December 23, 2022 | 12:15
5 Peculiarities of 2022, 5 Projections for 2023
5 Peculiarities of 2022, 5 Projections for 2023
Let’s just say it was a challenging year for economic forecasters. A completely new set of shocks in 2022 triggered the third consecutive year of outsized market swings. On the economic front, there’s little doubt that inflation was again the biggest story of the year, but this time it was accompanied by a surprisingly aggressive central bank response. There were many curious subplots and unexpected twists, from the food and energy price surge, to the meltdown in crypto, to the sudden reversal in North American housing markets. Here are our nominations for the top 5 economic and/or financial surprises of the year:
1) Inflation: No use sugarcoating it: For the second year in a row, the entire forecasting community fumbled the ball on the inflation call. After a steep ascent in 2021, the consensus among private sector forecasters and central banks almost everywhere was for inflation to pull back aggressively in 2022. For example, from around 7% at end-21, U.S. consensus expected inflation to drop below 3% by now, while it was expected to go from around 5% late last year to 2.5% in Canada and less than 2% in the Euro Area. Whoops. Instead, U.S. inflation is still above 7%, Canada’s rate is almost that high, and European inflation is in the double digits (Table 1)—a massive forecasting error. We had warned about high-side risks, and our U.S. call was at the top end of the spectrum, but even we were caught flat-footed by the ferocity of inflation again this past year. While flaring food and energy prices aggravated a tough situation, the reality is that underlying inflation took a big step up almost everywhere, something very few forecasters expected. Best factoid: When inflation peaked in Canada in June at 8.1%, it was 5.1 percentage points higher than the prior June—that marked the largest one-year jump in the inflation rate since 1951! The U.S. pulled a similar feat when February’s inflation rate of 7.9% was 6.1 ppts above the year-earlier reading, also the biggest one-year step-up in inflation since 1951.
2) Energy Prices: The biggest surge in inflation rates mostly occurred before Russia’s invasion of Ukraine. While sanctions sent energy prices flaring in the ensuing months, and grain prices added a second pain point, oil spent the second half of the year mostly in retreat. Even global food prices receded in the second half, albeit with that relief barely registering on the store shelves. Commodity prices overall spent the year coming full circle, with many broad indices now little-changed from year-ago levels. Still, for investors, energy was the top-performing equity market sector by far for both the S&P 500 and the TSX, for the second consecutive year. In fact, it was on track to be the only sector in the green in 2022 for the S&P 500. In turn, the strength in energy helped the TSX avoid the much deeper downturns seen in other major markets—and topping the S&P 500 for only the second time in the past 12 years (Chart 1). Best Factoid: The robust performance in energy equities was in spite of the fact that oil prices are ending 2022 lower than where they began the year. Amazingly, both gold and oil prices were almost unchanged, on net, in a year dominated by inflation concerns.
3) Exchange rates: The first 10 months of the year saw the U.S. dollar going from strength to strength, including grasping the ¥150 level for the first time since 1998 and a record high against the pound (the U.K. could fill an entire chapter of surprises all by itself). The strength was powered by the dramatic shift in Fed rhetoric, and then action, which saw U.S. short-term interest rates rise by more than in any other major economy (+425 bps in barely nine months). Some flight-to-safety also supported the greenback amid the year’s many geopolitical concerns. Even the commodity currencies suffered, unable to benefit when resource prices were strong in the first half of the year and then bludgeoned when commodity prices went south later on. Among major currencies, only the Brazilian real and the Mexican peso swam against the tide (Chart 2), while the Russian rouble also bounced back from its lows early in the war. Best factoid: The Canadian dollar is poised to end the year down against the euro. But even a slight decline is astonishing given that the BoC was almost as aggressive as the Fed (+400 bps), Europe dealt with a full-on energy crisis, double-digit inflation, a war next door, and is staring down a potentially deep recession.
4) Bond Yields: After initially mis-reading the impact of the war in Ukraine (by first rallying), bond yields then scrambled to adjust to the new central bank reality by soaring. From the post-invasion lows in early March at around 1.7%, the 10-year Treasury yield gapped more than 250 bps by its late-October peak. That was the fastest rise in these yields in such a condensed timeframe since 1987 (yes, just prior to that year’s crash). The sell-off spread to most major markets, with long-term GoC yields up the most in a year since 1994. But the surprises certainly weren’t finished there, as bonds rallied heavily in the final two months of the year, even as central banks pointed to yet higher short-term rates. To pick perhaps the most extreme case, Canadian five-year yields tumbled roughly 90 bps in the short space of seven weeks after the late-October peak. The rally was curtailed by one final surprise from the Bank of Japan, which let 10-year yields climb to 0.50% just ahead of the holidays. Best factoid: The late-year rally in bond yields amid the most aggressive central bank tightening campaign in decades left the yield curve deeply inverted. The gap between 3-month T-bills and 10-year Treasuries topped 70 bps in December, the deepest inversion since 1981. Suffice it to say that 1982 was a brutal year for the North American economy.
