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Can the Fed Stick the Landing?
2023 Investment Outlook
In 2022, inflation spiked around the world because of supply chain constraints, massive pandemic-era fiscal stimulus and the war in Ukraine. As the Federal Reserve implemented the steepest series of interest rate increases since the 1980s to try to stop the inflation surge, financial assets suffered across the board. The S&P 500 lost nearly 20% of its value while the tech-heavy NASDAQ lost 33%. Overall, stocks had their worst year since 2008. But while stock indexes are often very volatile year-to-year, what really shocked investors in 2022 was the meltdown in the bond market. With inflation raging and the Fed pushing up short-term rates, bonds cratered. (As interest rates go up, bond prices go down.) The U.S. Aggregate Bond Index lost more than 13% and long-term U.S. Treasuries lost 29%. By some measures, it was the worst year ever for U.S. bonds. Good riddance to 2022…
Some Reasons For Optimism
As we enter 2023, investors have reasons for optimism. Inflation has been on a shallow but relatively steady decline since the end of summer and many market participants are anticipating a Fed “pause” when the central bank says that it believes it has done enough rate-hiking to get inflation under control. Stocks and bonds both tend to perform very well in the period after the end of a Fed rate-hiking cycle. Thus, the key question for investors in 2023 is: Can the Fed keep inflation dropping towards its 2% target while not at the same time pushing our economy into a painful recession? Many strategists are expecting a modest recession this year, but it would be a strange one given how close the labor market still is to full employment. In the ideal scenario, Chairman Powell and the Fed would guide the economy into a mere slowdown (the so-called “soft landing”) and avoid an economic contraction altogether while still achieving their goal of 2% inflation.
But Prices Likely To Stay High
High prices are likely here to stay, whatever inflation does. This is because the rate of inflation, as derived from the Consumer Price Index (CPI) does not measure the absolute level of prices. Instead, it measures the year-over-year rate of change in prices. Thus, while inflation may edge down toward the Fed’s 2% target as we approach the end of the year, prices, in aggregate, are not likely to decline much, if at all, in absolute terms. Like toothpaste out of a tube, it is hard to reverse price gains without a grinding recession. And because wages have not kept up with inflation in recent years, this means that consumers’ discretionary income will be crimped in 2023, dampening overall economic activity.
And Corporate Earnings May Be Muted
Most strategists on Wall Street are expecting 2023 corporate earnings to land in a range of about +5% to -5% from 2022. Investors would be likely to receive very positively a scenario of flattish earnings in 2023, peaking interest rates and the prospect of an improving economy in 2024. Thus, 2023 market performance will probably hinge more on how the outlook for 2024 develops as we go through 2023. Investors should remember, however, that equity prices are a function of two inputs: earnings growth and changes in price-to-earnings multiples. With earnings growth likely to be muted and price-to-earnings ratios not likely to expand in the near term (at least in our view) we are not looking for a return to market highs in 2023. If Powell and the Fed stick the soft landing, however, investors are likely to become more constructive on both bonds and stocks.
Please contact us at 619-319-0520 or email@example.com if you would like us to review your financial situation.
*Image: swedishmonica from Getty Images via Canva.com
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