© Reuters

By Geoffrey Smith

Investing.com -- First the good news: 2022, a nightmare year for both stocks and bonds, is nearly over. Now the bad news: while 2023 is likely to be better, it won’t really seem that way for a while. At least not until the great disconnect between central banks and markets over the outlook for inflation is resolved. And at least not until China has acquired enough herd immunity to go back to work and play after a wave of COVID-19. The test of strength in Ukraine between Russia and the West is another thing likely to get worse before it gets better. Whether any or all of that is enough to wrench the world’s gaze from the immolation of Elon Musk’s fortune is another matter. Here’s what you need to know in financial markets in 2023.

1. Central banks, markets face off over inflation/recession

Without a doubt, the overarching market theme next year will be the battle between central banks and inflation.

Recent events - taken at face value - have greatly increased the risk that the Federal Reserve and the European Central Bank will push the world’s two biggest economic blocs into recession by raising interest rates further.

The Fed’s ‘dot-plot’ showed a clear majority of policymakers in favor of raising the upper bound for the Fed funds target to as much as 5.4% next year, while the ECB’s President Christine Lagarde threatened as much as 150 basis points of tightening from Frankfurt over the next four months.

The trouble is, markets believe that both institutions are either bluffing or have simply not thought such rhetoric through. Short-term interest rate futures imply expectations that the Fed will even start cutting rates in the second half of next year as the weakness already evident in housing and in core goods spreads to the rest of the economy. Futures for one-month euros likewise imply that the ECB is only good for another 50 basis points before it loses its nerve.

That is a disconnect that will have to be ironed out in the first few months of next year. U.S. stocks in particular are still priced at 18 times forward earnings, and so have little downside protection from valuation if the looming recession materializes.

From today’s standpoint, it looks like the key variables will be how far workforces in the U.S. and Europe can claw back some of their inflation losses with big pay increases, and how quickly the oil market tightens as Chinese demand returns. Both of those questions remain genuinely open for now.

2. Russia’s second year of war

The balance of risks for the world economy is inextricably caught up with the progress of Russia’s invasion of Ukraine. If it continues, then all manner of tail risks remain in play, from a collapse in Russian oil supplies to - God forbid - the use of nuclear weapons. If, however, some kind of path to peace can be found, then the normalization of food and energy supplies could have an electrifying effect on business and consumer sentiment globally.

The war is going against Russia, and it is hard to see what can change that, if the West continues to support Ukraine. Neither the U.S. nor France, Germany or Italy faces national elections this year, which may help to keep that front united. However, the economic price of that support is also rising. Europe in particular is quickly heading into recession and, while it may make it through the current winter without Russian energy supplies, the cost of replenishing empty gas storage when spring comes may well be too high for much of European industry to defend its presence in global markets.

Putin also faces no elections. His biggest risks are mutiny by an army that has already lost more soldiers than the Soviet Union did in a decade in Afghanistan (according to admittedly unverified Ukrainian assessments), and popular protest as the death toll – and the inflation rate – climb steadily higher. Yet the biggest risk for world markets is what would follow such events: hardliners such as Yevgeny Prigozhin, who runs the mercenary Wagner force, are much more likely to make a concerted grab for power than a fragmented antiwar opposition – and are also likely to wield that power more erratically. In all ways, the war is likely to get worse before it gets better.

3. China’s precarious reopening bounce

Getting worse before things get better is a theme that extends to the world’s other economic powerhouse, China.

While the fate of wars is inherently unpredictable, the progress of a lethal virus is typically much easier to forecast. China’s Communist leaders, rattled by the first sign of protest against their party, have thrown caution to the winds and effectively let COVID-19 rip. Herd immunity and the release of animal spirits by Chinese consumers should follow, but only after a wave of infections and deaths unlike anything seen so far in the three years since the virus first showed its face in Wuhan.

For the last couple of years, stringent public health regulations have been the chief culprit for anemic Chinese growth. But next year, with regulations largely lifted, the key factor will instead be fear of a virus for which Chinese medicine still has only partially effective cures. Fear may stay within manageable limits as long as China’s health system is not overloaded, and recent reports of big increases in emergency capacity suggest that the authorities are at least trying to get ahead of the curve. However, if cases outrun system capacity, then deaths will spike and the behavior of China’s consumers and industrial workforce – such as those packed cheek-by-jowl in Apple’s iPhone City in Zhengzhou – will become unstable in the extreme.

Here too, as with points 1. and 2., the balance of risks is for a perilous first half of the year, albeit with the prospect of a vigorous rebound in the second half if Beijing’s calculated gamble pays off.

4. Collapse of crypto

Talking of gambling, 2023 is shaping up to be the year when crypto’s luck runs out. The last 12 months of governance scandals, culminating in the grotesque collapse of FTX and the arrest of its founder Sam Bankman-Fried, have eroded confidence so badly that one more big implosion may be enough to finish the whole asset class off completely.

There is no shortage of candidates, but the spotlight on two “too-big-to-fail” names will be particularly intense. Both Binance – the world’s largest exchange – and Tether, which operates the world’s most valuable stablecoin network, have failed to dispel doubts about the adequacy of their reserves and the legitimacy of their business models in recent months.

Events in December have set an ominous tone for the months ahead: Mazars, the law and audit firm hired by Binance to ‘attest’ to the quality of Binance’s reserves, withdrew its attestation last week and suspended all its work with crypto companies. Critics also mutter darkly about evidence that Binance’s U.S. operations are no better protected than FTX’s were. And don’t even mention the DoJ investigation into suspected money laundering on behalf of Iran and others – which is likely to reach its conclusion next year.

5. Mars will look more attractive

If there’s one man on the planet big enough to be a theme for world markets in 2023, then it’s Elon Musk. This column believes that Musk will not be CEO of either Twitter or Tesla (NASDAQ:TSLA) in 12 months’ time.

The Twitter prediction is not a hard one. Musk himself polled his followers on Twitter on whether he should step down. Nearly 60% said ‘yes’.

In reality, all this does is create a misleading air of agency about a decision that his creditors have already taken. Morgan Stanley (NYSE:MS) and others are sitting on billions of dollars of bonds that they underwrote for Musk’s Twitter buyout, which they cannot now sell. That debt, combined with billions more that went to fund a leveraged buyout of software company Citrix, is gumming up the whole of the M&A market and the leveraged loan market that are essential to Wall Street’s profits. The quickest way to remove the blockage is for the banks to take control of Twitter, eject Musk and put a plan B into operation, whatever that may be.

Musk’s control of Tesla is also slipping. After the latest $3.6 billion stock firesale, his stake in the carmaker is down to 13.4%, nowhere near enough to guarantee control. For comparison, Henry Ford’s descendants still own 40% of Ford’s voting stock, while Ferdinand Porsche’s control 53% of Volkswagen's.

This wouldn’t be a problem if 2023 was lining up to be a stellar year for the car business, and Tesla's stock was priced realistically. But it isn’t, and it isn’t. Tesla has already had to cut prices in the U.S. and China, its two biggest markets, and there are signs of a looming disaster in the U.S. auto finance market next year that could accelerate a nationwide slump in prices. Despite a fall of over 50% this year, Tesla stock still trades at over 53 times trailing earnings, and those earnings will not survive major downturns in the U.S., Europe and China that – for the reasons discussed above – are only too possible. He may jump, he may be pushed, but our guess is that one way or another, Musk will have found a way to spend more time at SpaceX by the time we write the preview for 2024.

We read at: Investing.com