Stocks: Putting Some Stakes In The Ground For ‘23
January 2023
With this being our first outlook piece of the new year, we thought it an opportune time to make a few predictions for 2023 - some mainstream, others less so - and highlight a few broad themes we believe are worth monitoring that could factor into portfolio positioning. At a high level, we expect the coming year to again prove challenging for stock returns as a weakening global economy and elevated labor costs/falling goods prices lead to lowered earnings estimates while valuations remain pressured by higher for longer short-term interest rates. Investors should be rewarded by taking a more active approach in ‘23 as dispersion at the industry/sector level as well as between the U.S. and the rest of the world (RoW) could rise materially in the coming year given the wide range of potential outcomes facing the global economy and with central bankers in the U.S, Europe, Japan, and emerging markets set to take distinctly different paths regarding monetary policy.
More Modest Drawdowns, And Rallies, As Volatility Ebbs: Equity bulls and bears were equally confounded by price action last year. Inflation hitting a four-decade high, rising interest rates, and geopolitical unrest gave investors ample reasons to de-risk and reduce exposure to stocks, while hopes of a Fed pivot to more accommodative policy allowed the ‘buy the dip’ mantra that served bulls well over the past decade to remain alive. To put numbers around how volatile 2022 was, the S&P 500 ended the year lower by 18.1% on a total return basis – a painful outcome, but investors were forced to endure peak-to-trough selloffs of 11.7%, 20.8%, and 18.9% to capture trough-to-peak gains of 11%, 17.4%, and 16.8% along the way. As the FOMC winds down its rate hiking cycle, volatility should subside from 2022 levels, lessening the magnitude of equity drawdowns relative to the prior year, but economic, monetary policy, and geopolitical uncertainty aren’t going anywhere, and the ride is unlikely to be a smooth one.
‘Quality’ Outperforms Again: We entered 2022 with a strong preference for ‘quality’ given our outlook that central banks would tighten monetary policy and slow economic growth, which they did at an even more aggressive pace than we anticipated. However, the U.S. economy proved far more resilient than expected given the pace of rate hikes experienced, limiting the magnitude of outperformance from ‘quality’ factors as the S&P 500 Quality index outperformed the S&P 500 by just 2.5% in 2022. With a higher for longer Fed funds rate expected throughout 2023 raising the probability of a U.S. recession, stocks exemplifying ‘quality’ factors such as high profitability, low leverage/debt, low earnings variability, and dividend growth should fare relatively well in the coming year, perhaps even better than during a tumultuous 2022. Conversely, high beta, high leverage, and high earnings variability are less desirable factor exposures and should generate underperformance on a relative basis in 2023.
U.S. Dollar Weakens In ‘23: We expect the U.S. Dollar Index, or DXY, to remain relatively strong into mid-year as additional Fed funds rate hikes are likely in the first quarter, followed by a pause, not a pivot. However, the Bank of England (BoE), Bank of Japan (BoJ) and European Central Bank (ECB) will not be afforded such a luxury as inflation in Europe and Japan remains uncomfortably high and is unlikely to moderate quickly without central banks tightening policy further. In contrast to the BoE, BoJ, and ECB, emerging market central banks could, on balance, be in rate cutting mode, stimulating economic growth as signs inflationary pressures are subsiding emerge. Inflows into EM assets could increase demand and strengthen local currencies, a dynamic that could lead to a weaker U.S. dollar versus not just the euro and Japanese yen, but also against select EM currencies in the back-half of the year. A weaker U.S. dollar would benefit developed and emerging markets abroad on a relative basis, another potential tailwind for improved performance out of the RoW.
Emerging Outperforms Developed: On the heels of Russia’s invasion of Ukraine last February, our belief that the euro area would experience a prolonged period of elevated inflation and economic weakness led us to take down exposure to international developed equities. While higher energy and electricity prices have proven problematic, a worst-case scenario for Europe has so far been avoided as unseasonably warm winter weather has pushed natural gas prices lower, and euro area equities have outperformed meaningfully over the past three months. While recent price action is encouraging, the worst may lie ahead for Europe, and we remain comfortably underweight. Japan has understandably received less attention given what has been going on in Europe, but in December the Bank of Japan (BoJ) altered its yield curve control program to allow for a higher 0.50% yield on 10-year Japanese Government Bonds, an acknowledgement that sales of U.S. Treasuries to support the Japanese yen and the prior 0.25% 10-year peg were too costly to maintain. Should the BoJ allow yields to rise further, Japanese stocks would bear the brunt of such a move and weaken. Emerging market central banks moving to ease monetary policy, a reopening of China’s economy, and the prospect of a weaker U.S. dollar increase the appeal of emerging market stocks and bonds. However, the potential for China’s reopening to boost inflation and force EM central banks to remain tighter for longer, is a possibility, and given this unknown, a more constructive stance on EM may be justified later in the year.
