Investing Outlook for 2023 as Fed Looks to Pivot
Previously, we suggested a weaker dollar may not lead to the bullish outcomes many investors expect in 2023. We will build on that thesis in this article, and bonds will win in the first half of 2023 and stocks in the second half.
The big question heading into 2023 is the dreaded word. Can the U.S. economy avoid a amid the most aggressive rate hiking campaign by the Federal Reserve since 1980?
Anything is certainly possible. However, with economic activity impacted by higher rates and inflation, the odds of a recession seem elevated. Such was a point made in the previous article, stating:
declines.”
Monetary Conditions Index vs Dollar
Of course, the inversion of 80% of the ten economically important yield curves also suggests a recession is likely.
Yield Curve Inversion Chart
The inverted yield curves play an essential role in our 2023 portfolio positioning. While many hope the Federal Reserve will ,” such may not be as immediately as many expect.
The Un-Inverting Yield Curve
In “The Policy Pivot May Not Be Bullish,” we explained:
The last sentence is key.
So far, investors have mostly overlooked the rate shock impact on the real economy. However, the Fed’s aggressive rate hikes have collapsed the composite Economic Composite Index and the 6-month rate of change of the Leading Economic Index. These indicators are strong leading indicators of economic slowdowns and recessionary onsets.
EOCI Index vs LEI Chart
As noted recently by BofA, investors are ignoring the risk of aggressive rate hikes on three assumptions:
- The “Fed Always Blinks”
- “Stocks Always Go Up”
- “Tech Always Leads Stocks Higher”
These assumptions are not surprising given the last decade of monetary policy interventions each time the market hiccuped. However, the difference today is inflation is at its highest level since the 1970s. The Fed remains clear it will continue to hike rates and keep them there until its inflation battle is complete.
The problem is that such will lead to two eventual outcomes, neither supportive of being
The first is the still-coming impact on earnings and profit margins. Since early 2022, we warned earnings estimates to remain excessively high relative to what the economy will generate in 2023. With rates and inflation eroding economic activity, forward earnings estimates must adjust lower. As such, stocks will have to reprice lower as well. The Economic Composite Index, as noted above, confirms the same.
EOCI Index vs Earnings
The second is the UN inversion of the yield curve.
Why Bonds May Be The Best Asset In 2023
Our investment strategy for 2023 remains predicated on what happens when the yield curve UN-inverts. Interestingly, this un-inversion is part of the investor’s primary belief that the
The most likely outcome of the Fed’s most aggressive monetary campaign in history is a recession. Such would lead to an immediate policy reversal. Crucially, the Fed controls the short end of the curve, but the economy and inflation control the long end.
Therefore, as the recession takes hold, interest rates will decline on the long end of the curve. However, such will lead to a deeper reversion in yields until something . Only then will the Federal Reserve begin to cut rates.
Yield Curve 10-2 Spread
As yields fall, the race will be the Fed cutting rates faster than the long-end declines to boost monetary accommodation to offset recessionary pressures. Such is why, as shown below, Fed rate changes
Fed Funds Vs Financial Crisis
Of course, as yields plummet, bond prices rise as investors seek the over ” as the equity market reprices for recessionary outcomes.
Such leaves the real opportunity to buy stocks coming later next year.
What If I’m Wrong
In virtually every professional field, there is
Profession Risk Table
Those who fail to focus on and recognize the inherent risk, more commonly known as tend not to be around very long in any given profession. What always separates the are those that can avoid catastrophic damage over time.
While a recessionary outcome, given the magnitude of rate hikes by the Federal Reserve, seems to be the most logical case, there is always the something else could happen.
If I am wrong about a further earnings decline, and the economy avoids a recession, then the market is likely more reasonably priced than not. Such would also suggest investors are closer to the equity market lows than not.
However, there is a problem with that scenario. In a non-recessionary environment, the Fed won’t be cutting rates . In that scenario, the labor market will remain resilient as inflation stays elevated, albeit at lower levels.
Should such turn out to be the case, it would still seem that earnings, and profit margins, will continue to get pressured between high borrowing costs and inflation, still suggesting downside risk to asset prices.
Such is the problem with current earnings estimates, which remain deviated above their long-term 6% annualized growth trend.
S&P 500 Earnings Growth Trend
Throughout history, earnings regularly revert to the long-term growth trend, if not beyond it. The risk of a reversion was not expected in 2020 either before it came. I suspect 2023 may be no different.
S&P 500 Earnings Vs Growth Trend
While bonds will likely be the best asset class during the first half of 2023 as the yield curve un-inverts, equities will probably bottom in the second half as the bear market ends.
As Nobel laureate Dr. Paul Samuelson once quipped:
“Well, when events change, I change my mind. What do you do?”
