In 2022, the best many investors could do was to simply take shelter. Major equity indices suffered their worst year since 2008. Bond prices fell sharply in the face of much higher inflation and an aggressive central bank tightening campaign, suffering their worst year of performance in recent memory.¹ Commodities shined, particularly in the first half of the year, with oil rising above $120 before settling back down in the upper $70s. But the financial turmoil was staggering—and unsettling for those used to generally calm and upward-trending equity markets.

Of the many issues to sort through last year, the key one for investors was runaway inflation, which, after decades-long dormancy, erupted globally as a result of COVID-related pent-up demand, supply chain and production issues, labor shortages and a surge in geopolitical tensions. The Federal Reserve and other central banks were at first nonchalant, but eventually became appropriately aggressive, leading to the Fed’s curbing of quantitative easing and rapid interest rate increases. The combination of inflation, the central bank response and the potential impact on the economy created last year’s perfect storm for markets.

Late in 2022 and so far in 2023, the market weather has been mixed—a good day here, a bad day there—but the feeling of uncertainty is palpable, as investors grapple with whether we could find our way out of recent unsettled conditions or see things deteriorate once again. If the latter, many wonder about the length and severity of further downdrafts.

Economic Effects

Much depends on the macro picture. In the face of rate hikes, the U.S. economy has remained surprisingly resilient, growing a preliminary 2.9% in the fourth quarter—slightly less than in 3Q but better than the weak prints earlier in the year. The accumulation of COVID stimulus money has helped keep consumers spending, as have higher nominal wages, even as real wages (adjusted for inflation) have deteriorated. The labor market, a key focus for the Fed, remains remarkably strong, with just 3.5% unemployment in December, and a monthly average of over 300,000 jobs created over the past six months.

But cracks are appearing: The Conference Board Leading Economic Index is down 4.2% for the six months through December; layoffs at technology firms have accelerated; and the housing market continues to show weakness, both in volume and pricing. Manufacturing is also easing, with the much-watched Manufacturing Purchasing Managers’ Index now in negative territory. Overall growth will likely slow to a crawl this year (see display).

Growth Takes a Hiatus

Source: World Bank, as of January 10, 2023. U.S. GDP for 2022 is a preliminary figure from the Commerce Department. Otherwise, 2022 – 24 figures are estimates.

Importantly, the Fed’s tightening campaign seems to be having an impact in inflation. Consumer price (CPI) gains have moved from a peak of 9.1% (annualized) in June to 6.5% in December, while core inflation (excluding the volatile energy and food sectors) has eased to 5.7%.

Breaking CPI into component parts, we’ve already seen a reduction of goods inflation, while shelter appears ready to ease as well. However, services prices—which tend to be sticky and are a large portion of the economy—could take longer. All told, we believe that inflation will gradually recede in 2023 but remain above norms, with core CPI finishing the year at around 3.5% versus the Fed’s target of 2%.

At this point, we are in a bit of a waiting game. The Fed has done most of the hard work already, having lifted the fed funds rate by 425 basis points to its highest level in 15 years. However, policymakers need to see real evidence that inflation is waning. That suggests to us a few more 25-basis-point increases in upcoming meetings, depending on how the data plays out. After that, we are likely to see the central bank maintain peak rates for a while—likely into 2024.

So, a key wild card remains how long the Fed has to maintain high rates and if it has to raise them further than anticipated. A related question is how shallow or deep the economic decline will be. In our view, the risk is growing. Even without a technical recession, the unfavorable growth-inflation mix could be a threat to corporate profit margins and earnings—making most of us feel like we are in a downturn.

Implications

What does this mean for markets and investors?

Stocks: Keep an Umbrella

We believe these conditions create headwinds for equities, even if interrupted by periodic relief rallies as investors hope for easing from the Fed. Thus far, the downturn has largely been a function of price/earnings multiple contraction driven by higher interest rates. Reported earnings and earnings expectations have been fairly resilient, as many companies have been able to pass on price increases to customers. However, we wonder how long that resiliency will last.

The current bottom-up analyst expectation for 2023 S&P 500 earnings is around $227, or 4% more than last year. Although less than what was achieved in 2022 (an estimated 5%), in our view, such potential growth seems too optimistic given current headwinds, and is also at odds with the top-down views of many Wall Street strategists, who see the economy’s drift into recession cutting into earnings. As such, we believe there is likely to be disappointment, which could pressure valuations from here, although the timing and intensity of any downdraft remain to be seen.

The unusually uncertain macro environment suggests the range of potential outcomes is fairly broad. Best case, if we see a meaningful reduction in inflation and slower but still positive economic growth, earnings are likely to avoid a major shortfall even as the Fed is able to take its foot off the gas, all of which could help stocks. A mild recession and commensurate pullback in earnings would be more negative, while full-blown recession and its knock-on effects would likely be far worse.

All this calls for a degree of caution in the near term. We are in favor of investors tilting away from market “beta,” toward value over growth, and toward current income (i.e., dividends) rather than long-term growth expectations. We also would emphasize U.S. over foreign stocks given the relative strength of our economy and the Fed’s leadership in the tightening process compared to other developed market central banks. We are getting closer to the point where adding risk could make sense—we’re just not there yet. It will be important to avoid the trap of becoming more negative as prices decline; that is often an optimal time to add risk.

Bonds: A Fresh Start

Fixed income’s synchronized retreat with equities last year was unusual, but also disconcerting for many investors given the traditional role of bonds as an “anchor to windward” for portfolios. However, a major silver lining is that yields are much higher now, providing income streams and, in some cases, total-return profiles comparable to equities (see display).

Bonds’ Appeal Versus Stocks Has Improved

Stock Earnings Yield Minus 2-Year Treasury Yield

Source: FactSet. Data as of November 30, 2022. Earnings yield is earnings per share divided by stock price. Assets classes and indexes shown may have significantly different overall risk-return characteristics which should be considered before investing. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Overall, we favor an emphasis on quality, given the level of yields and the potential pressure from higher borrowing costs and slower economic growth on issuer fundamentals moving forward. Shorter-term yields are particularly appealing, although now may also be a good time to lock in exposure to longer bonds before policy rates begin to ease. Municipals have retained their comparable appeal for investors in higher tax brackets (see “New Horizon for Fixed Income”)

Weigh the Alternatives

Given our generally cautious outlook for stocks and coupon-driven bond prospects, we believe that exposure to alternative investments, where feasible, remains a valuable source of risk-adjusted return potential. We are intrigued by the impacts of current market weakness, which bodes well for valuations of new public-to-private transactions and “carve-outs” where companies adapt to a slowdown by selling noncore divisions. In addition, secondaries (seasoned fund investments sold on the secondary market) seem attractively priced as fund managers look for liquidity in a difficult environment (see “Private Equity: New Value in Secondaries.”)

Adapting to Evolving Conditions

One of the hardest things about investing is breaking from habit, as successful approaches in one era become less successful in another. Economic dynamics, monetary conditions, business incentives, supply and demand, geopolitical influences and more may combine to alter the flow of capital. As we have explained elsewhere, we are seeing a return to an “old normal” of higher interest rates and moderate growth, where business fundamentals may be more important than the benevolent hand of central banks.

In this evolving, sometimes turbulent era, we believe the time of “set it and forget it” stock/bond portfolios is waning, replaced by the need for nuanced judgment as to asset exposures and investment execution. Drawing from a wider array of opportunities will likely be important, as will understanding how portfolio elements can combine to achieve individual goals. Your NB Private Wealth team can help in considering these issues.