support job creation. Low inflation allows space for monetary policy easing and GDP growth should easily exceed the government’s 5.0 per cent target this year, he said. He is positive, assuming more stimulus will be confirmed, but is selective and targeted, remaining overweight in Chinese equities for this reason.

He believes that Chinese equities have scope to perform this year given the economic reopening and positive earnings momentum, saying that the diversification benefits of Chinese equities shouldn’t be under-estimated. “For example, value is outperforming growth in China and Asia. That’s the opposite of developed stock markets,” he added.

Along with China, he said that India is the main macro growth story in 2023. The economy has recovered strongly from Covid, with buoyant consumer spending and a rebound in services. “In India, recent upward growth surprises and downward surprises on inflation are creating something of a ‘Goldilocks’ economic mix. Improved corporate and bank balance sheets have also been boosted by government subsidies. All the while, the structural, long run investment story for India remains intact,” he said.

Alternatives
Real assets, positioned as a defensive growth investment, can play a part but he remains selective. For example, although the dominant US and European real estate markets struggle as hybrid working takes its toll on office demand and falling valuations reduce transaction activity, Asian Pacific markets are ‘out of sync’, and better protected from inflation and rising interest rates.

“There’s also increasing demand for infrastructure assets – particularly those that can aid the green energy transition or benefit from growth in digital communications. Real assets as a whole remain valuable diversifiers,” he concluded.