- Early indications point to inflation pressures subsiding, signaling a potential turning point in Fed policy soon.
- The economy is decelerating and may be in recession by Mid-2023. The absence of significant overheating in most sectors of the economy indicate any recession will likely be mild.
- More stable interest rates and fairer stock valuations should mean the worst of market volatility is behind us.
- Despite both negative stock and bond returns in 2022, Rain portfolios largely outperformed their respective benchmarks.
The economy and financial markets remained rangebound in the fourth quarter, after a year of historic shocks including surging inflation, the outbreak of war in Europe and sharply tighter monetary policy. Both stock and bond markets (typically negatively correlated) experienced heavy losses, making it the worst year since 2008 for traditional portfolios. As the Federal Reserve remains focused on credibly fighting inflation by maintaining higher interest rates and shrinking its balance sheet, the economy will face headwinds in the coming year. The good news, which we alluded to in our last communication, is that inflation pressures do appear to be abating and the absence of overheating in most sectors of the economy means any recession in 2023 should be mild. Furthermore, the Fed is nearing the end of its tightening cycle and much of the expected economic weakness is already reflected in market valuations. While history tells us that earnings will likely decline as we enter a recession, we believe fairer stock valuations and more stable interest rates should put the worst of the volatility behind us.
As we start the year, the US economy is decelerating and faces a number of important headwinds to growth. While the post-pandemic consumption binge has given the US consumer unusual staying power so far, higher interest rates have dramatically slowed home buying and new construction as well as business investment, while a surging dollar has weighed on exports. More likely than not, the US consumer will follow suit. Higher inflation is showing signs of putting stress on consumer finances, both in terms of cutting into personal savings rates (now at just more than 2%) and driving up credit card debt. Additionally, the pandemic-driven federal support programs of recent years that buoyed excess savings are unlikely going forward. Coupled with the end of the moratorium on student loan payments in 2023, these factors are likely to materially depress real consumer spending going forward.
The strong labor market, perhaps one of the few areas that spared the economy from outright recession in 2022, is also weakening. Higher costs and lower demand have prompted businesses to begin scaling back hiring plans, while many are already in the process of laying off existing workers. Job openings are now trending downward and, in this environment, are likely to continue to fall while initial and continuing jobless claims have begun to tick up. Of course, labor market demographics – namely reduced legal immigration and retiring baby boomers – will help offset weakness in employment going forward. That said, the ultra-low unemployment and red-hot wage growth that have characterized this expansion appear to be waning. At this point, based on both economic fundamentals as wells as technical indicators in bond markets, it appears that the economy faces a better than 50% chance of recession in 2023.
Given this backdrop, current earnings expectations of double-digit gains appear overly rosy at this point. More likely is that earnings will be flat to down this year when compared to last, albeit not the typical 15-20% decline of past recessions, but enough to put further downward pressure on equity market valuations. Rising labor costs and higher interest rates are largely to blame for earnings weakness in 2022, while slowing sales growth will add to this weakness going forward. We would also expect the strong dollar to impact sales abroad. Finally, should companies cut spending and investment in anticipation of a recession, profitability could decline further.