Strategy and Positioning written by Steve Orr, Chief Investment Officer

As of market close December 23, 2022. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

Outlook 2023

Heading to the finish line for 2022, it’s time for a checkup and a look ahead. In early January we will review 2022 performance, what went right and what went wrong. Until then, let’s put on a happy face. Last week’s action was typical of holiday weeks. Most desks were lightly staffed, and news tended to have an outsized impact. The one surprise was the final revision to the third quarter Gross Domestic Product. Real (inflation adjusted) growth ran at an annual rate of 3.2% versus earlier estimates of 2.9%. If the fourth quarter could scrape together a 2.5% growth rate, then 2022’s full year GDP would be close to 2%. 

Three percent growth sounds like a welcome reprieve from 2022’s first half negative GDP numbers. But this is a Fed tightening cycle, and all good news is “bad.” Stocks look at good news as forcing the Fed to raise rates higher for longer and sellers turned out in force last Thursday. December now has three down weeks in the books. Friday’s mild half percent rally was actually a good start to a Santa rally. Recall most Santa rallies start the day before Christmas and run through the second trading day of January. They average about 1.5% gains, not near enough to assuage this year’s pain. 

Starting line

What does the landscape look like to start the New Year? Around the globe, recessions are in the air. Purchasing Manager indices are highly correlated with future stock prices. Nearly every developed country has had falling survey scores for at least three months. Most manufacturing PMIs are in month-over-month contraction. New factory orders, same story. As a result, commodity and raw material prices have rolled over on falling demand. 

China is trying to stop the close/reopen virus carousel. The anecdotes we are hearing from people inside the country suggest the economy will take at least the first quarter to get going again. We expect China to be the global growth leader in 2023, possibly breaking 4%. 

Europe is in at least a mild recession, driven by fuel inflation, war costs and falling demand for their exports. There are not many bright lights for growth on the continent. Labor unrest around Paris and strikes in the U.K. mean first-quarter activity will be below trend. Full-year growth should contract in the Eurozone by one percent. 

The U.S. is not in a recession as we end the year. The inflation rate peaked earlier in the year, retail sales, manufacturing and construction all continue to slow. Consumers are in relatively good shape, but have used up their stimulus checks, as rising credit card volumes show. Company balance sheets are also in good shape. Labor availability and cost remains an issue. 

Later

Here at home, we expect a recession later in the year. Last fall we gave some chance to a winter recession. Despite falling manufacturing activity and a slight uptick in jobless claims, our economy enters 2023 in better shape than we anticipated. Think of the last three years' swings in the economy as striking a bell. One tap of the bell by the hammer (shutdowns) caused swings in both directions, big down followed by a big up (+6% GDP 2021). Over time the sound of the bell dissipates. That is what is happening here and abroad. 2022’s likely 2% growth will be followed by flat to barely positive growth in 2023. Growth should accelerate slightly into 2024 carrying the economy back to its pre-pandemic growth rates of 1.5% to 2%. 

The first half of the year may see slowing growth as the effects of higher interest rates take hold. Figure continued positive growth for the first quarter and flat in the second. Consistent with history, no recession has started in the first half of a pre-election year. The Most Anticipated Recession Ever will have to wait until the third quarter and likely carry through to the end of the year.

Drivers

Twelve central banks convened policy meetings in December. All save one are in rate increase mode. Many are just trying to keep up with our Federal Reserve. Only the Bank of Japan is in easing mode, and after decades of disinflation, the Bank’s goal of 2% inflation is in the rearview mirror. Japan’s current CPI level of 3.8% may be half of ours, but it is a sea change for that country’s consumers. 

The Fed will continue to raise interest rates until the nominal Fed Funds rate is at or above inflation. The Committee has changed focus a couple of times over the last two years, using Personal Consumption Expenditures and then headline CPI as its inflation gauge. Remember that headline CPI is heavily influenced by gas prices. Both measures have already peaked and will slowly decline in the first half of the year. Lower housing prices, accounting for nearly a third of CPI, will begin to impact inflation in the April to May timeframe. Next year, inflation should coast lower to between 4% and 5%. Well above the Fed’s 2% goal, of course, but finally equaling the rate increases the Fed should make over the next several months. 

Wage growth is the Fed’s target to pull inflation lower. By raising borrowing costs for everything, the Fed hopes to soften demand. In turn that should cause layoffs to rise and give employers more bargaining power. The Fed would like to see the unemployment rate rise a full percent to 4.7%. That would imply 1.7 million people lose their jobs over the next year. Given how hard it is today to find people, we wonder if companies are not more reluctant to let folks go. Several tech firms have announced layoffs, but that may be driven more by soft demand due to lower orders than just higher funding costs. We do believe layoffs will increase later in the year, but the job picture will stay stronger than Fed forecasts, barely breaking 4%. 

Commodity prices certainly grabbed headlines last year. The strong dollar pushed gold lower in dollar terms, as it has in the past. Oil supply dominated the headlines last year, in 2023 it will be demand. Uneven China reopening and Euro recession will keep a lid on prices in the near term. A weaker dollar as the “MARE” gets closer, combined with OPEC+ supply discipline should provide a floor to crude prices later in the year. A wildcard for both oil and grains would be a settlement in the Ukraine war. 

Pattern?

