Inflation was a core issue in 2022 and remains to be one in 2023. In the US, inflation started to decline in the summer of 2022 and remains currently at a level of 7.1%. Contrarily, in Europe and the UK, inflation remains a huge issue and has barely declined from its peak in 2022. It remains at 11.1% for the EU and at 10.7% for the UK. The difference between the inflation can largely be attributed to two factors. Firstly, the Fed hikes interest rates more aggressively than its European counterparts. This led to a quicker response to inflation. Secondly, Europe is more directly affected by the war between Russia and Ukraine and is largely dependent on Russian oil and gas, which soared in price following the war. Contrarily to other European countries, Switzerland managed to keep inflation relatively low with a peak in late summer 2022 at 3.5% and 3% currently. Switzerland managed to avoid high inflation due to its strong currency and relatively low demand for fossil fuels, as most of its electricity stems from hydropower and nuclear power. In Asia, both Japan and China also experience limited inflation issues. Japan achieved this through its central bank which continuously intervenes with large-scale monetary easing. Despite the low inflation, Japan is still suffering, as wages remain stagnant unlike in other major economies where it helps offset the higher inflation to some degree. China does not face an inflation problem, due to their different handling of the Covid crisis. Unlike most economies, they did not provide large stimuli to the economy. Additionally, their zero-Covid policy substantially reduced household demands. Figure 1 shows a summary of the inflation rates across the highlighted economies during 2022. Regarding 2023, it is widely expected that inflation, especially in high-inflation countries, will come down. For instance, in the US, it is expected that inflation will be around 4% on average, and close to the 2% Fed target by the end of the year. Inflation forecasts in the EU and the UK are more difficult to estimate, due to their dependency on the war and its outcome. Additionally, unlike in the US, inflation has not really started to decrease. Assuming further strong interventions by the European central banks, it is expected that inflation will drop substantially. The ECB expects the average inflation to be around 5%-6% during 2023 with inflation slightly below 4% by the end of 2023. In the short term, Europe will be under pressure and the measures take time to become effective, as shown in the example of the US. Despite a similar outlook to the US, albeit with a delay of around half a year, it is less promising. One important wildcard is energy prices, which are strongly linked to the war. While the EU managed to get its oil largely from other sources than Russia, it still needs Russia, and gas is not as easily substitutable. With the prospect of Russia’s supply cut and China reopening, prices of energy sources are likely to increase. Depending on the scale, if it occurs, the anticipated target may not be reached and inflation will remain higher than the target. In Switzerland, inflation is expected to remain around the 3% mark for 2023. Given the strong involvement of the BoJ, Japan’s inflation is expected to end the year 2023 below the 2% inflation mark. It is additionally expected that wages will rise for the first time in three decades. Inflation in China is expected to rise to around 2% in 2023. This is a combination of the reopening of the economy and the end of the zero-Covid policy. This will lead to an increase in economic activity and the necessity for further energy. Additionally, the price pressure across will also be felt in China, once demand picks up again. The interest rate hikes by most countries have been another crucial topic during 2022. So far, the hikes have shown limited effectiveness in dealing with soaring inflation. In high-inflation countries, it was effective for the US and had little impact on the European countries. However, this discrepancy is likely due to the steeper hikes in the US and less dependency on the war by the US. The US employed the strongest measures, as it hiked from 0% at the beginning of 2022 to 4.25% at the end of 2022. In contrast, the ECB just started hiking in June 2022 at -0.5%, which increased to 2% by the end of 2022. The BoE employed a mixture of the two. The UK started hiking at the end of 2021 but hiked in smaller steps than the US. Towards the end of 2022, it increased the step size and is currently at 3.5%. Switzerland started hiking earlier than the ECB, despite substantially lower inflation. Switzerland’s prime rate became positive for