This is an excerpt from Santander Investment Services 2023 Annual Global Market Outlook. For more information on how the markets are resetting, read the full report here.

Over the past two decades we have enjoyed an environment of price stability and low interest rates. This reality has now been structurally shattered by inflation figures above 10%. As central banks have been forced to raise interest rates aggressively to control the inflationary upswing, the full force of a negative effect on growth is yet to be seen. Although this complex backdrop initially calls for a cautious investment strategy, we believe that the foundation for a market recovery in 2023 is being laid in 2023 in two distinct stages.
 

The great interest rate reset

A new monetary policy regime after the shock

The sharp rebound in inflation is not only due to the Ukrainian invasion but also the result of major structural changes in the economy, like increased tightness in the labor market and energy transition, and the pause of globalization. The current process of recalibration in monetary policies is likely to lead us to a new interest rate environment. The future of interest rates is likely to be higher than in the previous decades and will rely more on market dynamics than on central bank interventions.
 

Markets will adjust to the new rate environment

The adjustment process is most likely already reaching its final phase from a monetary perspective. We believe that we are close to the level at which central banks stop raising rates and that the level of monetary tightening reflected in the curves will be enough to change the course of inflation. This phase of monetary stabilization will probably last most of 2023 as we do not expect a rate cut until there are clear signs that inflation is under control. The good news will come first to defensive assets (investment grade fixed income) and then to cyclical (equities and high yield debt).
 

The road to monetary stability

First signs of inflation peaking during Q1'23

The message from central banks is clear: the priority in the current environment is to sacrifice economic growth in favor of price stability. When analyzing inflation dynamics and differentiating between its different components, we can observe two positive developments: decreasing tensions in prices of goods and anchored inflation expectations. Although we expect positive news on inflation readings soon, the battle for monetary stability is likely to be protracted. The pause in rate hikes seems close, but the pivot towards monetary easing will take longer.
 

Value returns to fixed income markets

The resetting of monetary policy has been painful but looking forward it provides bond investors with two potential benefits: bonds can be considered again as a portfolio diversifier and offer higher yields to maturity. The monetary environment is once again favorable for fixed income investments after a prolonged period of artificially low rates. Market discipline has returned to fixed income valuation and yields are once again making sense as central banks' buying action has been withdrawn. Yield has returned to fixed income and bonds are back in the game.
 

Vigilant on the cyclical pivot

Recessionary risks, but crisis unlikely

Monetary tightening, the higher cost of credit, the cost-of-living crisis and high uncertainty will undoubtedly dent growth in 2023. Economists’ consensus already assigns a high probability of GDP contraction in several countries (mainly in Europe). In contrast, the private sector is starting from high levels of savings and the banking sector enjoys solid solvency ratios. We expect a complex environment for growth in 2023, but we do not detect factors that could trigger a crisis like 2000 or 2008.
 

Risk premiums could still widen during downturn

Yields across asset classes have increased as investors have priced in a higher likelihood of a severe economic slowdown. In this report we analyze the adjustment in risk premiums of cyclical assets (those sensitive to the economic cycle like equities) in the context of previous episodes of economic contraction. However, investors need to be on the lookout for the cyclical pivot as buying opportunities hardly occur at times of optimism.

For more details on how the global markets and the United States are responding to these shifts, read the full 2023 Annual Market Outlook.