While the Federal Reserve has reiterated its stance on continued vigilance against inflation, real time economic data have provided conflicting signals. There are signs of a general softening in many of the indicators, but employment trends have been abnormally strong. This pattern is consistent with a soft-landing scenario.
Treasury yields and credit spreads peaked in October. Consensus forecasts largely coalesce around a volatile first half of 2023, but credit spreads for both high yield and investment grade bonds have rallied since the end of October. Both measures are well off their recent highs and do not indicate a concerned credit market despite the consensus view that we will have very little growth, or a moderate recession. As we enter 2023, credit spreads on high yield debt are 4.5 percentage points above the Treasury curve, which is far from the 8.0 percent point spreads typically seen during a recession.
Total return for credit bonds in 2023 will largely be defined by the path of interest rate movements as well as the durability of the economy cycle.
The municipal market had similar challenges to other fixed income markets this past year although the losses were not as severe as those in other segments of the bond universe. Supply and demand dynamics played a large part in that outcome as new issuance was lighter than in years past, and was much lower than levels reached in 2021, while demand remained strong.
With elections behind us and the prospect that the Federal Reserve will take a pause in its tightening policy, the municipal market should have a better tone this year. However, we continue to monitor developments closely. Credit quality across this segment of the market remains solid, but there are some early signs of budget pressures that should be heeded given the slowing economy and potential for reduced tax revenue.
U.S. Equity
Last year the equity market was volatile, experiencing a dramatic sell-off followed by a modest recovery to finish with a decline of 18 percent. Returns were disparate across the market with the previous year’s winners suffering some of the largest declines. The tech-heavy Nasdaq Index was hit particularly hard, while many energy stocks increased dramatically.
As we enter 2023, investors are hopeful for an end to the bear market, and we view it as having two stages. The first stage was characterized by a reduction in valuations from historically high levels. Markets declined last year as the Federal Reserve’s tightening campaign led investors to anticipate lower growth rates in the future. During this stage, stocks fell despite rising earnings and a continuation of the economic expansion.
In 2023, we expect a different environment where the trajectory of the market will largely be determined by the rate of earnings and economic growth. Inflation remains high, but has been falling, and that should allow the Federal Reserve to pause its tightening campaign. Given this change in policy, investors are likely to shift their focus to the real-time economic and earnings data that allow them to assess the impact of last year’s rate hikes.
Currently, consensus expectations call for earnings growth to be somewhere between a modest expansion and a small decline, which is consistent with the outlook for the economy. That outcome is known as a “soft landing” where growth is essentially flat for several quarters before resuming its upward trend. While the odds for a soft landing have improved, downside risks remain and there is potential for a more dire outcome characterized by a larger decline in economic growth and earnings. While it is not our base case, it is possible the Federal Reserve has tightened too aggressively, and we will update our forecasts as more data becomes available.
International Equity
Many of the domestic market dynamics described above are also impacting international economies. Concerns about slowing growth, a possible recession, and high inflation are persistent throughout much of the world today. In addition, many central banks are expected to continue tightening their policies to restore price stability.
While the risks are widely documented, some of the fundamentals for international equities have improved. Europe is enjoying a warm winter and that has reduced the risk of an energy crisis that spurs inflation and a deep recession. China has reversed its no tolerance policy against COVID-19 and the country is now in the process of reopening. That will be a positive tailwind for global growth. Just as important, valuations for foreign stocks are compelling as they are below the long-term average in most countries. The U.S. dollar has also been a positive factor as our currency has been falling in recent months, providing an additional tailwind to returns.
Commodity
Prices for many commodities increased significantly last year. The energy and agricultural segments were particularly strong given a continuation of the economic expansion and the war in Ukraine.
In terms of the outlook, we see a mixed picture in the near-term as a slowing economy should result in lower demand and a general softening in prices. However, the extent of the declines may be tempered by ongoing supply constraints related to the war in Ukraine and a low level of investment in production capacity for some commodities. On a longer-term basis, we remain constructive on commodities given ongoing supply headwinds across many of these markets.
Potential opportunities & risks
Opportunities
New opportunities/new markets—The outbreak of COVID-19 presented a unique set of challenges. It also provided businesses with a unique opportunity to differentiate and develop new markets. By some estimates, technology has been pulled forward two to three years and new products and services are in high demand.
Despite a push for a return to the workplace, many people are resisting that pressure and continue to advocate for flexible work policies. The ongoing demand for remote work opportunities increases the demand for technologies that can facilitate a world of geographically distanced employees. In addition, a shortage of labor is leading companies to invest in technology to boost productivity, automate processes, and adapt to the lack of labor supply.
The emergence of new technologies—The convergence of cloud computing, significant increases in computing power and the advent of the smartphone have created a connected world in which new technologies change the way we live. This convergence has created investment opportunities centered around long-term themes such as cloud computing, artificial intelligence, and Big Data.
The evolution of finance—Technological advancements are disrupting traditional methods of banking, finance, and transfers of cash. We are experiencing a global shift from paper currency to electronic payments fueled by the popularity of credit and debit cards, as well as the emergence of cryptocurrencies. Online payment systems facilitating money transfers, e-commerce, buy-now-pay-later arrangements, and electronic bill paying services are also experiencing strong demand. This shift is still in its early stages and is expected to have a long runway as it is occurring across both the developed and the developing economies. In the coming years, blockchain technology may become a significant disruptor in the finance industry with opportunities for new entrants while creating risks for the firms that currently dominate this space.
Risks
Recession—The unprecedented tightening of monetary policy since March of last year has increased the risk of a recession. The Federal Reserve has reversed course from an aggressive stimulus policy to a tightening stance in a short period of time. Monetary policy works with a lag of about one year, so we are just beginning to feel the impact of the initial rate hikes last year. Accordingly, it is possible the central bank has tightened too aggressively, resulting in a hard landing for the economy, and a recession later this year.
Inflation—Given the unparalleled amount of fiscal and monetary stimulus in previous years, the war in Ukraine, reduced investment in production capacity for some commodities, the trend towards de-globalization, and a shortage of labor, there is a risk that inflation may remain above the average of the last thirty years.
Deglobalization—Rising geopolitical tensions across many parts of the world have resulted in a reversal of the globalization trend we have enjoyed since the fall of the Berlin Wall. A renewed priority to secure access to commodities and other vital product inputs, along with a race to establish global dominance in certain technologies, have led to a reversal of the free trade movement. We expect this development to be coupled with a sustained increase in geopolitical tensions, upward pressure on inflation, and a rising cost structure for some industries.
Debt related issues—Sovereign debt levels were rising prior to the outbreak of COVID-19. However, in the wake of the virus, they have increased significantly. In the U.S., government debt has increased approximately 40 percent since the end of 2019 and that trend shows no sign of reversing course. Furthermore, the United States has breached the debt ceiling and a near-term resolution is unlikely.
Increasing government regulation of technology companies—Several of the leading technology companies have established dominant market positions and have few competitors. As the power of these companies continues to increase, government regulators are placing them under greater scrutiny by assessing their privacy policies, acquisition plans, and competitive practices.
Geopolitical risks—Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We are closely monitoring developments in the war between Russia and Ukraine as well as relations between the West and China.
Cybersecurity—Cybersecurity remains a significant issue as evidenced by persistent attacks on governments, businesses, and individuals worldwide.
Originally posted on January 31, 2023