2023 Outlook:

Low Expectations Are

Easier to Beat

While we expect volatility to remain in both stocks and bonds, stocks have better valuations and bonds have better risk and return characteristics compared to the start of last year.
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After a turbulent year in both stock and bond markets, investors are looking forward to a new year that could see many of the headwinds from 2022 start to subside. Nothing is certain, and timing is always a question, but inflation is widely expected to ease at some point next year, and the U.S. Federal Reserve (Fed) would then follow suit by pausing and possibly lowering interest rates.

Why a U.S. Recession Should Be Mild

Before we start to beat expectations, it looks as though we may see a recession. Looking at leading economic indicators, the risk of a recession increases midway through 2023. The good news is that we expect a potential recession to be mild. Consumer balance sheets are strong and consumer debt levels are manageable. And the labor market, which will likely continue to weaken, remains strong. Currently, there are two job openings for every person looking.

Investors have already largely accounted for the possibility of a recession by discounting asset prices. Economic growth estimates and corporate earnings projections have been lowered, setting the bar for the economy and companies to exceed expectations.
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Setting the Bar Low

This could ultimately create better entry points for investors for both stocks and bonds. Stock valuations were high going into 2022 and are now near their 15-year averages. If inflation does moderate, companies may choose not to lower prices as much and thus increase their profit margins as their costs may come down, but their prices stay stable.

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Source: Cetera Investment Management, FactSet, S& Global. Data as of 11/11/2022.

A Brighter Future for Bonds

Bonds also have better risk-and-return characteristics now. Bond indexes that track the overall bond market have lower duration and higher yields. This means lower interest rate risk and more compensation for that risk. If yields continue to rise, the higher yields can cushion more of the price declines. Likewise, if yields fall on lower inflation expectations, bondholders could see price appreciation of their bonds along with healthier yields compared to the start of this year.
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Source: Cetera Investment Management, FactSet, Bloomberg. Data as of 11/11/2022.

Will the Fed Pivot?

Volatility is likely to remain in this Fed rate hike cycle. We will continue to look for clues in economic data such as moderating inflation and pay close attention to what Fed officials are saying. However, it is possible that we could be nearing the end of the current tightening cycle. Inflation data is backward-looking, and there are signs inflation could slow more quickly in the future, raising the risk the Fed may be overtightening financial conditions.


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