The current Bear cycle is somewhat unusual. The typical mid-term election year pattern sees stocks bump along through the spring, fall double digits and then rally after the election. U.S. indices did rally briefly in November but did not follow the historical pattern. Earnings growth fell quarter over quarter through the first three quarters but stayed positive. No earnings recession means most of 2022’s stock price decline points toward higher interest rates than any other factor. 

Non-recession Bear markets typically end after about a half year. This Bear cycle is clearly not over. Leading indicators, PMI surveys and the inverted yield curve suggest that recession is still a high probability and there is more volatility ahead for stocks. The small probability exists that “this time will be different” and a rolling or very mild recession will not crimp earnings more than a few percentage points. If that were to happen, then the lows were put in last October. A recession would mean stocks break lower before a sharp rebound later in the year. 

Reviewing prior pre-election year patterns of the S&P 500 shows a different story. Most pre-election years have moderately positive months to start the year, a rally in the middle and a flat to negative fall. A repeat would actually fit a “Fed stops; Recession follows” narrative fairly well. Our handy Stock Trader’s Almanac states that all pre-presidential election years since 1949 average double-digit gains. Since 1915 in pre-election years the Dow Jones Industrials finished in the red three times: 1931 (Depression), 1939 (War) and 2015 (Bear ending that February). Back-to-back negative years for stock market performance are rare. The last were 2000 (Y2K) through 2002 and the worst was the Depression stretch of 1929 – 1932. Very few of the economic conditions then are present today. 

History tells us that stock markets have not bottomed before a recession starts. Remember that stocks anticipate turns in the economy six months to a year on average. A rally in the middle part of 2023 as recession takes hold is not out of the question. If the Fed does increase rates at two or three more meetings to the 5.25% range and pauses, and a recession starts mid-year, stocks could see through the other side to future improving earnings.

Too high

As of mid-December, Wall Street estimates for S&P 500 operating earnings in 2023 averaged 13.6% year-over-year growth. We are getting neck strain from shaking our heads “No!” Ned Davis Research reports that since 1984 consensus estimates going into a new year average about 8% above what is actually reported in the year. So, whether a mild or severe recession, earnings estimates are coming down. Just taking the average gets us down to 5% growth, or right around the average inflation forecast for next year. On a real basis then, earnings for the S&P 500 would be about flat from 2022’s levels. 

The relatively high inflation levels of the past two years have made sales and profit growth look better than they are. Profit margins are coming down from record highs, suppressing earnings growth. Strikes in the U.K. and stalled contract negotiations with longshoremen and rail workers here in the U.S. put focus on wage costs. If sales stall in a recession just as wages rise with new contracts, then earnings margins will get squeezed more than markets expect. 

We expect the first two quarters of 2023 to produce earnings drops of around 5% over their 2022 counterparts. Earnings should improve as the recession clouds part later in the year. Pencil in 3% earnings growth for the year. If 2022 earnings for the S&P 500 reach $215 per share, then 3% growth should boost per-share earnings to $221.50. At a recession level P/E of 15x, that works out to an S&P 500 level of around 3,330, or about 14% below today’s level. Multiples lead earnings out of recessions, typically by about two to four times. 

Falling inflation, a recession that ends in the second half of the year and Fed stopping rate increases would drive that boost in price to earnings. A 19x multiple on full-year earnings of $221.50 yields an S&P 500 year-end level around 4,210. That would represent a 9% return from today’s levels. 

Rates

Interest rates are a real and nominal story for 2023 (inside bond joke there). Real rates are the interest amount you have left over after subtracting inflation. When real rates are negative, debtors can pay back loans in smaller “dollarettes,” thanks to inflation eroding the currency’s purchasing power. Real rates are and have been negative for most of the last decade. The European Central Bank kept its nominal overnight rate at -0.5% until the second half of 2022. Today’s 10-year U.S. Treasury yield of 3.85% is still well below November’s CPI reading of 7.1%. This means that despite the Fed’s raising rates at the fastest clip since 1981, monetary conditions are still relatively easy. 

The Fed should finish raising rates this coming spring. Markets believe the Fed will start lowering rates later in the year. Remember that markets want easy monetary conditions and low interest rates. By pricing futures that indicate the Fed dropping rates, markets are saying “we want a severe recession that is so bad it scares the Fed  into cutting rates.” Not the nicest thought. In prior tightening cycles the Fed stayed put at the highest rate level for seven to nine months before the first rate cut. Is the damage done by 2022’s increases bad enough that the Fed will cut in mid-2023? Job openings at 10 million plus and below 4% unemployment argue against that happy thought. 

We take the Fed at their word: rates will move to at least 5%, possibly 5.25% and stay higher for longer. At even 5%, as inflation falls later in the year, real rates will become positive, tightening monetary conditions further. In past tightening cycles the real Fed Funds rate has risen to at least 2.5%. That would imply inflation falling to near the Fed’s 2% target, which we would not expect to happen before late 2024. 

Thanks to continued Fed rate increases, for sure at the next two meetings in February and late March, short maturities in the yield curve are well above long-dated bond yields. When 3-month Treasury Bill yields, currently at 4.4%, are above 10-year Treasuries (3.85%), recessions usually follow within a year. If the Fed’s increases do top out at 5.25%, then bond yields need to follow the Fed higher. Granted, much of the price damage in bonds was suffered in 2022, one of the worst years for bonds since their indices were created. Along with stock volatility, expect the bond journey to be rough the first several months of the year.