Market Navigator – January 2023 edition

Monthly letter

A year to forget. For many, 2022 will be remembered as one of the most complex and challenging market environments in decades. Global markets came under pressure as inflation saw a resurgence worldwide, global central banks embarked on one of the most aggressive tightening cycles in decades, and Russia launched a full-scale invasion of Ukraine.

The S&P 500 recorded its worst year since 2008 and its sixth down year since the turn of the century. U.S. core bonds declined 13%, the worst year since the inception of the Bloomberg U.S. Aggregate Index in 1976. The one-two punch of declining stocks and bonds posed a headwind for diversified investors as the traditional 60/40 portfolio (60% S&P 500, 40% Bloomberg U.S. Agg rebalanced monthly) declined nearly 16%.

The silver lining is the reset in valuations in both bonds and stocks should benefit longer-term investors, which is reflected in an uptick in our long-term capital markets return assumptions. Moreover, the sharp equity market selloff over the past month since we published our 2023 outlook, likely exacerbated by year-end tax-loss selling, has left the market moderately oversold.

Still, we expect choppy waters to continue given macro challenges.

Indeed, either the economy is going to weaken, and that will tame inflation but also likely hit corporate profits and challenge asset prices.

Or instead, the economy stays stronger as does inflation, and the Fed and other central banks will continue to tighten policy, also challenging asset prices.

In either case, there’s a potential headwind for investors. To be fair, there is a third path, where inflation comes down, and the economy avoids recession, the so-called soft landing. It’s possible.

However, the path still appears somewhat narrow given the lagged impact of the most aggressive monetary tightening in forty years and the triggering of several historically reliable recession indicators.

As we turn the page into the new year, our team continues to see Three keys for 2023—remain defensive, remain tactical, and remain open-minded.

Remain defensive

• Recession risk is elevated, and equity and credit valuations are uncompelling. Therefore, we have a tilt to fixed income and are focused on high quality bonds.
• The recent market pullback has helped to ease valuations somewhat, but it’s not enough yet to suggest the risk/reward has flipped in a meaningful way relative to the macro challenges.
• We expect the market’s focus to shift from elevated inflation to fading economic growth in 2023, as the most aggressive rate hikes weigh on the economy and earnings.
• Notably, stocks have never bottomed before a recession has even begun. And history shows that a Fed pivot isn’t always a cure-all.

Remain tactical

• We have seen six moves of at least ±10% over the past year—three to the upside and three to the downside. While the recent decline has relieved some of the frothiness, most of our technical indicators are not yet at an extreme.
• Investors should be prepared for an opportunity to move from defense to offense later in the year should better value emerge. Although stocks have never found their low before a recession has even started, they tend to bottom well before the recession is over, and the initial snapback tends to be sharp.

Remain open-minded

• The post-pandemic backdrop is unprecedented, so the historical playbook may be challenged.
• We will adjust if the weight of the evidence shifts, as we did over the past year. In fact, we pride ourselves on this approach.

Positioning

We maintain our overweight in fixed income and a relative underweight in equities. Indeed, bonds are back.2023 will be a year to keep bond allocations simple and take advantage of the high-quality opportunities created over the past year. This month, we are further downgrading our view across credit, given our work suggests credit spreads do not properly reflect elevated recessionary risks.

Within equities, we still favor the U.S., a value tilt, and see better opportunities below the market’s surface, such as the equal-weighted S&P 500, a proxy for the average stock.

From a sector standpoint, we advocate for a barbell strategy. This includes higher weightings to health care and consumer staples, which are more defensive in nature given their lower sensitivity to weakening economic growth. We pair this with industrials, which should benefit from increased defense spending and reshoring, alongside energy, which is still relatively cheap and a partial hedge to a smoother China reopening.

Importantly, this is a starting point. We look forward to keeping you informed of our views as the year unfolds.

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