5) Government finances: Not all the surprises were negative this year. One positive development was a further recovery in government budget balances in many jurisdictions, albeit from the depths in 2020. Decent GDP growth in most major economies and strong nominal income gains helped revive government revenues. Inflation often benefits public finances, at least initially, as revenues respond quickly to rising nominal values while spending is slower to adjust. Even the U.S. improved despite the one-time hit from student debt relief: the 12-month rolling budget deficit was cut in half to $1.35 trillion from $2.7 trillion a year ago. That’s still above the pre-pandemic trend of just over $1 trillion, but comparable as a share of GDP at a bit above 5%. Likewise, Ottawa’s shortfall was much lower than expected last year at $90 billion and is expected to drop to $36 billion in the current year, or just above 1% of GDP. Best factoid: The 10 provinces combined produced a surplus in FY21/22, the first since 2007 and compared with expectations of a combined $30 billion deficit a year ago.
Honourable mentions go to Canada’s housing market, although almost nothing there can surprise any longer. But after a flaming start to the year, average home prices were down 12% y/y by November—the steepest yearly drop in more than 40 years of records. And, from the statistical oddity file, the U.K. is poised to lead the G7 in real growth this year at 4.4%, topping even China—despite the cost of living crisis, a myriad of strikes, the extra day off after the Queen’s death, and the Autumn market drama. And, U.K. equity markets lead the advanced world (up 1% this year). But that’s well shy of Argentina, the world leader in equities and soccer, where stocks almost doubled this year. Of course, inflation of more than 90% dulled the real gains.
Having dispensed with the fun factoids, we now turn to the hard part—trying to discern what lies ahead. Here are five of the key trends we expect for 2023:
1) Core inflation will prove to be more persistent. For the third consecutive year, we will officially position our call on the high side of consensus for the inflation outlook. Make no mistake, we do expect headline inflation to grind lower in 2023 amid very favourable base effects, calmer energy prices, improved supply chains, and the lagged impact of this year’s aggressive rate hikes. However, the inflation baton has been passed to services, and history suggests that they are much tougher to wring out of the system. We look for headline and especially core inflation trends to still be north of 3% by the end of 2023, simply too high for central bank comfort. Stretch call: We wouldn’t want to call it a spiral, but rising wage pressures see services prices initially accelerate in the year ahead, and they average increases of 5% or higher in 2023.
2) Central banks take rates higher, not lower, in 2023. The Fed and the ECB have made it amply clear that they are not done yet, and the Bank of Canada will be assessing whether further rate hikes are needed (we think one more). But the big debate is around what comes next. Given our view on core inflation, we believe the main story is that there will be no scope for rate cuts in the year ahead, and that central banks will maintain these relatively high rates until underlying inflation is truly cracked—and that process will take time. We don’t look for rate relief until 2024. Stretch call: Central banks surprise heavily to the high side again, and we are all still talking about rate hikes even into the second half of 2023.
3) The aggressive tightening leads to at least a shallow downturn in North America. This cycle is like no other, and the old playbooks do not necessarily apply. In fact, pandemic savings and pent-up demand have helped consumer spending prove to be surprisingly resilient deep into this year. However, rarely have we witnessed such an aggressive tightening cycle, and monetary policy does ultimately work. While the timing is still up for debate, we look for a mild recession in both the U.S. and Canada next year (Table 2), with the risks fairly evenly balanced between which economy will get hit harder. (Canada grew faster than the U.S. in 2022—3.5% vs. 2.0%—for the first time in five years.) Stretch call: Auto sales manage to rise in both economies, even in the face of recession. In normal cycles, the auto industry is often among the hardest hit in downturns, but the supply challenges of the past few years have left a deep well of pent-up demand for vehicles. As mentioned, this is no ordinary cycle!
4) Canadian residential construction will drop heavily, despite ambitious goals to double homebuilding in coming years. Lofty policy pronouncements of cranking up housing starts will be no match for the cyclical reality of much higher interest rates, suddenly soggy demand, and falling home prices. We have long asserted that labour shortages alone would render the homebuilding goals moot, but the deep pullback in the broader housing market will make them impossible. Our call is for starts to drop roughly 15% in 2023, and we are among the relative optimists. We also expect a further 15% drop in sales, and an average 12% drop in home prices in the year ahead. Stretch call: Canadian household debt/income falls heavily. After pretty much a two-decade one-way trip north, the combination of a chilled housing market and positive real interest rates blunt personal debt growth markedly.
5) The U.S. dollar loses altitude broadly, as the end of Fed rate hikes come into view. After sprinting nearly 20% in the year to the end of September, the U.S. dollar then pulled back roughly 7% in the final quarter of 2022. And we look for some further softening in the year ahead, as the Fed winds down what has been the most aggressive rate-hike campaign among major central banks. The Canadian dollar is expected to modestly benefit from this move, albeit perhaps less than other major currencies, as the BoC is nearly done its rate hikes. Accordingly, the loonie will likely be a bit lower on average in 2023 than this year due to the big pullback late in 2022 (we expect an average exchange rate of just under $1.33 in the coming year, or just above 75 cents(US)). Stretch call: A soggy U.S. dollar and a pick-up in China’s domestic economy help support commodity prices, even in the face of a North American recession, and the oil price average in 2023 (of about $90) is higher than current levels.