After a year full of surprises, we look ahead to 2023 prepared for even more. The two “shuns”—inflation and, increasingly, recession—form the heart of our questions for the global economy and markets next year. What path will they take? And, if they do take the world by surprise, which direction seems likeliest?
Having turned the page on 2022, we look ahead to what the global economy and markets may hold in store for 2023:
- We expect a significant slowdown in global economic activity, with recessions likely in the US, UK, and Continental Europe as global central banks tighten policy.
- With markets pricing in much of that slowdown and a likely decline in earnings, our base case calls for US stocks to largely remain rangebound.
- While we maintain our slight long-term overweight to the US equity market, we emphasize the importance of international exposure.
- Fixed-income markets look unusually attractive, with higher yields and wider credit spreads augmenting the return potential.
- Private alternatives such as private credit, private equity, and real estate could provide meaningful opportunities for investors.
We craft this outlook knowing the real world will inevitably surprise us. Nonetheless, in what follows, we highlight the critical data points and assumptions driving our views and our positioning as we enter the new year.
Global Economic Outlook
For most developed economies, inflation remains the key driver—for now. Yet, as we move through the year, we believe policymakers and markets will increasingly focus on deteriorating growth. We would not be shocked if the question for global monetary policy has shifted by the end of the year from “Where will the rate cycle peak and when will we get there?” to “When will rate cuts begin?”
In the US, the goods inflation from the pandemic (with added fuel from Russia’s invasion of Ukraine) has given way to more widespread services inflation. That has become an ongoing concern since services account for two-thirds of the US economy and inflation concentrated there tends to be more persistent.
Housing remains a critical area, as rents continue to reset at higher levels despite home prices peaking in June 2022. Shelter represents around one-third of the consumption basket in CPI calculations, and even for homeowners, observed rent increases serve as a proxy for monthly changes. Historically, we’ve seen a lag of around 15 months between the peak in house price inflation and a peak in the CPI’s shelter inflation measure. To that end, we expect several more quarters before the Federal Reserve can breathe a sigh of relief that rate hikes have had their intended effect (Display). In the meantime, we anticipate a 25 or 50 basis point increase in February followed by at least one rate hike after that before the Fed presses pause, putting the terminal rate around 5%.
That said, goods inflation has meaningfully receded as the supply chain issues and supply-demand imbalances that drove inflation earlier on have eased or reversed. Moving forward, while we remain on guard for signs of reaccelerating inflation, we also need to watch for evidence of disinflation or even deflation in certain areas.
Given the sharp rise in interest rates this cycle, our economic base case calls for inflation to gradually dissipate over the course of 2023, with economic growth declining as well. We expect growth to slow enough that a recession can be assumed. Not all recessions are created equal; while recent recessions have been deep, there is precedent for a shallow and brief recession. More importantly for investors, this Fed-induced slowdown will have a notable effect on both corporate earnings and sentiment. We estimate earnings will decline 5% in 2023 versus 2022.
In our more pessimistic bear case, the Fed’s policy and that of other global central banks—as well as increasingly conservative corporate and consumer behavior—combine to tip the economy into a more serious recession. Earnings drop more substantially (down ~15% from 2022), approaching something more closely aligned with a typical recession. On the other hand, in our bull case, the Fed lucks out and achieves something resembling the elusive “soft landing.” Here, inflationary pressures ease more rapidly than expected and without an economic contraction.
Around the World
Continental Europe and the UK face many of the same economic pressures and themes as the US, but more acutely, with inflation currently running at 10% in the Euro Area and 14% in the UK (Display). Having suffered a more direct hit to energy and food supplies in the wake of Russia’s invasion of Ukraine, Europe’s central banks face even more of a challenge in responding to inflationary forces.
We anticipate a deeper recession in continental Europe compared to the one we expect in the US. The UK is arguably in the worst position of all developed economies, and we foresee an even more damaging recession there.
Japan stands out as one of the most interesting cases across the globe—it should outpace other developed economies while also continuing to benefit from lower inflation. What’s more, the Japanese yen has risen by 13% since October, after falling 30% against the dollar in the 10 months prior to that. The yen’s weakness relative to a year ago could benefit Japanese exports in the near term, though we ultimately expect the yen to continue strengthening in the coming years. We’re also monitoring the country’s banking sector for signs of interest rate or credit risk challenges.
