While markets have begun the year on a rollicking note, investors remain understandably wary of investing in 2023. Bank failures now dominate the headlines, following in the wake of recession warnings and concerns over rate hikes. Then there’s growing speculation over a dramatic strengthening or weakening of the US dollar—not to mention the debt ceiling showdown on Capitol Hill.
If the past several years have taught us anything, it’s that no one can precisely predict what will happen this year. However, a sober assessment of the risks can help investors prepare for the shocks that these or other scenarios may bring to bear. Keep in mind, these are just some of the “known” risks of investing in 2023. Of course, other unknown challenges may arise, too. Either way, a clear-eyed appraisal of the landscape can help point the way for optimal portfolio positioning (the subject of our related blog).
The Risk of Recession
The most hotly debated risk of investing in 2023—and perhaps the most widely anticipated—is that of a US recession. Consider that the median economic forecaster surveyed by The Wall Street Journal in February estimated a 65% chance of an economic downturn in the next 12 months.
Where do we stand? For several quarters, our economics team has viewed a potential US recession as both elevated and increasingly likely. That said, strong economic data so far this year contributed to a slight decline in our latest forecasts, though recent bank stresses may cause us to revisit that in the coming weeks as we get more visibility into the likely fallout (Display).
Ultimately, an economic contraction resulting in a mild recession and a decline in earnings for US companies remains our base case. Yet uncertainty abounds in both directions, with something resembling a “soft landing”—or, alternatively, a deeper, more traditional contraction —both in the mix. Overall, we’d assign a combined 70% chance to our mild and moderate recession scenarios.
In such a data-dependent environment, we continue to monitor several metrics for more clarity. For instance, we’ve been watching the interplay between monthly consumer inflation data and Federal Reserve policy, along with recent bank stresses. We also parse what the Fed is saying for any changes that may be telegraphed. In recent months, we’ve grown increasingly attuned to the labor market, particularly the monthly employment report and weekly jobless claims. Given the Fed’s concerted effort to slow wage growth, the efficacy of their policy response—and its potential impact on both GDP and corporate earnings—should start to show up in those data points before it flows through the rest of the economy.
Will the Rates Shock Continue?
Interest rates are the second risk we’re eyeing, especially since 2022’s massive leap caught so many investors by surprise. Coming into the year, the market priced in around 75 b.p. of hikes. Yet in the end, the Fed raised by 425 b.p.—one of the steepest hiking cycles on record in such a short period. The obvious culprit? Inflation, which proved more durable than expected as it shifted from goods to services and Russia’s invasion of Ukraine added more fuel to the fire.
Fast forward to 2023, and the Fed is closer to reaching its peak rate for the cycle. Coming into the year, the market was already pricing in rate cuts over fall and winter 2023, while the Fed disagreed (Display). They’ve signaled their intention to keep rates elevated for an extended period. Following strong economic data to start the year but also the failures of several sizable banks in March, there’s now even more uncertainty about the Fed’s hiking path than there already was.
Moving ahead, we’ll continue to weigh the Fed’s projections against market expectations, as there is often wisdom in crowds. In the end, the final proof can be found through constricting or loosening financial conditions. We’ll be keeping a close eye on these to see if they are working for or against the Fed’s best laid plans.
Bank Failures—The Newest Risk
Let’s dive more deeply into those recent bank failures and their implications. In addition to certain banks having concentrated sources of deposits, the rapid pace of Fed hikes, the slowness of deposit rates to keep up with higher Treasury rates, and the failure by some banks to hedge their interest rate risk have created a new fault line in the banking system and overall economy.
While the Federal Reserve, US Treasury, FDIC, and their global counterparts have been working to prevent a mass of bank runs, there are still risks of further failures and downstream economic impacts as banks respond by becoming more conservative in their lending, further tightening financial conditions, harming economic growth, and increasing the likelihood of a recession.
A Dollar Reversal?
Currency risk is on our radar, too, given the US dollar’s astonishing strength in 2022. While helping some, the dollar’s impact cut both ways: it also hurt the value of US-domiciled companies’ foreign earnings and US-based investors’ foreign holdings. In the face of some weakening in recent months, the question now becomes whether the strong dollar will persist or succumb to the reversal we’ve seen lately as the beginning of a larger move.
With so much economic turbulence and uncertainty swirling around, the odds of large swings up or down remain quite high. What’s more, our level of conviction in the dollar’s path from here remains quite low. Investors should prepare for a wide range of potential outcomes. But the oft-debated topic of US vs. non-US equity performance when investing in 2023 will largely hinge on how the dollar does.
That Pesky Debt Ceiling
The final risk we’re staring down is the debt ceiling, which has boomeranged back onto the scene.
Why does the debt ceiling matter for investing in 2023? First and foremost, because US Treasury bonds play a “risk-free” role in global finance—investors count on receiving 100 cents on the dollar in cash on the date that their Treasury bonds come due, with 100% certainty. Plus, the liquidity Treasuries provide funds for the rest of the financial system. If they suddenly fail to pay—and there’s a liquidity gap in funding markets—that could unwittingly precipitate a systemic liquidity crunch.
Besides the direct impact on asset values and knock-on effects of a liquidity crunch, US government payments also form the backbone of much of the real economy. Think of compensation to vendors or employees, or transfer payments like social security. A failure to pay would sharply impact the cash flows of American consumers and businesses, while weighing on their sentiment and willingness to spend and invest. The combination of a potential liquidity crunch and a direct hit to the real economy could introduce the risk of a default-driven recession.
Ultimately, approval for the debt ceiling increase will likely rely on a bipartisan coalition, which is in short supply these days, particularly on issues related to government funding. Historically, brinksmanship has led to significant, but short-lived volatility in risk assets like stocks—a situation for which we’re currently bracing. At the same time, in past episodes we haven’t breached the debt ceiling in the end, and we expect the same will hold true this time around.
Survey the Risks, Then Diversify
In addition to these acute threats, a host of other tail risks may be percolating beneath the surface. But those typically lurk just out of sight, without actually materializing and posing a challenge to investor portfolios.
With a better understanding of today’s risk landscape, investors need to ask whether their current level of diversification is sufficient to give their long-term portfolios a fighting chance. That means considering a range of different asset classes—not just stocks and bonds—to shield and strengthen your overall wealth. When it comes to investing in 2023, it’s better to have your eyes wide open than to be blindsided by risks you might not have seen coming.
- Matthew D. Palazzolo
- Senior National Director, Investment Insights—Investment Strategy Group
- Christopher Brigham
- Senior Research Analyst—Investment Strategy Group