the first time in years in September 2022. Currently, the prime rate is sitting at 1%. Japan was one of the exceptions, as the BoJ did not hike at all. Its prime rate remains at -0.1%. However, the central bank still strongly intervened in the market as elaborated previously. The People’s Bank of China even lowered its prime lending rate over 2022, albeit to a minimal degree. Currently, the rate is at 3.65%. There is a strong consensus for the year 2023 in the US and Japanese markets. Most market participants expect the Fed to keep raising interest rates to around 5%-5.25%. The Fed is likely to do this in smaller steps than previously. Nonetheless, this level should be reached by the end of Q1 2023. Afterward, a majority of institutions do not expect further hikes or cuts in 2023. The remainder anticipates potential interest rate cuts in Q4 2023. The exact outcome of potentially further hikes or cuts largely depends on the state of the US economy in the latter part of 2023. While the measures seem to be effective and inflation is going down considerably, the risk of a recession is considerable. This largely stems from substantially higher financing costs for businesses, and lower demand from consumers as Covid reserves are exhausted and households feel the pressure from the inflation over the past year. Given that the BoJ has not intervened by raising interest rates, it is not expected that it will in 2023. It is more likely that it will continue its qualitative and quantitative easing philosophy employed so far. In particular, as Japan does not face an imminent inflation problem. With expected wages adjusted, the pressure of inflation should also be eased without a strong necessity to make policy adjustments. For the EU, it is expected that rates will be hiked further to combat the prevalent inflation. Market participants expect interest rates of around 3%, which should be reached during Q2 2023. For the UK, additional hikes of 1% are expected, resulting in interest rates of around 4.5% for 2023. For both economies, no rate cuts are expected in the latter half of 2023. In Switzerland, the SNB is anticipated to hike another 0.5% in 2023 with no rate cuts as well.
Although there is a recession looming, markets started well in the fourth quarter. In particular, equities were able to recover some of their losses during the year. This development largely stems from the better-than-expected inflation report in the US. The inflation dropped to 7.75% compared to more than 8% for the past couple of months. The strong stance on interest rate hikes by the Fed seems to show an impact finally. However, this development needs to continue until inflation is back under control. While this development is a good indicator, the threat of a recession is far from over. For example, the yield curve does not look healthy at all, which has been the case for a while now. Figure 1 shows the current yield curve inversion in percentage relative to the inflationary bust in 1973/74. It suggests a strong possibility of a recession, as there always was a recession if the current threshold was surpassed. Nonetheless, with the inflation “cooling”, there might be a chance to avoid such a recession. The largest shock occurred in the cryptocurrency market. With the bankruptcy of FTX, one of the largest centralized exchanges, the industry took a huge hit. Just a few months ago, the company was in talks of raising another $1bn at a valuation of $32bn. The company collapsed after a liquidity shock. Documents in the bankruptcy filing reveal that the company had less than $1bn in assets compared to more than $9bn in liabilities. Initially, it seemed as if Binance, the largest centralized cryptocurrency exchange, might buy FTX. However, Binance decided against this endeavor. Following these events, the cryptocurrency market took a substantial hit. Bitcoin dropped to below $16k, and Ethereum fell lower than $1.2k. Since then, the market has remained relatively stable close to its lows. Figure 2 shows the price development of Bitcoin over the past three months. Nonetheless, the crypto market remains of interest. There is substantial interest from institutional investors, and the new lows offer good entry points for VCs, especially as they are under pressure to deploy capital. In the recent past, VCs have committed substantial amounts to crypto startups and emerging companies. Among these emerging technologies, the metaverse has the potential to become a significant industry. McKinsey estimated that the metaverse could be valued at up to $5tn by 2030, as shown in Figure 3. They see high potential in e-commerce, banking, telecom, and retail, among other industries.
