With a very turbulent and challenging 2022 behind us, we would like to discuss some of our thoughts on the outlook for 2023. So far, major market indices are up for January, with the S&P500 up 6.6%, the Nasdaq up 10.7%, and the Bloomberg Aggregate Bond Index (AGG) up about 2.7%. Ongoing headwinds continue to impact the economy and financial markets; however, the COVID-19 pandemic has become less of a concern. We will continue to feel the lingering economic effects of the pandemic during 2023. Other global issues which have hindered the economic landscape are global supply chain issues as well as geopolitical issues including the Russia-Ukraine war and tensions between the U.S. and China. Additionally, two of the most prevalent issues remain: higher inflation and Federal Reserve policy.
In summary, PlanVest believes 2023 will remain volatile, with potentially lower economic growth and the risk of entering a recessionary period. We believe it is prudent to remain defensive in investment allocations. While 2023 may not be as difficult for markets as 2022, we believe things could get worse before they get better, and continued caution is warranted.
Fed Reserve Policy
On February 1st, the Fed raised interest rates 0.25%, down from 0.50% on December 14th, and the four consecutive 0.75% hikes from June to November of last year. These more moderate recent rate hikes suggest that the Fed is closing in on its indicated peak fed funds rate of around 5-5.25%. Once this “terminal” rate (the rate at which they stop increasing rates) is reached, it is expected that rates may remain elevated at this rate for much of the remainder of 2023. As we discussed in our last market update, this is an attempt to curb inflation which has remained stubbornly high. However, inflation is beginning to ease, as the rate dropped from a high of 9.1% in June to 6.5% in December of last year. The Fed’s inflation target is 2.0%.
The Fed is trying to walk the fine line between slowing economic growth enough to reduce inflation, while at the same time avoiding a recession—a feat known as achieving a "soft landing"—but historically this has been difficult to achieve. It appears that it is only a matter of time until labor markets should weaken, and we see a recessionary move up in the unemployment rate. In fact, the Fed told us in its own September forecast that a recession is expected: The central bank's latest expectation for 4.4% unemployment in 2023 would be a 0.7% increase from the December 2022 rate. Slack in the labor market could help put further downward pressure on inflation, allowing the Fed to potentially pivot towards a more growth-oriented policy. Depending on how the timing of things unfold, we could potentially see better days later in the year.
However, recent developments have challenged these expectations. The January unemployment numbers came out last week and show over 500,000 new jobs added and a reduction of the unemployment rate to 3.4% (a 53 year low). If this strong labor market persists, it will make the Fed’s job of reducing inflation more difficult and may lead to more interest rate hikes than expected.
In the event of a recession later this year, the consensus is that it will be relatively mild. Major economies around the world are in different economic stages, and growth in certain economies and sectors could help lessen the impact on other countries which may be in or near recession. This is in stark contrast to the “all at once” global recessions of 2008-9 and 2020.
As indicated above, when the leading economic indicators (measured on a 8-month, rearward-looking, percentage basis) drop below 0%, recessions have historically followed. Currently, the reading is around -4%, leaning toward recession.
Chinese authorities have ended the zero-COVID polices that have held them back for the past two years. Consequently, the MSCI China Index rose 29% last November, compared to just 5% for the S&P500. This Chinese outperformance has propelled emerging-market stocks higher. The emerging market fund, Fidelity Emerging Asia (FEAAX), was up over 10.8% in January. However, some analysts fear the abrupt and unexpected Chinese reopening could be a headwind towards getting global inflation under control.
After over a decade of modest performance and yields, and a historically poor 2022, this year may be the year where bonds become more attractive to investors.
Our optimism about bond returns for 2023 is based on three factors:
- Yields are the highest in many years—in both nominal (before tax and inflation) and real terms (after tax and inflation).
- The bulk of the Fed tightening cycle is over; and
- Inflation peaked last June and is expected to decline further.
In the bond market, yields have become more attractive relative to other income investments. A portfolio of high-quality investment-grade bonds—such as Treasuries and other government-backed bonds, and investment-grade corporate bonds—are yielding in the vicinity of 4% to 5% annually. In addition to the currently attractive yields, coupons have continued to increase.
Remaining Focused on Quality and Downside Protection
At least until the economy begins to stabilize, investment strategies should stay focused on quality-based factors. We prefer value stocks (but still maintain exposure to growth-oriented stocks), dividend payers, and high-quality fixed income.
Currently, around 15-25% of our strategies have downside-protected positions. As the year unfolds, and things potentially improve, we will consider moving from these hedged positions back to their unhedged counterparts. We added significant positions in several hedged ETFs and a mutual fund (JPMorgan Hedged Equity – JHDAX). These equity funds follow consistent options trading strategies around their underlying holdings to protect against downside risk, while still maintaining strong upside potential.
If you have any questions or concerns, please contact us at any time.
Your PVF Team
1 Federal Open Market Committee, "Summary of Economic Projections," September 21, 2022.