Through December 16, the S&P 500 was down 19.2% in 2022, putting it on track for its worst calendar year performance since the 2008 global financial crisis. Unfortunately, the factors that brought down stock values in 2022 aren’t going away anytime soon.
Inflation has dominated Wall Street this year and is the main concern for investors and central bankers moving into 2023. Concerns about the detrimental impact of inflation and monetary tightening by the Federal Reserve spurred a sell-off in risky assets in 2022. Growth stocks, technology companies, and cryptocurrencies were especially heavily affected.
While the Fed has made some progress on inflation in the second half of 2022, prices, wages and interest rates continue to rise. The U.S. economy has remained mostly resilient throughout the year, but a sharp downturn in the housing market and weakening consumer sentiment are just two signs that cracks are starting to form. Economists and analysts see a strong possibility for a U.S. recession within the next year.
What key themes should investors be watching, and how can they position their portfolios to limit risk and capitalize on these conditions? Here are four themes investors should keep in mind heading into 2023:
- Elevated inflation.
- Rising interest rates.
- Slowing economic growth.
- The importance of stock selection.
Inflation has been the primary concern for both the Fed and investors in 2022. Consumer price index, or CPI, year-over-year growth peaked at a 40-year high of 9.1% in June 2022. The Fed has been raising interest rates aggressively since March in an attempt to get inflation closer to its 2% long-term target. Those rate hikes included four consecutive increases of 0.75 percentage point from June to November.
As a result, the fed funds target rate has increased from essentially zero in early 2022 to between 4.25% and 4.5% heading into 2023. The CPI dropped to 7.1% for November, suggesting the Fed is making progress in its battle against inflation.
Unfortunately, the Fed’s preferred inflation measure – the core personal consumption expenditures price index, or PCE – still has a long way to go to reach the target range. Core PCE, which excludes volatile food and energy prices, was up 5% as of October. Core PCE inflation is down from a peak of 6.8% in June but is still more than double the Fed’s 2% target.
To make matters worse, a tight labor market is contributing to rising wages and pricing pressures. Wages grew 5.1% in November, and many companies are simply choosing to pass on higher labor costs to customers by raising prices on goods and services, further contributing to inflation.
Inflation will likely remain elevated for some time and will be a key concern for investors in 2023.
Rising Interest Rates
Elevated inflation is one sign of an overheating economy, and the Fed’s primary ammunition against an overheated economy is tighter monetary policy. In addition to allowing $95 billion in assets to roll off its balance sheet per month, the Fed has been raising interest rates to cool inflation.
Higher interest rates increase borrowing costs for both companies and consumers, slowing economic growth and weighing on corporate earnings. Looking ahead to 2023, the Fed will likely continue to raise interest rates until it pushes inflation significantly lower.
In December, the Federal Open Market Committee, or FOMC, released its updated long-term economic projections. The FOMC projected 2023 core PCE inflation of 3.5% and a 2023 terminal fed funds interest rate of 5.1%.
The bond market is currently pricing in a 52.7% chance that the Fed will raise interest rates by at least another 0.5 percentage point by March 2023, according to CME Group.
Each additional rate hike makes life more difficult for investors in 2023, and the timing of the eventual Fed pivot from rate hikes to rate cuts could be a major stock market catalyst in late 2023 or early 2024.
Slowing Economic Growth
Up to this point, the economy has remained relatively resilient to Fed tightening, but the writing may be on the wall that a U.S. recession is coming in the first half of 2023. Consumer confidence is falling. Rising mortgage rates have sent home sales tumbling. Existing home sales have declined for nine consecutive months and were down 24% year over year in October.
Wall Street analysts are taking note of the softening economy. A growing number of economists and investment banks expect a recession in the first half of 2023, along with a sharp drop in stock prices.
Quincy Krosby, chief global strategist for LPL Financial, says economic indicators are clearly suggesting the U.S. economy is slowing. Krosby says Fed Chair Jerome Powell’s commentary following the December FOMC meeting indicates the central bank is prioritizing inflation over economic stability.
“Although continuing claims are climbing higher, Chairman Powell’s focus was on the strong labor market and the need to bring it into balance even if it means considerably higher unemployment levels,” Krosby says. “The market’s reaction is similarly focused, but on the possibility of a recession. As the (FOMC) and … Powell’s comments at the press conference (suggest) … the Fed will continue to raise rates in early 2023 and will not begin to cut rates until 2024.”
Unfortunately, Krosby says the Fed’s aggressive mindset probably means a “soft landing” for the economy is unlikely.
Analysts are now projecting S&P 500 companies will report a 2.8% decline in earnings for the fourth quarter of 2022. If not for the booming energy sector, the S&P 500 would be on track for a full-year earnings decline of 1.8% in 2022.
The Importance of Stock Selection
In a weakening economic environment, stock selection can become even more important than usual.
Bank of America analyst Savita Subramanian says soaring interest rates have completely shifted the risk dynamics in the stock market.
“Things have changed: Energy is now low beta – along with financials and industrials – after sporting higher betas than every other sector for the prior decade. Tech, discretionary and (technology, media and telecom) have morphed from in-line or low beta to the three riskiest sectors,” Subramanian says.
Bank of America projects the S&P 500 will drop to new multiyear lows of about 3,000 in the first half of 2023 before bouncing back to just 4,000 by the end of the year.
Nicholas Juhle, chief investment officer for Greenleaf Trust, says investors should be cautious of the energy sector after a big year in 2022.
“The energy sector tends to go through boom-and-bust cycles, and if restrictive monetary policy is effective in reducing aggregate demand while the supply chain recovers, energy may be in store for a pullback,” Juhle says. “On the flip side, I would be more constructive on harder-hit sectors like information technology and communication services, where valuations have taken a beating due in part to higher discount rates.”
Despite the potential for major volatility, Wall Street analysts still see overall upside for stock prices in 2023. The average 12-month S&P 500 analyst price target is about 4,496, according to FactSet, suggesting about 16.7% upside from the index’s value at close on Dec. 16.
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