For most of us, the holidays are a time to reflect on the year – the accomplishments and memories made, the challenges endured, and the triumphs achieved. For investors, in contrast, the holidays mean we are that much closer to leaving a difficult 2022 behind for good.
During 2022, the economic environment was dominated by global political turmoil and central banks in a race to curtail rapidly spiraling inflation as quickly as it had arrived. The investment environment was unfavorable to almost every asset class. A calendar year has only twice before notched negative returns for both stocks and bonds. As of last Friday, the MSCI All Country World Index (a proxy for stocks around the world) was down almost 20% year-to-date, and the Bloomberg U.S. Aggregate Bond Index (a proxy for intermediate investment grade and government bonds) was down approximately 12.5%. If the tried-and-true 60/40 portfolio was on the ropes during 2021, 2022 brought the knockout punch. But the past is prologue, and as we look toward 2023, opportunities are beginning to present themselves.
In the year ahead, much like in 2022, all eyes will be on the U.S. Federal Reserve (the Fed). The prevailing expectation is that we are due for another 0.75% or 75 basis points (bps) of rate increases, resulting in an eventual Fed Funds Rate of 5.0-5.25%. In keeping with its current effort to front-load increases, the Fed is likely to raise rates during its first two meetings in the first quarter of 2023. There is less consensus about what happens afterwards.
We think the most likely scenario is the Fed pauses after the next 75 bps of increases, holding at the 5.0- 5.25% level through the balance of 2023. We believe the Fed is still attempting to engineer a “softish” landing, while acknowledging that some damage will inevitably be done to the economy in the process. The Fed’s focus is on cooling the wage pressures due to the tight labor market without causing an undue increase in unemployment.
Ultimately, the Fed must tame inflation. Its hawkish tone is intended to convey its resolve that it can constrain inflation and not be seen as likely to quit the fight too prematurely. NWCM believes that corporate profits will soften and perhaps for some industries turn negative year-over-year. Equity markets are ‘forward looking,’ and could turn positive even as a ‘profits recession’ unfolds. With this as a base case, we think investment grade credit and some shorter maturity U.S. Government debt are attractive investments.
Valuations will be important for equities, and in general, they remain stretched. However, several sectors and regions now appear oversold and perhaps undervalued. Within these sectors, companies with strong balance sheets and the ability to execute in a difficult economic environment should provide opportunities for investors.
What are the risks and the range of outcomes we envision? There are two distinct scenarios that differ from our base case.
- 1. The Fed increases interest rates beyond the expected 75 bps given inflation that is more stubborn and entrenched than currently assumed.
- 2. Inflation pulls back more quickly than expected and the Fed begins a loosening cycle sooner than planned and ends up cutting rates in 2023.
In our base case, the Fed will pause its interest rate hikes in early 2023. The financial markets will view this as constructive progress and we would expect modest gains for both stocks and bonds in 2023.
In the scenario of inflation remaining stubbornly high, the Fed continues its tightening cycle into the summer and maybe beyond. The equity and fixed income markets would be under continued price pressure for much of the year.
The scenario in which inflationary pressures dramatically decrease and supply chain capacity improves has the Fed lowering interest rates with a likely result being a strong rally in both stocks and bonds.
In summary, there is no shortage of concerns the market will worry about on any given day leading into 2023. We believe, however, that inflation—and subsequently what the Fed does in response— will be the single largest contributor to the direction of markets for the year.