December 12, 2022

In our last new letter, we introduced the potential for greater balance in 2023 and pledged to share our thoughts and outlook for 2023 in greater detail: First up – Stocks!

LOOK FOR EQUILIBRIUM BETWWEN THE MACRO AND MIRCO IN 2023

Equity markets lacked balance in 2022 as the challenging macro environment overwhelmed business fundamentals. Stubbornly high inflation and sharply higher interest rates were the dominant market drivers, pressuring valuations and inciting fears of recession and falling corporate profits. In 2023, we look to equity markets to find a balance between key macroeconomic factors—inflation, interest rates, and Fed policy—and business fundamentals.

REACHING THE PEAK OF THE RATE CLIMB

If stocks are going to go higher in 2023, a prompt end to the Fed’s rate-hiking campaign will likely be a key component. The timing of the last rate hike of this cycle is uncertain and won’t be clear for a while, but our view is that the Fed will pause in early spring of 2023 amid an improving inflation outlook and a loosening job market. Should that occur, stocks would likely move higher, consistent with history. Stocks have tended to produce solid gains after hiking cycles end, including a 10% average gain one year later.

The two instances when stocks struggled the most after a Fed rate hiking cycle ended, 1981 and 2000, were both during recessions. A recession in 2023 may be more likely than not, but our expectation is that if a recession occurs, it will be milder than those cases. Fourth quarter 1981 marked the start of the second leg of the double-dip recession after Fed Chair Paul Volcker famously broke the back of inflation with significant interest rate hikes, while 2000 was the start of the burst of the tech bubble that contributed to the recession in 2001.

WHAT GOES DOWN TENDS TO GO UP

They say that what goes up must come down. For the stock market, it also works the other way. Through many economic downturns, recessions, and geopolitical crises over many decades, the stock market has always recovered. Those patient and courageous investors who were able to take advantage of those declines have usually been rewarded nicely. Following down years, the S&P 500 has risen an average of 15% with positive returns in 15 out of 18 years. Since 1950, a down year was only followed by another down year three times: in 1973, 2000, and 2001.

Looking at this another way, after losing 20% or more at any point in time, the S&P 500 Index has gained an average of 17.6% over the subsequent 12 months (monthly data). The positive post-midterm election year pattern, discussed later in this publication, provides another historical analog that should be supportive of higher stock prices in 2023.

WIDE RANGE OF POSSIBLE EARNINGS OUTCOMES

Corporate America faces significant headwinds as 2023 gets underway. Cost pressures amid high inflation and still-snarled global supply chains are the biggest factors but slowing economic growth and the strong U.S. dollar may make any earnings growth in 2023 difficult to achieve. Many companies over-earned during the pandemic, so some reversion back to normal still needs to occur. Inventories also need to be brought down. Even though some of these pressures have started to ease, lower commodity prices and slightly looser labor markets have, thus far, had a limited impact on inflation overall.

Revenue will continue to get a boost from inflation, as many blue-chip companies during third-quarter earnings season have demonstrated an ability to pass along higher prices due to their pricing power. But margins will likely compress further over the next several quarters before support from lower costs potentially arrives. An upside scenario could materialize if inflation falls faster than we anticipate, propping up margins and potentially putting pressure on the S&P 500.  On the other hand, stubbornly high inflation and a more prolonged economic downturn could introduce downside risk.

CONCLUSION: TILTING THE SCALES BACK IN FAVOR

In 2022, the bear market decline in stocks was all about the macro picture—high inflation, surging interest rates, and rising recession risks. Strong consumer and corporate balance sheets and growth in corporate profits were not rewarded by investors, who were focused on rising recession risk and concerns of higher interest rate levels affecting future earnings. Add to that a tense geopolitical landscape and a strong U.S. dollar, and stocks struggled to make any headway throughout the year.

Looking ahead to 2023, stock drivers are likely to be more balanced. Rather than the scales tilting toward rising interest rates and runaway inflation, we may see falling interest rates and lower inflation supporting higher stock valuations. Should the outlooks for economic growth and inflation improve as 2023 progresses, stocks may also get a lift from prospects for stronger earnings growth in 2024.

We look for stocks to find a better balance between the macro environment and business fundamentals in 2023, tilting the scales toward the bulls.

As always, please do not hesitate to contact me if you have any questions or concerns. We wish you all a safe and prosperous Holiday Season!