2023 Outlook – Land of Opportunity
As we enter 2023, we are still coping with the inflationary effects of closing and reopening the global economy. China has only recently relaxed their zero-Covid policies, and the tragic events in Ukraine have made the inflation issue worse. In response, central banks continue to aggressively hike rates, and in the U.S., the Fed has pushed rates to levels not seen in fifteen years. They’ve made it clear that controlling inflation is their top goal, and that rate hikes would only stop once they’re confident they have done so. The question all along has been whether they’d be able to engineer a soft landing, or will we have a deeper recession with rising unemployment, depressed corporate earnings and even lower stock prices?
By some measures, the economy is already in a recession, while by others we’re not quite there yet. Either way, broad stock market indices, as well as bond markets, sold off significantly during 2022. We expect the volatility we’ve experienced recently to stick around through the first half of 2023, followed by an easier second half which could see stocks climb modestly higher.
For longer-term investors, it is important to step back and assess where we stand in light of the selloff. With the selloff in equities, valuations are now below their long-term averages. With the increase in rates, bonds now provide competitive yields to maturity. This doesn’t mean asset prices can’t fall further, but it does mean both stocks and bonds are much more appealing from a long-term perspective than they’ve been for some time.
Our primary takeaways for 2023 are:
  • It is likely that the U.S. will enter a recession sometime in 2023. The timing is uncertain, but it should be relatively mild without a significant deterioration in employment conditions.
  • Inflation has dropped quickly which should allow the Fed to ease up on its hawkish policy. In fact, many expect them to actually cut rates later in 2023, signaling a full pivot to easing conditions.
  • Corporate earnings are being revised downward, which could mean volatility for stocks for a bit, at least through early 2023.

First of all, let’s acknowledge where we are. The markets have been lousy; stocks and bonds both posted significant losses in 2022. Inflation hit a 40-year high and is still elevated. Mortgage rates are still north of 6%. We’re in a difficult environment. It’s concerning, and we can acknowledge that, but we shouldn’t react to it.

Entering 2022 the biggest question was how the Fed was going to get inflation under control. They had a plan to do so, but lingering supply chain issues, strong demand, and the situation in Ukraine all worked against it. The Fed quickly found themselves behind the curve and has moved aggressively to catch up before it’s too late. Similar conditions exist globally.

But recently, inflation is easing as the earlier hikes are already delivering tightening financial conditions. Global inflation (CPI) is on track to slow towards 3.5% in early 2023 after approaching 10% in the second half of 2022. China is relaxing its zero-Covid policies which should continue to help with supply chain issues. Inflation itself ultimately drives prices lower as people cut back on spending. 2023 should deliver the completion of one of the fastest and most synchronized central bank tightening cycles on record, with most expected to be done by the first quarter of 2023.

Why are we here? In the U.S., the Federal Reserve wants to avoid 1970’s-type inflation at all costs. In addition to high inflation, the 1970’s also saw high unemployment and a recession. It was a disaster that no one wants to be responsible for causing again. So, as inflation ramped up and hit 40-year highs, the Fed became increasingly concerned with avoiding just that, and embarked on their most aggressive tightening cycle over the last three decades.

When the Fed hikes rates, it becomes more expensive for banks to borrow money to fund their day-to-day operations. When borrowing becomes more expensive for banks, they pass these higher costs on to consumers, and it gets more expensive to borrow money. This leads to less spending, less demand, and lower prices. This takes some time, however, and with inflation at 40-year highs, that’s one thing the Fed doesn’t have. The result has been an aggressive tightening cycle, concerning some they’ll tip the U.S. economy into a deep recession. While the economy has yet to feel the full impact, the financial markets have been rattled. Similar situations have hurt financial asset prices globally.