The UK’s economy continues to be under high pressure. While high inflation affects all countries, Truss’s historical tax cut and its outlined budget sent markets crashing. In particular government bonds alongside the British Pound experienced an alarming development, such that the BoE had to intervene and stabilize the economy. This had a brief stabilization effect, as the support was for a limited amount of time, as shown in Figure 1. This short support is largely due to the fact that it goes against the plan of central banks globally which try to reduce their balance sheets following the substantial interventions during Covid-19. This financial emergency led to Truss’s resignation from her position as prime minister. Her initial rival Sunak took over the office soon after and faces a tough situation ahead. Following this turmoil, markets have somewhat calmed down with Sunak’s appointment as PM and his experience in former financial positions. Meanwhile, other countries are still committed to raising interest rates. For the Fed, it is widely expected that rates will be raised by another 75bps in early November reaching 4%. With this following hike, officials say that further hikes are to be expected, although the magnitude might slow down. Further hikes are increasingly likely as the inflation rate is not really cooling down, and remains at 8.2%, down from 8.3% in the prior month. The relatively stable decline in equities is also unlikely to stop any time soon. Not only is there a constantly looming threat of a recession, but the equity market also tends to be correlated to central bank assets, as shown in Figure 2. This relationship is intuitive, as more assets or capital in the market are deployed. Furthermore, during Covid-19, much of the injected capital flew directly into stocks. With the back scaling of available capital, it is withdrawn from more risky capital, which is frequently stemming from equities. Although cryptocurrencies took a huge hit in early 2022, since July 2022, their performance is positive unlike bonds, stocks, or gold. This is a relieving sign for the industry, as cryptocurrencies tend to be strongly correlated with other asset classes at the beginning of a drawdown, but is the first asset class to recover from it. In this state, the asset class usually regains its attractive property of being non-correlated to other asset classes. Another highly intriguing development is taking place with Web3 applications. Web3 applications essentially fulfill the same role as technology companies leveraging the internet. However, unlike these technology companies, Web3 platforms are built decentral and are not maintained by a single entity. The current state of the Web3 industry strongly resembles these technology companies during the dot-com bubble. Figure 4 highlights a few key similarities. Venture investing in these types of companies also has not taken a large hit, compared to most other asset classes. This is in particular notable, as traditional venture investing took a substantial hit in 2022. Figure 5 shows the consistent decline in venture investments since Q4 2021.
For once, inflation was not the most prominent topic over the past two weeks. Instead, it’s the UK government and its optimistic tax cut. The UK’s new prime minister Truss promised a large tax cut in her election campaign. If implemented, the tax cuts would lead to losses of around £40bn and would be the second-highest budget cut in the past 50 years. Figure 1 shows a breakdown of the largest budget adjustments over the past 50 years. This seems very optimistic given the already existing struggles with ever-soaring inflation at the 10% mark and the severe gas/oil crisis in Europe. When further details on its implementation were revealed, the UK economy faced severe issues and could only narrowly avoid a complete disaster. The British Pound almost dropped to an equivalent level to the US Dollar for short time. Especially, the bond market crashed, as the BoE initially wanted to step back its bond buying program introduced after Covid-19. Figure 2 shows the drop in the value of UK gilts with maturities exceeding 15 years. Although they have been declining since 2020, the most recent drop is substantial. Currently, UK gilts are down 54%. A complete crash could only be avoided by the BoE strongly intervening in the bond market to stabilize the situation. It is very unlikely that the BoE can afford to step back its bond buying program any time soon, as the risk of fire sales is large, especially, if market participants know that UK gilts are no longer stabilized by the BoE. With rampant inflation across the world, central banks are continuing their consistent and strong hikes to combat further rising inflation. These interest rate hikes have led to substantial bond yield increases. The G7 average 10-year bond yields have now surpassed their average yield of the past two decades, as shown in Figure 3. Given the current development, bond yields could rise to their average at the beginning of the 21st century and likely stay there for a while until inflation is under control to a large degree. While it is debatable whether central banks acted fast or not; when they started doing so, the frequency and magnitude were substantial. This is especially true for the Fed. Figure 4 shows a comparison of the speed and magnitude of the current hikes compared to other historical hike cycles. With the current expectation of two further hikes (each between 50bps and 75bps), the current cycle is not only the largest in terms of magnitude but also the fastest at any given time. Despite the strong hikes of the Fed already, inflation in the US still increased by 0.4% to 8.2%, which was higher than expected and is likely to put further pressure on the Fed. This development is likely to emphasize further rate hikes, potentially even higher than currently anticipated. Equities also continue to be under pressure. After reaching their low of the year in mid-2022, they bounced back until August 2022. Since then, they have been consistently facing losses and reached new lows in 2022. The S&P 500 index is down 25% YTD, while the tech-heavily Nasdaq is down almost 35% YTD. The outlook is certainly not great with rising interest rates and a looming global recession. Additionally, it is worrying that the Covid-19-induced bull run strongly resembles the development during the dot-com bubble. Figure 5 highlights the similarities between the two tech bull runs and potentially bubbles.
