2023 Market Outlook: Cross Currents

Cross currents continue to rock the economic boat, even though we believe a brighter year is on the horizon.

The Federal Reserve’s ongoing commitment to raising interest rates to cool inflation is likely to lead to weak U.S. economic trends in early 2023. However, Fed policymakers have indicated they are looking to an eventual pause in rate hikes, possibly in early to mid-2023, and that it is likely the federal funds rate target will remain at its peak, or “terminal,” rate for a while.¹

In other words, there may be more choppiness, given that inflation is still a noticeable (although receding) problem, but the longer-term U.S. economic outlook has improved.

It wouldn’t surprise to us to learn that a U.S. recession is coming or already in progress. The Conference Board’s Leading Economic Index has had an eight-month change consistent with every recession going back to 1960.

The Fed is trying to thread the needle between slowing growth enough to curtail inflation while at the same time avoiding a recession—a feat known as achieving a “soft landing”—but that’s a very narrow opening. And frankly, history isn’t on the Fed’s side when it comes to soft landings. We think it is only a matter of time until cracks in the labor market widen and we see a recessionary move up in the unemployment rate. In fact, the Fed is telling us in its own forecast that a recession is expected: The central bank’s latest expectation for 4.4% unemployment in 2023² would be a 0.7% increase from the current rate.

It may seem counterintuitive, but employment weakness would be welcome sooner rather than later, as it would bring the Fed closer to “checking the box” of increasing slack in the labor market—ultimately helping put downward pressure on inflation and allowing the Fed to ease up on the brake it has been applying to the economy. If this occurred alongside a stabilization and/or turn higher in leading indicators, it would set up the economy for better days later in the year.

A better year for global investors may lie ahead, but volatility may remain high in early 2023 as a potential global recession lingers, central banks step down rate hikes, and China’s post COVID-19 reopening introduces upside risk to inflation.

Inflation is still stubbornly high. Central banks stepping down the pace of rates hikes is more about responding to weak economies than making strong progress on lowering inflation. Even though third-quarter economic growth was better than expected for many major countries in North America, Europe, and Asia, a global recession likely began sometime during the third quarter.

One important signal of an already-underway recession is the leading indicator for the world economy produced by the Organization for Economic Cooperation and Development. In this index, a drop below 99 tends to happen right around the start of a global recession. It’s a repeating story, and it’s below 99 again, signaling another potential recessionary period.

China’s authorities are preparing to end the zero-COVID policies that have held back their economy for the past three years. In reaction, the MSCI China Index rose 29% in November, compared to just 5% for the S&P 500 Index. This surge in Chinese stocks has propelled outperformance of emerging-market stocks. Yet—in another example of counterintuitive cross currents—the potential reopening poses upside risk to inflation just as central banks appear to be stepping down their rate hikes. We will be watching developments carefully to assess the balance between the impact of reopening excitement and inflation worries on the stock market.

It has been a long time coming, but 2023 looks to be the year that bonds will be back in fashion with investors. After years of low yields followed by a brutal drop in prices during 2022, returns in the fixed income markets appear poised to rebound.

Our optimism about returns for 2023 is based on three factors:

• Starting yields are the highest in years—in both nominal and real terms;
• The bulk of the Fed tightening cycle is over; and
• Inflation is likely to decline.

After a long drought, the bond market is awash in yields that are attractive relative to other income investments. A portfolio of high-quality bonds—such as Treasuries and other government-backed bonds, and investment-grade corporate bonds—can yield in the vicinity of 4% to 5% without excessively high duration. Tax-adjusted yields in municipal bonds are also attractive for investors in higher tax brackets. In addition to the relatively attractive yields, higher coupons for newly issued bonds should help dampen volatility.

We expect the Federal Reserve to end its rate hikes in early-to-mid-2023 amid a soft, perhaps recessionary, economy that brings inflation lower. Given that outlook plus the year-end rally in bonds, yields may rebound early in the year. However, the yield curve (the difference between short-term and longer-term Treasury yields) is likely to remain deeply inverted as monetary policy remains tight. Assuming the Fed sticks to its tight policy stance at the expense of economic growth, 10-year Treasury yields could fall as low as 3%. With that backdrop, we favor adding duration to bond portfolios during periods of rising rates, while staying up in credit quality.

We continue to recommend more of a factor-based investment process than a sector- or style-index-based process. At least until the economy begins to stabilize, we suggest that stock-picking-oriented investors focus on quality-based factors, such as balance sheet liquidity, positive earnings revisions, strong free cash flow, and lower volatility.

In global stocks, one way we’ve been defining quality is high-dividend payers—generally a sizeable dividend is a sign of financial strength and good cash flow. High-dividend-paying stocks have outperformed during past recessionary bear markets, and they outperformed again in 2022 across sectors and countries. So did short-duration stocks (that is, stocks of companies with more immediate cash flows, rather than cash flows in the distant future): They outperformed in 2022 both when the market was falling and in the fourth quarter when it rebounded. There can be no guarantees, but investors may be able to navigate 2023 by sticking with what has been working in both up and down markets during 2022.

We’re similarly focused on quality in the fixed income market. Investment-grade bonds are likely to provide attractive yields in 2023 at lower risk than we’ve seen for several years. Current yields on riskier bonds, such as high-yield bonds, don’t provide enough compensation for the extra risk, in our view. Things may change as the year progresses, but for now we recommend staying up in credit quality and increasing duration, keeping the average near your long-term benchmark.