Wealth Matters Newsletter - January 2023

Reflecting on the past year in capital markets, investors may feel relieved that 2022 is behind us.  I’ve sensed relief in the voice of clients and colleagues alike, and have read numerous articles and heard various strategists expressing similar spirits.  Nearly every major asset class, with the exception of commodities and the U.S. dollar, experienced negative returns last year, including double digit declines in the S&P 500 and the Bloomberg U.S. Aggregate Total Return Bond indexes.  The culprit: aggressive tightening of monetary policy by the U.S. Federal Reserve.  Over the course of 2022, the Fed raised the Fed Funds rate from 0.25% to 4.50%, the most aggressive policy tightening in decades.  Higher interest rates reduce the present value of future earnings and cash flows, resulting in the lower prices of assets.  In addition, many investors and strategists are concerned that such rapid tightening of policy to combat inflation will cause a recession in the near future.  What might the new year bring for investors?  Our team is focused on the following events and themes.

The Fed
Combatting inflation has been the Fed’s primary objective over the last year and we expect the Fed to continue raising interest rates several times in 2023.  The magnitude of those rate hikes is likely to be less than in 2023, as we anticipate inflation waning as the year progresses.  The Fed remains data-dependent in its policy decisions, so slower wage growth in the months ahead and meaningful declines in year-over-year inflation measures would likely result in more expeditious end to rate hikes.  We do not anticipate the Fed cutting interest rates this year; though we expect easing of inflationary pressures, the Fed is likely to keep the Fed Funds rate higher for longer in order to attain its goal of reducing inflation to its long-term target of 2% annual inflation.  The onset of a recession, which we believe is likely in 2023, may test the Fed’s willingness to keep the Fed Funds rate elevated.

The Consumer
The duration of this inflationary environment, and the inability for wage growth to match inflation, has impacted consumer spending and is likely to continue to pressure spending in 2023.  Consumer spending pivoted from goods to services materially in 2022, leading many retailers to offer significant discounts to merchandise throughout the year and through the holiday shopping season.  Most concerning is the growth in revolving credit usage, which increased at double-digit annual rates through the first three quarters of 2022, and 10.4% in October 2022, according to data released by the U.S. Federal Reserve.  We expect that spending on services and experiences (travel and leisure) will slow in 2023, as consumers’ capacity for discretionary spending is further impacted by stretched household budgets.

The Economy
The U.S. economy is likely to experience a recession in 2023 as a result of Fed policy actions and their follow-on effects.  Interest rate hikes typically take time (6-12 months) to work their way through the economy, so the aggressive Fed actions of the summer and fall may not be fully felt until the second quarter of 2023.  If there is ever good news associated with a recession, it may be that we would anticipate a broad but mild economic contraction.   Strong employment conditions and healthy corporate balance sheets should provide some buffer to a more significant economic downturn. 

Corporate Earnings
A December 9, 2022 report published by FactSet indicated aggregate analysts’ estimated earnings growth for the S&P 500 of 5.5% in 2023, following months of downward revisions.  We anticipate an increase in the number of companies missing earnings estimates and issuing reduced earnings guidance in 2023, with much of that activity occurring in the first half of the year.  Slowing consumer spending and the potential for decreased business investment due to increased risk of recession during the year will likely lead to slower revenue growth.  Reluctance to reduce employee head counts (big tech names notwithstanding) due to the staffing challenges faced by many employers over the last couple of years, combined with higher capital costs, may lead to profit margin compression and earnings pressure.

Stocks
We anticipate continued volatility in 2023, as investors assess the impact of potential slowing earnings growth, Fed rate hikes, and weakening economic data.  A re-test of market lows experienced in 2022 is not out of the question, given our expectations for earnings challenges and the potential for a recession.  International investments may provide better return characteristics in 2023, as we anticipate the U.S. dollar continuing to weaken relative to other foreign currencies from the lofty levels of late 2022.  A weakening U.S. dollar has historically provided a tailwind for foreign investments as a U.S.-based investor.  In addition, international stocks currently trade at more attractive valuations relative to their domestic counterparts.  At the end of 2022, the S&P 500 traded at 17.5x 2023 expected earnings, whereas the MSCI EAFE index traded at 12.31x and the MSCI Emerging Markets index traded at 11.37x 2023 earnings.

Bonds
For the first time in over a decade, bonds present a more constructive return profile.  As interest rates have moved up substantially during the Fed’s tightening cycle, investors have greater opportunity to earn real, inflation-adjusted returns from fixed income investments.  We expect some volatility in interest rates during the year, as the Fed continues to tighten monetary policy and investors grapple with changing economic conditions.  However, we view the current interest rate environment much more optimistically, as we believe the Fed is nearing the end of its policy tightening regime.

As always, our team enters 2023 prepared to help you navigate the complexities of our financial world and wish you a happy and healthy New Year.