At the beginning of 2022, the major theme in developing an outlook for the coming year revolved around pondering a post-pandemic market environment. The key considerations at that time were the implications of the enormous liquidity that had been injected into the system through both pandemic-induced monetary and fiscal policy, the increasingly tight labor markets, and the continuing logistical challenges that were wreaking havoc on interconnected supply chains in the economy.
The financial markets were faced with brewing inflation, strong but uncertain corporate profits, and historically high Price/Earnings (P/E) valuation multiples, especially in the growth segment of the market. Evidence of speculative fervor was also manifest in prices of disruptor stocks and crypto currencies.
Although a cautious investment stance was advised for 2022, market returns have been significantly worse than expected. Volatility also increased dramatically in both the stock and bond markets which made tactical portfolio navigation during the year particularly challenging.
As 2023 comes into focus, some major themes and trends of 2022 are persisting, some have reversed, and some new trends are emerging.
- Inflation was the dominant theme affecting the capital markets in 2022, and it remains a dominant theme for 2023. Inflation statistics peaked at uncomfortably high levels over the past year but are now showing some signs of moderating. Commodity prices, led by oil, spiked during the first half of 2022, declined sharply during the middle of the year, and have been stable to lower for the past six months. Declining commodity prices are a necessary but not sufficient condition to alleviating inflation pressures.
- Tight labor markets will continue in the new year as a major issue for the markets, and more importantly, the Federal Reserve (Fed). Since labor costs are such an important driver of inflation at a macro level, and a significant issue for corporate profitability at a micro level, labor markets must show signs of cooling off. A loosening of the labor market is both a necessary and a sufficient condition for the Fed to become more comfortable with the inflationary environment, which would allow for a moderation in monetary policy.
- Sadly, the war in Ukraine, and its toxic effect on the global economy seems a persistent backdrop for the foreseeable future. The war’s impact on the energy markets remains a continuing source of uncertainty to the macro-economic environment.
- Supply chain concerns have dramatically reversed. Sharp declines in shipping and freight rates, along with significantly higher corporate inventory levels, are clear indicators that logistical and supply chain issues have diminished. These supply developments will support the nascent deceleration in inflation pressures.
- Although corporate earnings collectively for the market held up surprisingly well during 2022, this was mostly due to surging profits generated by energy companies. Earnings estimates for 2023 have been declining throughout the year. As companies cope with higher input costs and potentially flattening revenue, earnings expectations should continue to decline. Declining confidence in corporate earnings will dampen the near-term outlook for the equity market.
- Although statistics continue to point to a very tight jobs market, there is anecdotal evidence of a moderating labor demand. As corporations deal with the changing post-covid environment, as well as the cost pressures coming from multiple sources, layoff announcements are accumulating – especially in the previously hot technology sector. If this development becomes more entrenched, the risk of recession increases.
- The Fed is poised to slow its campaign of aggressively hiking rates after a year of historically large incremental increases in short-term interest rates brought the Federal Funds rate from effectively 0% at the beginning of 2022 to about 4% heading into December. The bond market is already pricing in a move in short-term rates to 5% by the second quarter of 2023, in addition to factoring in a decline in rates later in the year. If job layoffs become more widespread, the risk of recession becomes much more elevated, and rates could indeed be lowered by a responsive Fed. But significant softening evidence will be needed for such a move.
- Even in the face of persistent inflation news, long-term bond yields have declined dramatically in just the past month. This decline in long-term (30-year) bond yields, while short-term (2-year) bond yields have only declined modestly, has led to a deeply inverted yield curve. It has been well-chronicled that such a development has a very high correlation with eventual recession.
Market implications for 2023 – Consensus expectations review
After an incredibly volatile and challenging year, both the bond and stock markets have recovered significantly over the past two months. Market consensus for the coming year seems to be that the economy will fall into a shallow recession, inflation will continue to decline, allowing the Fed to pivot from its tightening policies, and corporate earnings will modestly weaken, but not to a degree that will lead to a resumption of the bear market environment that characterized the first half of 2022.
This somewhat benign consensus market outlook regarding the severity of a potential recession seems reasonable. The labor market, consumer spending, a relatively strong financial system, and the lagged effect of enormous fiscal stimulus polices remain fundamental supports that should help preclude a serious recession. However, rising interest rates, a weakening housing market, global geopolitical uncertainties, and diminishing capital spending will be ongoing challenges.
The view that inflation will quickly and materially decline in the near term toward the Fed’s long-term goal of 2% seems optimistic. Although there are clear early indicators of softening price pressures, especially in the goods sector of the economy, inflation in the service sector, and especially wages, remain problematic. Inflation is a sticky phenomenon once it becomes embedded in economic activity.