In China, the greatest question centers around the country’s reopening. Chinese policymakers have finally eased the highly restrictive lockdowns they’d previously relied on for COVID control, which would seemingly bode well for growth. However, poor vaccination uptake among the elderly and rising case counts could spark a policy reversal. Pacing will be important too. Reopening too slowly could keep supply chains snarled while harming economic growth. Yet reopening too quickly could constrain supply in the face of rebounding demand—much like the rest of the world experienced in 2021. In the process, inflationary pressures could be exported to other countries, including major economies whose central banks are already working hard to tamp it down.
The economic prospects for other emerging economies continue to fall along two lines—whether a country imports or exports commodities and the degree of exposure to a strong US dollar. Last year favored commodity exporters, who benefited from global inflation. Countries with limited dollar-denominated debt or imports also outperformed, as the strong dollar took a wrecking ball to those most vulnerable. The outlook for 2023 will depend greatly on whether inflationary pressures remain stubborn—either on their own or as China reopens—and whether the strong dollar persists.
Asset Allocation Implications
As unfortunate as 2022 has been for asset values, the combination of higher interest rates and lower stock market multiples sets up higher long-run expected returns. While lower valuations have little statistical impact on returns over the following year, over longer periods, they have considerable predictive power. With that said, over the near to medium term, investors should expect ongoing volatility.
We believe that time horizon and risk tolerance will be particularly important for investors in 2023. Stock market returns over the next two or three quarters could differ materially from their performance over four or more quarters. This is most notable in our economic bear case, as the inflation and growth backdrops slowly come into focus.
Should our economic base case for the US materialize, we would expect a largely range-bound stock market in 2023, potentially ending in line with year-end levels. Even in our economic bull case, limited earnings growth and little room for multiple expansion could keep the market from moving substantially higher (Display).
What’s most surprising, though, is our economic bear case. As you might expect, stocks would fare the worst over the near term in this scenario as a recession leads to a material decline in earnings. Historically, during most recessions, the Fed has stepped in to cut interest rates. Their intervention puts a backstop under both the economy and stock market multiples, which are driven by rates and risk appetite. Yet investors relying on the same playbook this time around may be in for a surprise if the Fed needs to prioritize containing inflation over responding with quick rate cuts. Indeed, our fixed income team notes that it’s easier to tame inflation going from 8% to 5% than from 5% to 2%. Depending on the magnitude of the decline in earnings and the Fed’s determination to reach their terminal rate, stocks could face some tough sledding.
But here’s the paradox. Because we believe inflation will continue to fall, we think the Fed will eventually have the ability to once again cut interest rates in a downturn, though we can’t predict when. Reaching that turning point would impact market multiples and spark hopes for an earnings rebound—likely fostering a better backdrop in 2024 than if the Fed were to hold steady at their terminal rate for the next year or longer.
2022’s volatility proved conducive for stock-pickers, with around 57% of actively managed large-cap funds beating their benchmarks through the end of November. We think 2023 will favor active management too. Our portfolio managers see strong opportunities for security selection coming into the year, with the potential to identify relative winners and losers within sectors. In equities, we’re most positive on sectors that have avoided extended valuations while being best suited to the current economic backdrop—namely communications and healthcare.
We consider energy intriguing, given the tight balance between near-term supply and demand and ongoing, producer-led capacity constraints. What’s more, China’s reopening could stoke a substantial level of global demand, and valuations sit near their lowest levels relative to the market in decades. At the same time, an improvement in the war in Ukraine could work against the sector. Furthermore, energy stock returns—which are typically highly correlated with oil price returns—have outperformed the commodity recently, potentially offsetting an otherwise attractive setup.
We’re wary of the industrial sector—where high valuations are out of step with the business cycle—as well as consumer discretionary and financial stocks. Nonetheless, even in these areas, idiosyncratic winners could emerge. Consumer staples may have already factored in this well-flagged economic slowdown and their valuations may leave them less defensive than they would be otherwise.
In terms of factors, we’d advise caution when it comes to momentum. Here, we’re wary of being whipsawed by either the range-bound markets we’ve articulated in our base and bull cases, or by the dramatic, fast moves we’d expect in our bear case. Instead, we see both value and growth working in this type of environment. From a size perspective, small cap stocks currently trade at extremely low valuations relative to the broader market. While they could still suffer significantly in a downturn, small caps could also be poised to rebound sharply when market sentiment shifts to risk-on (Display).
