Before the dawn – 2023 outlook

Uncertainty, complexity and volatility mean that risk managers face a multitude of threats in 2023. The economy is on the edge of recession, still recovering from the macro consequences of the pandemic, and beset by energy and cost-of-living crises.

Most disturbing is the war in Ukraine, which is unlikely to end soon. Russia’s invasion jolted geopolitical risk perceptions, shifting the assumptions of decision makers more than any event since 1990.

“The era of globalisation has given way to the age of insecurity,” said John Hulsman, a geopolitical consultant, speaking at a recent risk management event, with the war’s effects ranging from energy shortages to transformed supply chains.

Potential flashpoints ahead, he noted, include renewed tensions in Kosovo, and fears of a China-Taiwan crisis, the latter of which would represent a profound risk to the global economy. However, assuming no further geopolitical shocks, economic forecasts are cautiously optimistic.

“Food and energy prices have recently fallen from their 2022 spikes. That’s really good news for inflation,” said Yael Selfin, chief economist at KPMG in the UK, at an Airmic webinar in January.

Further foundations for optimism came from The Sunday Times economics editor David Smith, when addressing Airmic’s recent ERM Forum.

“Economists are looking for a recession, although most are not as gloomy in the short term as the Bank of England or the Office of Budgetary Responsibility (OBR),” Smith said. “Expect only a mild recession or a flatlining economy, not a deep downturn.”

The OBR forecasted in November that the economy would head into a recession lasting just over a year from the third quarter of 2022, with a peak-to-trough fall in GDP of 2%. It further forecasted a relatively short recession (-1.4% of real GDP in 2023), followed by a rebound to growth (1.3% in 2024, 2.6% in 2025 and 2.7% in 2026).

This cautious optimism was reinforced by news in January that the UK economy actually grew slightly in November, reducing the anticipated fourth quarter dip towards recession (defined as two consecutive quarterly dips).

In response, Selfin and Smith, both citing the OBR data, expected two to three further Bank of England interest rate rises, but to less of a peak than the 5% base rate that markets feared last year.

“The good news is that we are almost at the peak of interest rate hikes. Expect two to three further rate rises. However, we’re not expecting rates to go back to that very low level,” said Selfin.

Smith said he expected the inflation rate to fall sharply in 2023 to around 5% and to just 2% the following year.

“Central banks were shocked by the inflationary period. We shouldn’t look too soon for rates to come down, but 2024 is realistic. Expect the Bank of England to raise official interest rates to about 4%,” he said.

However, the cost-of-living crisis will hit many hard. According to the OBR, rising prices will erode real wages and reduce living standards by 7% in the next two years, wiping out eight years of growth, despite more than £100bn of additional government support.

Middle- and high-income households are insulated by savings accrued during the pandemic, Selfin noted. The lowest-income households have the least buffer, she emphasised.

“Food, utilities and housing costs account for almost of half of spending for low-income households,” said Selfin. “It is not surprising, therefore, that we see strikes in the roles and sectors where wages have not risen significantly.”

Unemployment is at historically low levels despite the storm. The OBR estimates a rise from 3.5% to peak at 4.9% in the third quarter of 2024.

“It’s unusual and quite encouraging to be going into a downturn with unemployment at such a low level, which is a source of optimism,” Smith said. “Job vacancies are still high – there are more job vacancies than unemployed people.”

However, credit conditions have reached an inflection point, particularly for corporate debt, posing a risk depending on how the macro picture develops in 2023. This was according to a US market analysis from Ed Altman, finance professor, Stern School of Business, New York University, speaking at another recent event.

The pandemic transformed debt levels in the system, he warned. Altman’s forecast focused on default rates and recovery rates of corporate debt, rates of return demanded by investors, and the distress ratio for high-yield bonds.

“Default rates will rise as we get more stress in the system. If inflation continues to be at high levels and this recession is still with us, it’s 2024 and 2025 I’m concerned about,” he warned.

Selfin’s UK analysis also noted increased corporate yields. Company insolvencies have risen above pre-pandemic averages, she warned, with the hospitality sector affected most.

“The majority of corporate debt is floating rate, affected quickly by interest rate rises,” she said. “There’s an uptick in defaults for medium-sized companies, and we’ve already seen corporate default rates up among small businesses.”

The root of divergence between forecasts appears to be whether inflation will be checked in the months ahead, because its combination with high interest rates would continue to reduce room for manoeuvre for governments and businesses.

Watch closely, then.

David Benyon, Editor, Airmic News