Well, it's that time of year again, and I am not talking about holiday parties or holiday shopping or ugly sweaters, I am talking about 2023 investment outlooks. So, here we go. I am not one to throw out predictions for where the S&P 500 is going to finish the year or what the 10-year Treasury will be yielding or how strong the U.S. dollar will be. However, I will highlight some economic and investment trends that can impact markets in 2023. Below are eight trends that I will be watching in 2023 that will impact markets and what to consider when preparing investment portfolios for the new year.
Disconnect Between the Federal Reserve (Fed) and Investors Will Continue to Cause Volatility in 2023
While the Fed downshifted its rate hikes from 75 bps to 50 bps during its December meeting, the tone of the announcement was hawkish, while the dot plot startled investors. The Fed is committed to taming inflation and doesn’t believe its job is close to being done, evidenced by the “higher for longer” stance. As a result, Fed officials are projecting rates will end 2023 at 5.1% before dropping to 4.1% in 2024; meanwhile, investors are forecasting something much different and hoping for rate cuts in 2023. Adding to the uncertainty is the fact that back in September zero Fed officials predicted that rates would climb above 5% while the December dot plot showed 17 of 19 are forecasting rates will now climb above 5%. These changing views from the Fed are having a very negative impact on investors. Additionally, falling Treasury yields are defying Fed actions as bond investors fear the Fed is going too far. Investors are looking at the deeply inverted yield curve, which is signaling pain ahead, while Fed officials continue to signal that its fight against inflation is far from over with.
The 60/40 Comeback Tour
2023 is going to be a comeback tour for the 60/40 portfolio. There has been a lot of talk about the death of the 60/40 portfolio as the 40-year bond bull market finally came to an end as interest rates finally reversed course and started to increase, which resulted in the largest drawdown in the history of the Bloomberg U.S. Aggregate index. Additionally, stocks and bonds plummeted together, which resulted in a very poor period for the “60/40” portfolio.
After a period of rising correlations, look for correlations between stocks and bonds to normalize or fall as inflation falls in 2023. 2022 was a very bad year for bonds, but there was a positive: It was a much needed reset as yields climbed to relatively attractive levels. The softening inflation combined with tighter monetary conditions will help lower correlations between equities and bonds and bring relief to the 60/40 portfolio. Bonds will regain their role in providing some “safety” and producing income within investment portfolios, while also producing some attractive total returns as yields stabilize and fall as we move through 2023. More on bonds in a little bit.
Inflation vs. Economic Growth
The determining factor on how long and aggressive the Fed must be in tightening monetary policies is going to be like a teeter totter and the question will be–what falls first, inflation or economic growth? If inflation falls first then we might experience a soft landing as it will allow the Fed to stop its rate hikes or even better yet start rate cuts sooner than planned, which will be a big boost to investor sentiment and equity performance. However, if inflation remains stubbornly high, the Fed will have to keep rates higher for longer, negatively impacting economic growth. The higher for longer rates will cause economic growth to fall first and result in a recession as the Fed continues to try and tame inflation, which is the Fed’s primary goal right now.
A Mild Recession Likely
It is often stated that you don’t want to fight the Fed. Well the Fed has made it abundantly clear that more pain is needed and it has a lot more work to do to corral inflation. The more pain will be felt particularly in the labor market as the Fed tries to balance the supply and demand of labor, which will slow wage growth and hopefully cool inflation. We have started to see signs that the economy is slowing whether that is in the housing market or in the recent poor retail sales numbers that signaled consumers may be pulling back due to high prices, less liquidity and higher rates. As I mentioned before, the Fed is hyper focused on bringing down inflation and if that means causing a recession, so be it, it’s a necessary evil. It’s important to note that I think it will be a mild recession as consumers and businesses alike still have solid balance sheets, which should keep the economy from taking a deep plunge.
More Volatility Ahead
I mentioned at the beginning that the disconnect between the Fed and investors will result in more equity volatility. Additionally, a slowdown in economic growth and tighter financial conditions will contribute to volatility in 2023. Furthermore, we are looking at a potential earnings recession in 2023 as margins shrink due to higher borrowing costs, higher wages and higher input prices. Finally, and maybe the biggest wildcard, are the geopolitical risks associated with the conflict between Ukraine and Russia and the ongoing tensions with China.
The volatility will provide opportunities for investors with longer time horizons to take on risk, which will be rewarded down the road. There will be opportunities to buy growth at relatively attractive prices. There will be some bumpy roads ahead, but if you can stomach the volatility, you will be rewarded down the road due to being opportunistic and buying at attractive valuations.
Remain Cautious for the Short-Term Investor
Conversely, investors with short time horizons should remain cautious, focusing on dividend paying stocks and high-quality investments. With 10-year Treasurys yielding less then 3.5% again, high-yielding stocks start to look attractive again. Look for companies, sectors and industries that are more resilient to an economic slowdown, such as consumer staples, health care and, if you are really cautious, utilities. High-quality, dividend paying stocks will help reduce portfolio volatility and increase downside protection for your more risk-averse clients.
Bonds Attractive Again?
Lastly, look for bond yields to moderate and eventually fall later in the year as the economy slows. Later in the year the Fed will begin to hint at potential rate cuts in 2024 due to the economic slowdown and hopefully cooling inflation. The moderating bond yields will offer attractive total return opportunities while yields will remain relatively attractive compared to the past 10 years. As with equities, focus on high quality investment grade issues. Furthermore, high yield bonds are not as attractive when you consider the risks due to an economic slowdown. High yield spreads, which currently sit at 4.37%, have narrowed over the past couple of months and are not attractive at these levels considering the credit risk that lies ahead due to tighter financial conditions and an economic slowdown.
I am going to leave you with this as we move into the new year, make sure your clients remain focused on the big picture while not losing sight of the forest through the trees. Stay the course that is mapped out in their investment policy statement or financial plan because achieving their financial goal is the most important objective. Happy Holidays and Happy New Year!