Developed International Equities
We’ve long held that equity portfolios benefit from international diversification over multi-year horizons. Currently, in our view, it continues to make sense for US-based investors to maintain a roughly 4%–5% strategic overweight to the United States versus the global equity benchmark, translating into around a 65% target US allocation. At the same time, ongoing opportunities for global diversification and security selection to add value remain worthwhile.
Currencies will likely play an outsized role for international investors again in 2023. The dollar rallying by close to 9% in 2022 created a major headwind for US-based investors’ global exposure. In fact, in local currency terms, non-US stocks outperformed the US by 10%—but the strong dollar offset that gap. Should dollar strength persist in 2023, this headwind would too. But if the dollar reverses as the Fed pauses and other central banks catch up, it could create a tailwind for international stock exposures.
While our European economic outlook is rather gloomy, earnings expectations appear fairly reflective of the economic reality there. Likewise, valuations and sentiment appear to be closer to trough levels. Relative to other international markets, our equity strategies are slightly overweight Europe and are gradually beginning to position for a turn.
Japan merits particular attention. While earlier we covered the asynchronous top-down conditions, our portfolio managers are also finding bottom-up opportunities in that market, with a wide dispersion of valuations providing fertile ground for stock-pickers.
Emerging Market Equities
China remains a major area of interest, as a source of both upside and downside risks to the global economy and markets. Relative to other geographic regions, Chinese stocks appear to trade at notably cheap multiples, but part of that stems from the anticipation of rapid earnings growth. Whether that materializes will largely depend on the pace and shape of the country’s reopening. After spending most of 2022 slightly underweight in China, our portfolio managers have been re-engaging recently as COVID restrictions have loosened.
Beyond China, the emerging markets picture will vary by country, with the backdrop defined by both commodity and dollar exposure. Several emerging market countries enjoy higher expected growth than either China or developed economies. Meanwhile, emerging market valuations stand nearly 20% below historical discounts to developed markets. Within these economies, we’re largely looking for companies and countries benefiting from specific themes such as the secular energy transition or the remapping of supply chains away from China.
Global Fixed Income
The inflationary pressures of 2022 led to one of the most painful market outcomes of the year. Rather than cushioning portfolios (as they historically have) from sharp stock price declines, bonds also fell substantially. In fact, it was the second-worst combined performance for the two asset classes in at least 40 years.
Looking ahead, the correlation between stocks and bonds will continue to pose a major question for investors from both a tactical and strategic standpoint (Display). Over the near term, we still expect the two to move in tandem more so than in the past, as inflation and central banks’ responses continue to drive returns for both asset classes.
In the event of a recession, that recent correlation could hurt investors. Bonds may not shield investors from a growth shock if central banks are forced to maintain elevated interest rates until they’re satisfied inflation has been defeated. But once central banks pivot to reducing rates, both bonds and stocks could rally. As previously noted, precisely when central banks might shift to rate-cutting mode remains a key controversy entering the new year.
Once the current bout of inflation has ended, we could see stocks and bonds revive their past return patterns. Yet since we forecast growing inflationary pressures over the coming decades—and greater fluctuation in inflation levels—we won’t be surprised to see more glimpses of positive stock-bond correlation compared to the last four decades.
While the Fed may be close to the end of its hiking cycle and a mild recession is built into our base case, we remain cautious about taking interest rate (or “duration”) risk. The bar for the Fed to begin cutting rates is extremely high and we don’t believe we’re close enough yet to justify more aggressive positioning toward longer duration. Furthermore, we continue to believe that over the long term, intermediate duration provides the most appropriate balance of return and risk.
In municipal bonds, we’re avoiding the short end of the curve where the relative returns seem poor. Within taxable bonds, we’re focused on the three-to-five-year area of the yield curve.
Moving from interest rate risk to credit risk, investment grade credit stands out as one of the most attractive risk-adjusted returns available in the market today. That holds for municipal bonds as well as for US and European taxable bonds. In general, the elevated compensation investors are receiving for taking credit risk appears to be quite disconnected from relatively strong fundamentals, even accounting for the risk of recession.
