The Balancing Acts we identified for 2022, most notably the Federal Reserve (Fed) and its ability to rein in inflation without a recession, created significant volatility and made 2022 a challenging year for investors. The paths for inflation, monetary policy, and the economy remain uncertain, but we expect to find balance with these issues as the year progresses, initiating a transition to a new cycle of positive but lower economic growth and the next bull market. 

 

INFLATION

Our outlook on inflation serves as an important input to our work assessing monetary policy, consumers, businesses, the economy, and markets. When it comes to inflation, the main question is:

 

Will inflation cool enough to allow the Fed to claim victory and unwind its restrictive policy stance, or will price pressures persist, forcing the Fed to maintain that policy stance for longer?

 

We expect core PCE inflation to fall to 3.50%–3.75% by the end of 2023, modestly above the Fed’s latest projections and consensus estimates. We expect housing prices to rise further, then begin to cool mid-year as the lagging effects of policy tightening take hold and existing lease renewals catch up to market rates.

The labor market remains extremely tight and out of balance, with demand for workers substantially exceeding the supply of those available. This imbalance translates to persistent wage pressures and has made the Fed’s job more difficult. During 2023, we expect wage growth to normalize and fall closer to a level that’s consistent with 2% inflation. This labor market balance should result from fewer job postings, an increase in unemployment, and a slowing economy. However, this may take longer than consensus thinking, as structural forces like worker shortages and imperfect job matches put upward pressure on wages.

MONETARY POLICY

The Fed remains in a delicate balancing act of trying to reduce inflation without causing a recession. We believe a soft landing is still possible, but it will require a lower terminal rate than is currently forecasted by Fed officials and no rate cuts in 2023, contrary to consensus expectations. The Fed is likely to pause after an additional 50 basis points (0.50%) of tightening as policy reaches a sufficiently restrictive level, and the full effects of cumulative tightening have yet to show up in the economy.

Many market participants project an easing in policy by the end of the year. We believe that this is too optimistic and unnecessary unless the economy enters a more severe recession. This is due, in part, to the labor market dynamics previously mentioned and the Fed’s goal to ensure that inflation expectations do not become entrenched. Chair Powell has repeatedly stated that history cautions against premature policy easing and that policy will be restrictive “for some time.

The Fed’s monetary policy will play a key role in direction of the economy going forward.

ECONOMY

Recession or not, we expect economic growth to be muted in 2023. We see a reasonable chance of a soft landing (0.0% to 0.5% GDP growth), but a roughly equal chance of a mild recession (-0.1% to -0.5% GDP growth). The consumer will be a deciding factor, especially the consumer’s confidence and willingness to keep spending.  Decelerating inflation and continued wage gains should improve real incomes, but a slowing economy and rising unemployment may erode consumer confidence and mute spending. There is still close to $1 trillion in excess savings accumulated during the pandemic that could provide a cushion despite a slowing economy. 

STOCKS

We’re anticipating modestly positive calendar year returns for stocks in 2023.  But we will likely need to weather continued volatility and market weakness in the near term.

As we’ve been discussing for a number of months, we expect the environment to improve as investors (and the Fed) see inflation cool, leading to greater confidence in the Fed’s ability and willingness to pause its rate hikes.  Other resolutions, like China’s effort to move away from its zero-COVID approach and diplomatic progress in the war in Ukraine, will help.  As we find balance with these and other issues around mid-year, investors will sense relief, and we will transition to a new growth cycle, albeit a muted one, which should lead equity markets higher.

Of course, earnings play an important role.  At present, the consensus bottom-up earnings growth forecast for the S&P 500 is 5.3%.  We believe analysts continue to process and reflect the Fed’s continued policy shift, and we expect earnings growth in the 0%-5% range for 2023.  As unemployment moves higher and wage pressures slow, profit margins should somewhat stabilize.  This, coupled with a modest price-earnings multiple expansion from the relief discussed above, leads us to a forecasted 2023 S&P 500 total return of roughly 6% and a related price target of 4,000 at year-end.

BONDS

2022 was a challenging year for bonds, causing investors to wonder if the downside risk will continue.  We think not, based on our forward-looking views on interest rates, the shape of the yield curve, and credit spreads. 

The 10-year Treasury yield ended last year at 3.87%.  We expect this benchmark yield to remain range-bound, ultimately ending the year between 3.25% and 3.75%. 

The three-month T-Bill and two-year Treasury had yields of 4.37% and 4.43%, respectively, at the end of the year, so the yield curve is inverted. 

As inflation cools and investors gain confidence in a Fed pause, we expect this inversion to diminish some, with shorter yields declining. 

Credit spreads often widen out during a recession, putting downward pressure on bond prices.  But given our view of muted economic growth, instead of a deeper recession, we believe spreads will remain well-behaved, with investment-grade corporate spreads between 1.00% and 1.50% and below-investment-grade (high-yield) spreads ranging from 4.50% to 5.00%. 

Given the higher yields on bonds as we start the year, these forces combine to an expectation for modestly positive bond market returns.