Key takeaways:

• The outlook for the stock market in 2023 centres on interest rates, China reopening, and the risk of a recession

• Higher rates are expected to restrict economic growth this year, posing a challenge for corporate earnings

Following the worst year for Wall Street since 2008, and a testing year for the ASX, investors will be hoping that 2023 brings a change of fortune. 

However, with a number of unresolved issues still at play, one of the only things that seems all but certain for the year ahead is that volatility will remain a pressing theme.

Is the share market likely to deliver a better performance this year, or will investors see negative returns for the second year running? These are three key questions to consider over the coming months.

Is a Recession on the Cards?

With monetary policy tightening at the fastest pace in decades, the consensus forecast among financial pundits points to economic growth slowing both here, and abroad. 

While the jobs market is showing signs of strength, this is widely expected to reverse course once the delayed impact of higher rates flows through to businesses.  

Developed economies like the US, Europe, and the UK are among those identified by observers as most prone to a recession in 2023. 

On the other hand, the outlook for Australia is a little more uncertain, with a recession arguably less likely than other economies due to the strength of the resources sector, but still a live possibility.

Learn more about the warning signs of a recession.

The impact of slowing economic growth will be felt by way of an expected slowdown in consumer spending. In itself, this is a major headwind for corporate earnings, as lower spending aligns with lower sales revenue. 

Meanwhile, investors should be mindful that earnings are measured nominally. This means they are expressed in terms of current values, without making allowance for changes over time.

Since inflation is expected to decrease over time, there is a distinct possibility that earnings peak when inflation peaks. This may push some companies to cut costs further or avoid investing for growth, which are both symptomatic of a challenging environment that could impact equities markets.  

In 2023 investors should consider whether markets have adequately priced in the risk of a recession.

Here are three things to watch for an Australian recession this year.

How High Will Interest Rates Climb?

For the second year running, interest rates will be a major talking point. Whereas 2022 was all about the pace at which interest rates would rise, the year ahead is likely to focus on the terminal rate in the rate hike cycle.

After a series of aggressive rate hikes in the US, inflation has started to cool. Although still significantly above the Federal Reserve target range, the response shows encouraging signs. 

It has led to increased bets that the US central bank will soon ease the pace of its rate hikes further, potentially downsizing to 25 basis point adjustments as soon as its next meeting.

A similar story exists for the Reserve Bank of Australia, which effectively became the first major central bank to wind back the pace of its rate hike program. Unlike the US, local inflation has yet to show signs of slowing down, but the government suggests it may have peaked in the last quarter of 2022.

Nonetheless, central banks around the world are expected to increase rates modestly from current positions, before pausing and assessing the state of the economy. With a sharp pull-back in economic activity likely, this has prompted some analysts to predict the first round of global rate cuts could begin later this year. 

For equities markets, and particularly growth stocks, the trajectory of interest rates will be a pivotal factor over the next 12 months. It will also be a fresh consideration for highly-leveraged companies, which will need to set aside a larger portion of their earnings to service debt and fund growth.

If for any reason inflation suddenly reaccelerates, investors may be nervous that central banks will need to hike rates beyond peak forecast levels. On the contrary, a timely rate cut later in the year and optimism may sweep across the market. There is no doubt, however, the number one priority for central banks is to get inflation under control, even if that brings pain to investors.

What Does China Reopening Mean?

After the best part of nearly three years, China is open once again. The nation pivoted away from its hardline COVID-zero stance late last year, paving the way for activity in the world second largest economy to pick up once again.

Early stages of the reopening have proven challenging as the health crisis poses a monumental challenge. It has also hampered manufacturing activity at assembly plants around the country.

However, the move is expected to provide a source of growth for the global economy, with Australia arguably best placed of any country to benefit from China resurgence.

A number of economists believe the Chinese government will seek to kickstart growth through accommodative policy this year, which could offer cyclical sectors potential growth exposure across the course of 2023.

This includes the resources sector, where demand for key commodities such as iron ore, lithium, copper, gold, and other minerals is likely to be supported by a pro-growth setting across manufacturing and construction.

At the same time, China reopening could be one factor that helps address supply chain issues embedded into the global economy. For most of last year, these constraints put upward pressure on inflation, so the change in policy could offer a tailwind in fighting inflation.

Meanwhile, early signs suggest China pivot has coincided with a thawing of relations with Australia. This is something that local investors would be wise to monitor closely, as a large cohort of ASX-listed stocks derive benefits from trade with China.