High-yield credit requires a more selective approach. With spreads quite elevated and fundamentals still generally strong, it’s relatively attractive. In addition, certain parts of the high-yield market hold more promise than others. For instance, both US and European corporate high yield look fairly compelling, and emerging market corporate high yield grows more interesting once investors account for currently distressed assets. Meanwhile, emerging market sovereign credit suffers both from poor valuation and especially weak fundamentals.
We also see notable risk-adjusted return potential in areas of the securitized credit markets. Mortgage-backed securities and credit risk transfer securities offer relatively high yields and strong fundamentals, which can mitigate both inflationary and recessionary risks.
Alternative investments are critical elements of diversified portfolios, yet we believe many individual investors remain under-allocated to these opportunities. As demonstrated over the course of 2022, alternative assets have historically improved overall portfolio performance by enhancing return potential, reducing risk, or diversifying exposures to varying macroeconomic themes.
The long-term opportunity in middle market private equity remains robust, although we have seen deal and exit volumes impacted by valuation uncertainty and higher interest rates rippling through the markets. Despite the sharp drawdowns in publicly traded growth stocks, venture capital fundraising remained remarkably robust in 2022. We’re keeping an eye on that dry powder as well as a weaker environment for late-stage funding and exits. With markets dislocating and select players seeking liquidity, we continue to see a solid backdrop for secondary deals where enterprising investors can offer liquidity and other solutions at attractive entry points.
As regulations and capital requirements have reduced banks’ lending to middle-market businesses, we’re still finding attractive opportunities in private credit markets and direct lending deal activity remains strong.
With their floating rate structure, private market loans provide greater protection against inflation and rising rates compared to public, fixed-rate bond markets. Our investment teams—always acutely focused on companies’ creditworthiness—continue to prioritize senior secured loans in this space.
Within alternative investments, hedge funds also play an essential role. In today’s environment, we especially favor strategies with limited exposure to the overall market direction. We also lean toward global macro strategies, which tend to benefit from the kinds of seismic geopolitical and macroeconomic events that loomed large in 2022 (and could have an outsized effect again in 2023). But not all hedge funds are comparable. A careful assessment of the manager’s approach and skill can help reduce the risk of disappointment that many hedge fund investors experienced in 2022, especially in the long-short space.
Real estate has raised many questions recently due to negative headlines surrounding two of the major publicly traded investment firms operating in the asset class. With rising interest rates hurting valuations, deal volumes have slowed substantially—and bid-ask spreads have widened—but we’ve not seen widespread distress in the market. In real estate debt, we’re focused on the sustainability of properties’ cash flows and the degree of confidence we have in the equity cushion. In real estate private equity, we benefit from being leverage optimizers rather than leverage maximizers. As other players who have used more aggressive capital structures face financing issues, the opportunity set for our managers could become particularly compelling over the next 12–24 months.
For inflation-sensitive investors, we continue to recommend incorporating sufficient protection as part of a strategic asset allocation, even though we expect inflation to subside from recent peaks. Here, our favored approach remains a blend of inflation-linked bonds, floating rate loans, commodities, stocks of commodity producers, stocks of companies with pricing power, and real estate.
Finally, for investors worried about the current economic climate, consider whether the level of risk embedded in your portfolio suits your risk tolerance. If they are aligned, then you should be able to weather any near-term storms and achieve your longer-term goals. If not, then adjusting the allocation or including risk management tools can bring the portfolio back in line. In addition, we recommend keeping 6–12 months of cash on hand. While helping manage through uncertainty, cash is finally earning a healthy yield again.
What Surprises Await?
As we look ahead to 2023 and beyond, we do so with a healthy dose of humility. The pandemic in 2020 and the Russian invasion of Ukraine in 2022 weren’t reflected in anyone’s outlook but had outsized effects on the economy and markets. We sincerely hope similarly material, adverse shocks don’t await the world in 2023. Yet, our goal is to ensure that our long-term portfolios are positioned to handle whatever near-term surprises arise and to take advantage of opportunities created by market dislocations. After a depressing year in both the real world and the financial markets, we also remind everyone that few things have served investors better over the long run than an optimistic bias and a balanced approach.
Alex Chaloff—Co-Head of Investment & Wealth Strategies
Beata Kirr—Co-Head of Investment & Wealth Strategies
Matthew Palazzolo, CFA—Senior National Director, Investment Insights—Investment Strategy Group
Christopher Brigham, CFA—Senior Research Analyst—Investment Strategy Group
- Investment Strategy Group