The Fed has softened its rhetoric about its policy of aggressively raising rates. However, the economy is showing surprising resiliency, and there are no signs of financial system instability (unlike the crypto currency system).
While there is evidence of declining inflation, it’s early in a process that will extend through next year. The Fed seems poised to reduce the size of forthcoming incremental rate hikes, but it likely will not stop hiking rates until the end of the first quarter or early in the second quarter of 2023. Even after stopping rate hikes, it seems unlikely the Fed will pivot quickly to cutting rates absent a sharp downward turn in the economy, which we don’t expect. Therefore, investors should be prepared for higher interest rates for an extended period.
Corporate earnings expectations for the overall market appear to be too optimistic. Inflation, and the inability of wage growth to keep up with inflation, is beginning to change consumer behavior, leading to a softening in aggregate demand. Inflation is also affecting corporate cost structures. Rising wages and higher input costs are beginning to negatively impact corporate profit margins.
A view of 2023 – a changed environment
The past year was an historically bad one in terms of performance for a diversified portfolio, with both bonds and stocks experiencing double digit declines. The silver lining is that some of the extreme valuation excesses across markets have been significantly reduced, if not eliminated, providing a more reasonable environment for investors going forward. However, still elevated inflation, restrictive monetary policy, and declining confidence in corporate earnings will continue to limit returns.
The Fed is in the late stages of its policy of tightening financial conditions to combat inflation, but declaring victory over inflation is a ways off. High-quality bond yields probably peaked this past fall at 4 to 6%, depending on the sector and credit quality and have subsequently declined. But a sustained move to significantly lower yields is unlikely. However, in such an uncertain environment, collecting income of 4 to 5%, especially in short/intermediate maturity bonds, remains an attractive proposition after years of trivial bond yields.
Corporate credit seems reasonably priced given the expectation that a possible recession would be mild, which would reduce the risk of default. High-quality, mortgage-backed bonds also are reasonably priced, given an expected more stable interest rate environment. Combined, these modestly higher risk sectors of the bond market provide yields of 4.5 to 5.5% currently.
There is a very wide range in yields for riskier high-yield bonds depending on credit quality. The better-quality segment of this market offers yields of approximately 7%, while the very low-rated credit segment trades at double digit yields. There are opportunities in this sector, particularly as a surrogate for equity risk, but selectivity is important, as low-quality bonds will be much more sensitive to a significant economic slowdown.
The past year’s market weakness, along with a significant change in market leadership, was driven primarily by newly restrictive Fed policy actions which drove interest rates to levels not seen in more than a decade. This move contributed to a meaningfully lower valuation for the stock market, as P/E multiples declined. Although P/Es are now lower, the “E” (earnings) in this ratio remains uncertain at best. Corporate managements will continue to be challenged to deliver strong profit results in a softening macro environment.
Favorable changes in the market over the past year include the demise of extreme speculation, the re-emergence of quality, value, and dividend factors as positive characteristics for valuation, and the broader differentiation of returns across sectors. Market index concentration in only a handful of large, technology-oriented companies is now considerably lower, and many stocks of companies in more varied industries are outperforming broad index returns. This increasing breadth and heterogenous performance of individual stocks is positive for the overall market.
Historically, a significant change in equity market leadership tends to persist for several years. As such, value stocks, and even some international sectors of the equity market, seem positioned for a relative performance advantage in the coming year. Small cap valuation looks attractive, with small caps poised to outperform likely later in 2023 as cyclical headwinds turn to tailwinds. Quality growth stocks have trailed, but likely would benefit from falling rates and a scarcity of growth in a slowing economy.
The road ahead
In summary, we believe interest rates and bond yields will remain at a higher level, but we don’t expect them to surge significantly higher. Also, longer-term yields likely have peaked, reflecting growing concerns over a slowing economy and recession risks. And after years providing meager yields, fixed income now provides a meaningful income benefit for investors, and once again may provide ballast to a diversified portfolio.
Higher bond yields are indeed somewhat of an alternative to equities in the short-term, given the continuing uncertain environment for higher risk assets. However, equity valuation is much more reasonable relative to historical metrics. Earnings results are always important for stocks, but in the current environment, they take on even more significance.
An uncertain earnings environment is a key reason to maintain a cautious stance on equities to start 2023. Also, it seems likely a new cyclical leadership change is now developing as value and small cap segments could lead the overall market.
While caution is warranted to start the year, volatility is likely to become increasingly two-sided with the potential for large downdrafts but also strong rallies. As the year progresses, we expect markets to increasingly look forward to the prospect of stabilizing growth later in 2023 or beyond. Investors should be prepared to position their portfolios for a possible market recovery, as markets can gap up just as intensely as they moved down.