Central banks continue to be in the spotlight. Over the past months, it is hard to find a central bank that has not raised interest rates at least once. Inflation remains at four-decade highs in most countries, despite the measures taken by central banks so far. The Fed raised interest rates by another 75bps this month and maintains its stance to aggressively combat inflation. This led the 2-year Treasuries to surge above 4%, for the first time since before the global financial crisis, and increases the likelihood of a recession as well as potentially sharply declining equities. The latest hike increased the federal fund rate to 3% - 3.25%. The ECB also raised its interest rate by 75bps in September, while the Bank of England increased its rate by 50bps. The ECB’s rate is now at 1.25% and the UK’s is at 2.25%. Switzerland also raised its rate by 75bps which brings it into positive territory as the last country in Europe. In the middle East, Saudi Arabia, the UAE, and Qatar follow the Fed with their 75bps hikes as well. Across the developed countries, Japan remains the last country with currently negative rates at -0.10%. September 2022 has also been highly relevant for the currency market. The dollar has strengthened substantially over the year. Compared to the Euro, it appreciated from around 0.9$/€ in 2020 to 1.03$/€. The British Pound declined strongly. The latest tax cut in the UK is threatening even higher inflation and will force the BoE to act more aggressively in tightening. After the announcement, the Pound dropped below 1.1$/£, and some speculate that the Pound could fall below parity to the USD. The Japanese Yen also experienced substantial movements, as the country is buying Yen again for the first time in nearly a quarter century. In spite of the negative developments of equities in 2022 and their even more grim prospect, equities are doing great on a historical scale. Figure 1 shows the growth of global equities with the impact of several crises
The still high inflation and the potential reaction from the Fed continue to dominate the financial market news. Last Friday when Powell gave a short speech on how the Fed will move forward, stock markets crashed amid a more hawkish stance than expected. He emphasized that inflation has to be brought down relatively soon even if it hurts businesses and households, at least in the short term. Although inflation decreased for the first time in months, the inflation rate is still way too high at 8.5%. Following the speech, another 75bps hike is not outside the realm of possibility. Unlike earlier estimates, it is also likely that the federal fund rate will be around 4% in the short term and will persist for some time. The degree of interventions does depend substantially on the economic data and whether the measures taken achieve their intended goals. This led to a massive drop in equity prices, such as the Dow Jones which dropped more than 1,000 points in a single day. It also hurt cryptocurrencies substantially. Bitcoin dropped below the $20k mark for the first time since June. In Europe, the situation looks very different. While inflation is still soaring with a new record high of 8.9% in 2022, its interest rates are still at 0bps even after its 50bps hike in July. It is likely that inflation will continue to soar even if substantial rate hikes take place soon. The ECB’s measures have been very mild compared to the Fed’s and other central banks and were widely expected to stay on the milder side. However, with the continuously growing inflation, the ECB is forced to intervene. For its September meeting, it is expected that a rate hike of at least 50bps will take place, if not 75bps. These developments also make a recession in Europe more and more likely. The impact of the war, especially energy as a whole, further exacerbates this likelihood. In the UK, inflation is an even bigger problem, as the 10% mark was surpassed in July 2022. This is very relevant, as the BoE was very active in 2022 in rising interest rates while the ECB was not. The BoE’s current base rate is at 1.75% after five small interest rate hikes from December 2021 to June 2022 and the subsequent 50bps hike at the beginning of August. For the next meeting, another 50bps or even 75bps are considered as likely. Current expectations are around a base rate peak of 3.75% at the beginning of the next year. It is questionable whether the rate will in fact be “that low”, as the Fed pointed out 4% for a while is a possibility. This is concerning for the UK, as the US has both, a lower inflation and a currently decreasing inflation.