Where are we headed? That’s the million-dollar question. By some measures, the economy is already in a recession. By others, we’re not there yet. The National Bureau of Economic Research (NBER), who declares recessions, has yet to do so, but it’s apparent the Fed’s hikes have delivered slowing conditions. It’s widely expected a recession will officially be declared before year-end 2023, and it’s also widely expected to be mild in nature.

With the selloff in equities, valuations are now below their long-term averages. And while volatility is likely to remain elevated, we continue to look for high-quality companies with strong balance sheets that hold up well during turbulent periods. Value has started to show signs of leadership and may continue to do well. Growth areas of the market have sold off, and at some point, they’ll gain more attention. Valuations outside the U.S. are particularly compelling, even with the elevated Geopolitical risks present.

Equity market returns have been robust for the first 36 months of past tightening cycles. This cycle began in March, so it will be 9 months old entering 2023. Historically, this should portend well for equities.

Turning to bonds, 2022 was the worst year in history. Strategists from Deutsche Bank, citing an index from Global Financial Data that uses proxies for long-term debt that go back centuries, have noted this year’s drop is the worst since a 25% drop in 1788, a year before the U.S. Treasury was established.

But now they’re back. Bonds haven’t been this attractive since the 2008-09 period. The best predictor of future returns is the starting yield. It makes sense that with higher starting yields, we should expect higher future returns. This is a good thing for income-starved investors. Even short-term government bills are paying over 4% and yields much higher across the spectrum.

But - and this is a big but - anytime the Fed acts, there is a risk of a misstep. If the Fed can’t engineer a soft landing, the economy could suffer. The range of outcomes is very wide, with a U.S. recession likely before the end of 2023. The timing, depth, the path of Fed policy, and the reverberations for the rest of the world vary.

Many think the Fed will overtighten in the first half of 2023, which would likely mean continued volatility in the financial markets. This sell-off, combined with disinflation, rising unemployment and declining sentiment, may be enough for the Fed to start signaling a pivot. This could in turn drive a later durable market recovery over the second half of 2023.

What does this mean for financial markets? Markets tend to be forward-looking, meaning much of the information we’ve discussed is already priced into the markets, at least partially. Even though things could get worse economically before they get better, that doesn’t necessarily mean financial markets have to. Bearish sentiment among investors is the highest it’s been since tracking such data started 35 years ago. With this negativity, there’s room for things to surprise us in a positive way. It’s entirely possible the stock market is closer to the bottom than the daily headlines may suggest.

Within equities, we prefer high-quality companies, specifically dividend growers and value stocks of all market capitalizations. After more than ten years of growth stocks leading their value counterparts, the tables have turned. Value has started to show signs of leadership and should continue to do well until market volatility settles.

International equity valuations are particularly compelling. European stocks have never been this attractively priced relative to the U.S. and yield nearly twice the U.S. market. The earnings outlook is better for certain areas globally. And while the strong dollar has favored U.S. stocks recently, that won’t always be the case. Should the dollar weaken, this would be a tailwind for companies based outside the U.S.

Bonds are attractive at current levels. Yields in nearly all fixed-income sectors are near fifteen-year highs after last year’s selloff. Historically, bonds have offered additional diversification benefits when yields are higher. This can be especially meaningful if the equity markets remain volatile as expected. Shorter-term, higher-quality bonds will remain a focus in our models until we are better rewarded for looking to other sectors for additional income.

Better times are likely coming for investors in 2023. That’s not to say there won’t be continued volatility, another market drawdown, or even a mild recession. But after 2022, we can say both stocks and bonds appear to be much more appealing from a long-term perspective than they’ve been for some time. And, as always, a diversified portfolio and long-term view still offer the best route to reach financial goals. 

Thank you for the opportunity to serve you!

The McCarthy & Cox Team
Authored by Wesley Bean, CFA
This communication is for McCarthy & Cox clients only and may not be distributed to the general public.
Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. Commonwealth Financial Network does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.
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Securities and advisory services offered through Commonwealth Financial Network, member FINRA/SIPC, a Registered Investment Adviser.