Annual Outlook – Three keys to 2023

Market Perspective

December 5, 2022

Three keys to 2023

2022 was one of the most challenging years in history for capital markets. We see three keys for 2023:

  • Remain defensive – Recession risk is elevated, and credit valuations are uncompelling. Overweight fixed income relative to equities.
  • Remain tactical – We expect volatile markets that will provide investment opportunities.
  • Remain open-minded – We find ourselves in an unprecedented post-pandemic backdrop. The historical playbook may be challenged, and a wide range of potential outcomes persists.

Remain defensive - Global economy—Fading growth/easing inflation

We expect next year will be the worst year for global growth since the 1980s, aside from the global financial crisis and COVID years.

  • Many countries are set to experience recessionary pressures as the supersized rate hikes of the past year start to take stronger hold.
  • Europe is likely to see the deepest recession, with countries closer to Ukraine and Russia being hit especially hard.

Our base case calls for a U.S. recession in 2023, even though economic growth in the U.S. is expected to remain stronger relative to global peers.

  • The 2/10-year U.S. Treasury yield curve is the most inverted since the 1980s. The Federal Reserve’s (Fed) favored 3-month/10-year yield curve is also inverted.
  • The Conference Board’s Index of Leading Economic Indicators is flashing a recessionary signal.
  • The housing market is set to remain pressured.
  • The Fed expects the unemployment rate in 2023 to rise by more than 0.5% from this cycle’s low of 3.5%. Historically, such an increase from a cycle trough has always coincided with a recession.
  • Any fiscal and monetary policy response to a downturn or an outlier event is likely to be much more restrained relative to recent history.

    Central banks and governments have developed scar tissue over the past year resulting from persistent, elevated inflation and the significant rise in government debt levels due to pandemic support packages.

Positive economic offsets in the U.S. include:

  • The significant amount of excess savings remaining from pandemic support.
  • Low consumer debt service ratios.
  • Strong labor market.

    Still, it’s important to recognize that labor is a lagging indicator, and the unemployment rate is typically near a trough just prior to the start of a recession.

We estimate inflation will trend towards 3%-4%, as measured by the Consumer Price Index (CPI).

  •  A slowing economy should result in easing inflation, albeit remaining above the pre-pandemic range.

Remain defensive - Equity markets—Choppy waters to continue

Equity valuations have been reset, driven by the sharp move higher in interest rates, with stock markets under pressure across the globe in 2022.

  • Our 10-year forward annualized total return assumption for the S&P 500 has risen a full percent, from 6% to 7% since last year.

The path toward getting those higher returns will remain choppy though. And the near-term risk/reward appears less favorable.

  • Our initial estimated 2023 S&P 500 range is 3400 to 4300 relative to the November closing level of 4080.
  • This is consistent with the average annual spread of 27% between a market high and low since 1950. The wide range should provide tactical opportunities.
  • Consistent with elevated recession concerns, risks to corporate profits remain, yet valuations are far from compelling.
  • The S&P 500’s forward P/E is near the top end of its pre-pandemic range, while consensus earnings estimates remain overly optimistic. 
  • Notably, stocks have never bottomed before a recession has even begun. And history shows that a Fed pivot isn’t always a cure-all.

Within equities…

Retain a U.S. bias.

  • Overseas markets remain cheap on a relative basis, but valuation is a condition not a catalyst.
  • Given the weak global economic backdrop we expect next year, the U.S. economy should remain a relative outperformer, and while the upward momentum in the U.S. dollar is likely to slow, it should remain relatively strong.

Tilt toward value

  • Maintain value tilt—After more than a decade of underperformance, value’s relative price trends have improved. We expect this to continue.
  • Even with this year’s decline, growth valuations are still expensive. For example, technology shares are trading at a 25% premium to the overall market.

Seek opportunities below the market’s surface

  • There’s value in the equal-weighted S&P 500.
  • Favor a barbell sector strategy, with energy and industrials on the cyclical side, and health care and consumer staples on the defensive side.

Remain defensive – Fixed income—Bonds are back

In 2022, bonds had the sharpest decline since the 1976 inception of a prominent bond index.

  • This led to significantly higher yields. Bonds are now more capable of providing critical income and portfolio stability again.

We recommend a meaningful up-in-quality bias, with a heavy emphasis on core fixed income sectors.

  • Areas such as U.S. Treasuries and investment grade municipal bonds should offer portfolio stability in the year ahead.

U.S. credit spreads should widen as the year progresses and the impact of the Fed’s aggressive policy tightening begins to emerge more fully.

  • Areas like leveraged loans, high yield corporates, and emerging markets bonds will likely see meaningful underperformance as economic risks rise.

Extending duration remains attractive on a total return basis when the 10-year U.S. Treasury yield is closer toward the top end of our expected range of 2.75% to 4.25%.

  • History suggests longer duration outperforms during economic slowdowns and recessions.

We anticipate a continuation of this year’s elevated rate volatility and strained liquidity conditions in 2023.

  • We estimate that the Fed will maintain its current pace of quantitative tightening (i.e., balance sheet reductions) as long as economic and financial conditions allow.

The Fed will likely finish raising rates in the first half of 2023, with the Fed funds rate reaching roughly 5%.

  • The Fed’s singular focus on curbing generationally-high inflation will continue next year, likely holding policy rates at elevated levels until core inflation and job creation ease markedly and consistently.
  • As a result – for investors seeking high quality, passive income – U.S. Treasury yields in the first few years of the curve will remain very compelling.

Remain tactical

Much like in 2022, we expect investors will need to maintain a more tactical approach.

A data-dependent, nimble playbook will be required, given the uncertainty around the global economy, inflation, and the Fed.

We anticipate tactical opportunities as markets are likely to continue to vacillate between bouts of optimism and pessimism.

  • For example, in 2022, U.S. markets have seen three double-digit declines and three double-digit rallies.
  • Also, we expect significant divergences among asset classes and sectors — this year, the return difference between the best sector (energy) and worst sector (communications services) in equities has been roughly 100%.

We remain prepared for an opportunity to move from defense to offense as the year progresses, should a more compelling risk/reward backdrop develop.

  • As we anticipate the U.S. economy will enter recession some time in 2023, it’s important to recognize that equity prices tend to rebound well before recessions end, and the initial snapback rally is usually sharp.
  • Moreover, credit spreads widening to levels more consistent with prior recessions would likely create more compelling entry points in riskier fixed income. Likewise, as the 10-year U.S. Treasury moves toward the bottom and top end of our projected range, we will consider adjusting exposures.

Remain open-minded

We have high conviction in our process and outlook, yet we also have a healthy dose of humility.

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.

There will be unexpected events that markets will need to contend with in 2023. The rapid shifting of prospects was demonstrated in high profile ways this past year:

  • The Russian invasion of Ukraine wasn’t considered a high probability event coming into 2022.
  • A year ago, the Fed expected to raise interest rates from zero to just under 1% by the end of 2022, and markets agreed. Instead, the Fed funds rate is set to end this year above 4%, and inflation has been far from transitory.

We also recognize that we’re still in the post-pandemic era.

  • It remains debatable whether permanent paradigm shifts in trends such as inflation and labor are taking place, or whether they’ll end up being temporary.

A narrow path to an economic soft landing remains, which would likely lift stocks above our baseline view.

There’s also the risk that the consensus view of a short and shallow recession, underpinned by labor market strength and a healthy consumer, remains too sanguine given policy constraints.

So, yes, there are things that are different this cycle. It will be important to remain flexible and follow the data.

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