2023 Outlook
Inflation heated up throughout 2022, prompting an aggressive response from the Federal Reserve to bring it back under control. The Fed increased short-term interest rates from 0.1% to 4.4% by year-end and signaled more increases would follow. Higher bond yields for all maturities ensued, resulting in the worst return for stocks since 2008 and a bloodbath for bonds as well. With higher interest rates and a slowing economy, most economists and many large company CEOs are currently anticipating that the economy will slide into a recession. While that scenario may sound dire, we see numerous reasons for optimism.
Inflation has been slowing significantly and appears likely to continue in that direction. On an annual basis, inflation slowed for a sixth straight month in December. The Consumer Price Index (CPI) peaked in June at 9.1% and exited the year at 6.5%, the slowest inflation rate in more than a year. Core inflation, removing food and fuel prices to get a sense of underlying price trends, was even lower at year end at 5.7%. Simultaneously, Producer Prices (PPI) plunged from 11.7% to 6.2%. Additionally, the Personal Consumption Expenditure (PCE) index, the Fed’s preferred measure of inflation, is expected to have ended December up 5.0% versus the prior year. While rapid progress has recently been made, the Fed’s goal is to return this to the neighborhood of 2%.
The Fed’s interest rate hikes are clearly generating results and therefore the Fed has become less aggressive. Fed officials increased rates by a half-point last month to a target range of 4.25% to 4.5%, slowing the pace of rate increases after four consecutive three-quarter point moves. It is widely anticipated that the Fed will only hike rates by a quarter-point next month as it continues to temper rate increases. Higher rates generally work with a lag of at least a year and therefore the Fed needs to be careful not to slow the economy too much. Interestingly, investors currently expect the Fed to raise rates only slightly more, and not by as much as the Fed projects. The bond market also anticipates that rates will start to decline before year end.
While the Fed is busy slowing the economy, the job market paradoxically remains robust. Sizable layoffs have primarily emanated from technology companies, who recently over-hired during the pandemic in anticipation of continued acceleration in growth. Due to their desirable skillsets and the tight job market, many of these laid-off workers appear to be able to rapidly find new employment opportunities. This is helped by the historically-low unemployment rate of 3.5% and subdued weekly unemployment claims. At the same time, layoffs and reduced hiring appear to be negatively impacting wage growth and helping to reduce inflation, just as the Fed intended.
Increased inflation and a slowing economy have not decimated corporate earnings. However, dire economic predictions and uncertainty, combined with higher interest rates, have weighed heavily on stock valuations (i.e., what investors are paying for those earnings). Focused on earnings estimates for the coming year, the forward 12-month P/E ratio dropped by 22% during 2022. The ratio finished the year at 16.7x, which is below both the 5-year and 10-year averages at 18.5x and 17.2x, respectively. Amazingly, the multiple paid for growth stocks plummeted by almost a third during the year. Investors were very pessimistic in 2022, as contracting valuation multiples caused a bear market in stocks while earnings held up surprisingly well.
We enter this year in better shape for both stocks and bonds than many would realize. The primary concern has been inflation, which is cooling. The Fed has already scaled-back the magnitude of its interest rates hikes. The next step would be to reduce the cadence or halt the increases altogether, should inflationary pressures continue to wane as the full impact of recent increases has yet to be felt. Plateauing rates would likely be very beneficial for stocks, especially growth stocks, from both a valuation and earnings perspective. Historically, when the tide turns, bear markets have been followed by strong returns driven by oversold markets and improving economic conditions.
It is premature to rule out a recession, however. Many people anticipate that the Fed will overexert its slowing of the economy. That result, combined with a strong job market (even if it weakens some), would most likely make for a mild recession. In that situation, interest rates would likely be reduced and a new economic cycle would be set to begin.
While we believe the economic indicators are predominantly headed in the right direction, uncertainty remains in the near term. Investors quickly interpret and react to many data points, adding to volatility. Looking beyond that, many of the potential paths the economy may take this year lead to positive outcomes for financial markets.
Holger Berndt, CFA
Director of Research
hberndt@rssic.com
