Will a protectionist and divided Washington sink stock markets in 2023?

On Jan. 3, 2022, the S&P 500 index peaked at almost 4,800. It would subsequently close the year with a loss of 20 percent due to high inflation, a tightening Fed, the consequences of the Ukraine war and a faltering China, among other factors. The International Monetary Fund now assumes that one-third of the global economy will experience a recession this year. 

Will 2023 be another sad year for stock markets and will the global economy indeed be dealt severe blows?

The U.S. is still the largest economy in the world, Washington is the most important political player, the Fed is the most influential central bank by far and the U.S. financial markets are decisive in terms of what happens worldwide. It, therefore, makes sense to focus on the U.S. political outlook first of all.

Washington will be divided for at least the next two years, in the sense that the House of Representatives has passed into Republican hands — albeit with a very small majority — and the Democrats still control the Senate, having made their superior position slightly less minimal in the last midterm elections. The fuss surrounding the election of the leader of the House has made it immediately clear that the radical wing of the Republican Party has been undeterred by the disappointing result for them last November and by Donald Trump’s problems.

Divisions in Washington are generally seen as positive for stocks, as a great deal of legislation is less likely to be pushed through in this case, and less political interference with the economy and markets is generally considered to be positive for growth prospects. But the question is whether this is also the case now, since faltering productivity, growing inequality, the Chinese challenge and climate change call for a strong government.

The 2022 Inflation Reduction Act may therefore prove to be the last major economic law signed by President Biden by the end of his first term in January 2025. This act is geared towards reducing CO2 emissions, lowering healthcare costs, funding the Internal Revenue Service and improving taxpayer compliance. According to the independent Congressional Budget Office, if fully implemented, the act would reduce the U.S. budget deficits by more than $200 billion. The Inflation Reduction Act is one of three acts passed in recent years — along with the bipartisan Infrastructure Investment and Jobs Act and the CHIPS and Science Act  — that will collectively result in roughly $2 trillion in new federal investment and spending over the space of a decade.

If the aforementioned laws are indeed implemented successfully, the U.S. will take a massive step in sustainability (and rightly so because the country is lagging behind Europe) and the U.S. will produce more high-quality technology domestically, significantly thwarting China in its rise as a high-tech country.

This brings us to one of the areas where President Biden will have the most influence in the coming two years with a divided Congress: foreign policy. Under Biden, America has become just as protectionist as it was under Trump, if not more so, with the main goal of weakening China.

Financial Times commentator Gideon Rachman recently wrote “it is crucial for the U.S. and the [European Union] to be clear that their goal is not to prevent China from becoming richer. It is to prevent China’s growing wealth from being used to threaten its [neighbors] or intimidate its trading partners.”

However, it is no accident that Beijing believes the first aim is the main one of the U.S. Indeed, in all likelihood, Washington will stick to its line of recent years and could adopt an even tougher approach in the military, economic, technological and diplomatic fields. Indeed, a zero-sum game mentality rather than a win-win attitude prevails, both in Beijing and in Washington.

This will (further) complicate global trade flows, slow down technological progress (as the countries are increasingly building walls around themselves, wanting to keep prying eyes away, and refusing to share knowledge), increase geopolitical tensions (for example, surrounding Taiwan) and frustrate cooperation on problems that can only be resolved internationally (e.g. climate change).

The Ukraine war has shown that many countries are wary of siding too clearly with the West. Moreover, it has become crystal clear — if it was not already clear before from sanctions against Iran — how risky it is to be (too) dependent on the dollar and U.S. capital markets; hundreds of billions of Russian funds have been frozen. This makes autocratic states in particular more cautious about investing in U.S. government bonds. If tensions between the U.S. and China rise further, countries will probably continue trying not to be drawn too much into a certain camp and will endeavor to spread risks even more. Reduced demand for Treasuries and dollars could consequently exert upward pressure on U.S. long-term interest rates and downward pressure on the dollar.

Incidentally, these forces could be partly offset by the fact that the dollar and U.S. government bonds are still regarded as safe havens par excellence in uncertain times and by the fact that the U.S. is playing an increasingly important role as an energy exporter.

In this uncertain politico-economic and geopolitical environment, it is unlikely that the S&P 500 will have moved back towards 4,800 by the end of this year. Although it must be said that share prices are generally well ahead of earnings. In other words, if corporate earnings bottom out this year, stocks may have moved ahead in anticipation of better times ahead.

Andy Langenkamp is senior political analyst at ECR Research which offers independent research on asset allocation, global financial markets, politics and FX & interest rates.