“I don’t think anyone knows whether we’re going to have a recession or not, and if we do, whether it’s going to be a deep one or not. It is not knowable.” Jerome H. Powell, Chair of the Federal Reserve. News conference, December 14, 2022.
We are not smarter than the Federal Reserve, so we will not try to predict how equity markets will perform in 2023. Rather, we will look at some of the scenarios that could unfold for the economy and the markets over the next twelve months.
Let’s start with a review of 2022. We will make it brief. The S&P fell (19.4%); the Dow (8.8%) and the Nasdaq Composite (33.1%). While the stock indices logged their biggest declines since 2008, the Wall Street Journal summed up the bond market sell off as “the worse ever.” The price change for the Bloomberg US Agg Bond TR USD was down (13.01%). What about the previously high-flying tech companies known as the FAANG? Performance was downright ugly. The only bright spot was energy, which was loved by investors and hated by consumers. Enough said.
Before dividing our outlook into four possible scenarios, we’ll define some key factors that will play into those scenarios.
- Inflation is most often found in a hot economy, when there is too much demand chasing too few goods. In 2022 post-pandemic consumer eagerness to spend was challenged by supply chain woes, resulting in high prices. Inflation was also magnified by increasing costs, examples being rising wages, and commodity inputs. Inflation likely peaked in 2022, but it is not yet subdued.
- The Federal Reserve oversees monetary policy, which seeks to reduce the demand that causes inflation. The Fed’s current plan is to raise interest rates to a level that exceeds inflation and then hold those rates steady until inflation expectations have stabilized at a much lower level.
- Earnings estimates could be the biggest risk for the stock market in 2023. Severe downward earnings revisions are currently not priced into the markets, because earnings reports are a lagging indicator. If a recession ensues, downward earnings revisions will likely weigh on market performance.
- Valuations – stocks are trading at P/E ratios that have fallen for the last two years to levels suggestive of a recession. This could make stocks attractive when markets anticipate that the economy is ready to turn around. However, if corporate earnings have been overestimated too much, valuations could still need some downward adjustment.
- Employment continues to overheat, as job openings exceed available workers by 1.7 times. Unemployment is near record lows, and while wage growth is impressive, it has not kept up with inflation.
The Federal Reserve is in charge of tackling inflation through restrictive monetary policy. It does so by raising rates to lower demand, which has a negative effect on economic growth. Overly aggressive efforts to control demand can lead to a recession. However, a recession is not inevitable, and if one does occur, the degree of severity is up for debate. (See the above quote by Jerome Powell.)
So, what are some of the possible scenarios for the economy and the markets in 2023? What follows are hypothetical frameworks for how stocks might respond to various economic outcomes.
- Soft landing is achieved; markets continue to struggle
Economy
GDP growth stays above 0%; the Federal Reserve destroys job openings before destroying too many jobs, and consumer/business spending declines without triggering a recessionary spiral.
Markets
Investors become discouraged that the Federal Reserve will not need to pivot to significantly lowering interest rates any time soon. (Lowering rates and creating liquidity often results in excess money going into the stock market, providing the opportunity for rallies). If the economy remains resilient enough (soft landing), the Federal Reserve will likely not make a dramatic pivot, and there will not be a large cash infusion into equities. Market performance will need to depend on other factors, such as (declining) profits in a slowing economy, making meaningful rallies much less likely.
- Economy flounders: markets rebound
Economy
Inflation is sticky and the Federal Reserve finds it must be very aggressive in raising rates. The economy sinks into a recession.
Markets
Stocks seesaw higher and lower until the nature and severity of the recession is clearer. Once uncertainties are definable, markets experience a sharp rebound in anticipation of the post-recession recovery.
- Economy struggles along with the markets
Economy
Along with rising rates, corporate earnings experience a severe downward revision. Labor costs, which become sticky, exceed price increases, weighing on profits. The economy experiences a serious recession. Historically, economic recessions have always been accompanied by earnings recessions, which can weigh heavily on stock performance.
Markets
The steep earnings recession, combined with higher than anticipated borrowing costs, keeps corporate profits lower for longer. The Fed waits to decrease interest rates to ensure inflation expectations are anchored at 2%, causing economic growth, and the earnings recovery to be slow. Market performance continues to be sluggish.
- Economy avoids a recession and markets share in the joy
Economy
Inflation cools without a substantial slowing in growth, unemployment continues to be relatively low, business and consumers maintain a pool of savings, and individual net worth remains above pre-pandemic levels. Consumer spending declines, but not by enough to seriously impact business profits.
Markets
With prices stabilizing and a recession averted, markets declare that the 2022 October lows were the bottom of the cycle. A two year decline in P/E ratios has resulted in valuations priced for a recession. When a recession doesn’t materialize, stock prices rebound, and embrace a new period of sustained growth.
Again, the above cases are examples of what might happen to the economy and markets this year. The point being that, not only is the future not yet knowable, there are still a number of trajectories economic growth and market prices can take.
It has been fifty years since we have faced sustained high inflation. We didn’t get the prescription correct back in the 1970’s. We are trying again this time, but with a better playbook, a stronger underlying economy, and lower inflation. That could mean a better chance of success. However, investors need to call upon their patience for a little while longer. The process of lowering inflation takes time.
I will end with a silver lining: the Bond Market. Bonds and stocks sank together in 2022. Given the Federal Reserve’s stated strategy of pausing interest rates at slightly above 5%, it is quite possible that this year investors will see a period when they clip healthy bond coupons, leading to a positive return for the year. Bonds acting like the “bonds of old” would be very welcome!
Betsey A. Purinton, CFP® is the former Managing Partner and Co-Chief Investment Officer at StrategicPoint Investment Advisors in Providence and East Greenwich.
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