As 2022 comes to a close, real risks persist. China is still struggling with the economic impact of Covid-19. Crypto companies here in the U.S. have imploded. The Ukraine war is ongoing, disrupting global food and energy markets. Last, but certainly not least, inflation remains at a 40-year high, which has left both stocks and bonds in a bear market. Given all this disruption, there are many questions and worries about what’s in store for the economy and markets in 2023.
As citizens, as workers, and as family members, we question whether we’re headed for a recession. If so, what would that mean for us and our loved ones? As investors watching the markets after a difficult 2022, we want to know whether we will see a rebound—or more declines. And with everything that is happening, we’re concerned that things might get even worse, a repeat of sorts of The Great Financial Crisis. In other words, worry levels are high, coloring everyone’s outlook on the year ahead.
Still, there’s reason to believe that things are not nearly as bad as many headlines suggest. Yes, we do face risks. But the economic and market fundamentals are much stronger now than they were at the start of 2022. That strength should limit the risks and provide more opportunities in 2023.
The Economy: Recession Worries Abound
Many of the recession headlines we’re seeing revolve around inflation and the Fed, which continues to raise interest rates as we end 2022. Given those two factors, we can expect substantial economic slowing. Indeed, this slowdown is already apparent, especially in housing (see Figure 1).
The economic effects of interest rate hikes can take a year or more to show up in the economy. If those effects are severe enough, a recession is very possible sometime next year. Here, it’s important to keep in mind that not all recessions are severe. If we do get a recession in 2023, it is likely to be both mild and short-lived. The reason? Consumers and the job market.
The consumer and jobs. When discussing the outlook of the economy, the consumer plays a central role. After all, consumer spending accounts for more than two-thirds of the economy. But consumers can’t spend if they don’t have an income and confidence, so the job market is an equally important factor. Given that, generally speaking, a severe recession isn’t possible without a pullback in both jobs and confidence. The good news is that both remain strong.
Job growth over the past 12 months was more than twice the level typical of past expansions. Plus, there are more than 10 million open jobs. While the labor market does seem to be slowing, it has quite a way to go before it hits recessionary levels (see Figure 2). With that cushion, we are not likely to see a recession until the second half of next year, if then.
Confidence has also pulled back, but it remains high based on historical levels. People are making money and spending money—this will provide economic support, even in the face of higher rates.
Business confidence and investment. Driven by both consumer spending and the strong labor market, business confidence and investment also remain healthy. While we see slowing (and, as mentioned, may see a recession), the economic fundamentals remain surprisingly strong.
Inflation and interest rates. If the economy continues to grow, those strong fundamentals could well keep inflation high and keep the Fed hiking, leading to a worse recession. This outcome is a possibility—but it’s not what the data is telling us.
Inflation appears to have peaked, with most of its components turning down, and that trend is likely to continue. The Fed will likely keep hiking interest rates. But both the pace of those hikes and their ultimate peak will begin to subside as inflation starts to ease.
As 2022 ends, we see that scenario not only in the inflation data but also in the bond market, with the yield on the U.S. Treasury 10-year note peaking and then rolling over. That peak in rates likely reflects an impending slowdown but also indicates that the interest rate damage may be topping out as well. All of that provides a good foundation for markets.
The Markets: Risks and Opportunities
Much of the damage to financial markets in 2022 came from higher interest rates. If rates peak, the damage will subside. And if rates start to decline? Markets could see a rebound.
Bonds. The declines in bond values in 2022 were linked directly to higher rates. As rates moderate, those declines are unlikely to repeat. Beyond that—and for the first time in years—bondholders are now being paid competitive rates of interest. So, while the bond market took a big hit in 2022, the year ahead is likely to be substantially better.
Stocks. The picture for stocks is more complex—but still relatively positive. Stocks also got hit by rising interest rates, as valuations (which depend on rates) dropped. That said, we entered 2022 with valuations at very high levels. We’ll be entering 2023 with valuations at a much more reasonable place: not cheap, but in line with historical averages. From a valuation standpoint, the risk to stocks will be much lower next year.
With valuations reasonable, the results for stocks will depend largely on how corporate earnings play out. Again, the headlines are discouraging, as analysts have downgraded expectations. Beyond the lower sales a recession would generate, there are concerns about corporate margins, with higher wages and debt service costs likely to hit the bottom line. Even if valuations hold, lower earnings are a headwind for stocks.
Here, there is some good news, as wage growth and interest rates appear to be peaking. As such, the damage may be less than expected. Typically, analyst expectations are too pessimistic, so this outcome would be in line with historical results. And as noted above, any recession will likely be mild. There is certainly some downside risk, but relative to expectations, there is more upside opportunity.
Will 2023 Be Better Than It Looks?
As you can see, there is much to worry about when assessing the 2023 outlook for the economy and the markets. Fortunately, those worries are largely incorporated into expectations and prices. So, if things are better than expected (which seems probable on multiple fronts), then the results should be positive as well.
After a difficult 2022, when both the economy and markets adjusted to high inflation and interest rates, supply shortages, and other shocks, the natural expectation is that things will remain bad. What we are seeing in the data, however, is that despite those shocks and the real risks, the economy is doing better than expected, and inflation is in the process of being contained. We are making progress, and that progress should continue into 2023.
Will 2023 be a great year for the economy and markets? Not likely. Will it be better than 2022? Very likely—and quite possibly substantially better. As a motto, “better than it looks” isn’t what any of us would aspire to. But as we enter the new year, it could be a lot worse.
Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Investments are subject to risk, including the loss of principal. Past performance is no guarantee of future results. This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product.
Authored by Brad McMillan, CFA®, CAIA, MAI, managing principal, chief investment officer, at Commonwealth Financial Network®.
© 2022 Commonwealth Financial Network®
Commonwealth Financial Network® or Blakely Financial does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.
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