Goldman Says These Five Themes Key For 2023

2023 will be the year when “we finally put pandemic disruptions behind us to deal with more conventional risks around inflation and recession.”

That’s according to Goldman’s Dominic Wilson, Kamakshya Trivedi and Vickie Chang who, in conjunction with the release of the bank’s year-ahead outlook pieces, detailed “top themes” for 2023. This is an annual tradition. I’ll summarize the first five here.

The first theme revolves around the notion that the Fed will manage to stick the landing. Or, at the least, not crash the plane. “The mix of ultra-easy monetary and fiscal policy at the start of the cycle, healthy private sector balance sheets and remaining tailwinds from post-COVID normalization has led to a greater ability to absorb rising policy rates,” the bank said.

The figure (above) illustrates the scope of the tightening in financial conditions witnessed this year.  Needless to say, markets haven’t absorbed that as well as the real economy.

Goldman conceded that the distribution of possible outcomes is unusually wide, and also that for “many macro investors,” stagflation is the base case. But, the bank said, “investors may still be underestimating the potential resilience of the US economy to tighter policy and the capacity for ‘cycle extension’ amid offsetting positive tailwinds from real income growth and fading fiscal drag.”

The bank’s second theme for 2023 can be roughly summarized as a reiteration of the idea that although valuations have improved, we’re not there yet. On anything.

“It may not be until well into 2023 that the potential for inflation relief and some recovery in global growth become clear enough to allow for a sustained easing in financial conditions, even in our central case,” Goldman said, adding that “the pressures pushing policy rates higher for longer may not fade quickly… and even a softer landing may be preceded by a longer period of muddier market direction.” In the bank’s view, the “cyclical conditions for a decisive equity trough (a clear peak in yields and a trough in activity growth) and a convincing peak in the broad USD look more likely to be met further along [the] forecast path than they do now.”

Third, Goldman flagged downside growth risks from ongoing tightening, and noted that in a “true recession,” US equities would likely fall “meaningfully.” The figure (below) is a helpful guide to S&P performance around historical recessions.

“Because recession risks are directly linked to the tightening process, and the impact is lagged, it will be hard for the market to be confident that recession has been sustainably averted until the end of tightening is in sight,” Wilson, Trivedi and Chang said.

They also cautioned on the risks associated with tightening into a market which spent years optimizing around low rates and suppressed volatility, a discussion I dove back into on Friday morning in “Don’t Cut The Wrong Wire!”

“Tightening affects the economy with lags and persistent inflation threatens to keep the Fed in a position where it sees the need to tighten to slow the economy more sharply,” Goldman wrote, adding that “the impact of higher rate levels also poses risks through other channels includ[ing] the potential downside risks to housing markets and the possibility that pockets of stress emerge in the non-bank financial system over time in areas where decisions were predicated on much lower rate discussions (private equities and credit; leveraged loans) as they have done in the UK LDI and crypto space.”

I can’t stress the importance of that point enough. The near implosion of the UK pension complex and the meltdown across crypto culminating in FTX’s bankruptcy are symptoms of macro and policy regime shift.

Fourth, Goldman discussed the path towards more “ordinary” rate hikes, where, in the Fed’s case, that means a step-down to 50bps and then 25bps thereafter. There’s palpable concern that inflation will remain stubborn, thereby preventing the Fed from pausing, particularly if the labor market holds up and the economy continues to expand, even at a below-trend pace. In that scenario, policymakers may be compelled to add incremental 25bps hikes.

The more nuanced bit came when Goldman discussed the implications of a higher neutral rate. “We still see the medium-term risks skewed to the upside of current pricing,” the bank said, of the policy rate trajectory, adding that,

In keeping with the notion of a more “ordinary” tightening cycle, we think this repricing may happen incrementally, with the market pushing the tightening profile higher quarter by quarter as the economy continues to deliver modest positive GDP growth. While the market still worries about recession risk, curves should remain relatively flat, but longer-dated (‘neutral’) rates are also likely to move higher if the market continues to push up its views on peak rate pricing. With short-dated US real yields now firmly through longer-term real rates, the beta of back-end pricing to the terminal Funds rate has increased. So continued economic resilience is likely to see the market continue to push Fed pricing towards ‘higher for longer’ but also to keep it nudging the neutral rate upwards, as it has been doing.

That’s a key consideration. A higher neutral rate represents a structural shift, so if it looks as though that’s where we’re headed, you’d want to stay apprised, as it could create the conditions for, as Howard Marks suggested this week, a prolonged period of elevated policy rates.

Relatedly, 2023 could look like a mirror image of the post-GFC era — a vice versa version, if you will. “Faced with deleveraging and austerity headwinds, major economies struggled to deliver even trend growth and inflation persistently fell short of targets but the cyclical fragility was matched by a long decline in real yields that drove strong financial asset performance (particularly in long-duration US equities) that stood in contrast to a weak economy,” Goldman said, describing the “old” regime. “Now, with low levels of slack and above-target inflation, cyclical resilience may keep central bank tightening cycles extended and help to push the real yield structure higher and a better economic environment may bring continued headwinds to asset valuations.” Depending on who you are, that doesn’t necessarily have to be a bad thing.

Finally, Goldman sees more room for dollar strength despite the greenback’s historic run higher. Relative economic resilience in the US will make it more difficult for central banks around the world to keep up with the Fed, and if the macro backdrop deteriorates meaningfully, the dollar could benefit from haven flows.

Even with the broad Dollar overvalued to an extent only witnessed on a handful of other occasions (figure on the left, above), Goldman sees scope for another 3% in trade-weighted appreciation.

The bank did say that the path higher would be “choppy,” and conceded that the greenback is “now in thinner air.”

Still, Wilson, Trivedi and Chang remarked, “dollar peaks in recent decades have typically coincided with troughs in activity, equity strength and an easing Fed,” conditions the bank doubts will be met before the back half of next year.