Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

A look ahead to 2023

Most forecasters would rather forget 2022. Rarely have so many prognosticators been so wrong as they were in handicapping the year just ended, which should serve as another reminder not to rely too heavily on short-run predictions in constructing long-term investment portfolios.

Still, what fun would New Year’s be without an intrepid preview of coming attractions? With an abundant dose of humility, here goes.

Inflation. With few exceptions, most economists missed this one. A surge in demand combined with supply chain disruptions caused inflation to heat up in 2021, but most experts including the Federal Reserve expected price disruptions to be “transitory”. Instead, 2022 proved to be even hotter. The Philadelphia Fed survey of Professional Forecasters predicted that CPI inflation would average 2.7% in 2022. The actual number is closer to 7.7% and its stubbornness required a drastic shift in Fed policy.

Expect inflation to decline throughout 2023 but not reach the Fed’s 2% target by year end, ending up around 3% to 4% by December. While prices are moderating in durable goods and energy, some components of the CPI like rents, services, and wages tend to be “sticky” and will take longer to tame.

Interest rates. Once the Fed recognized the persistency of inflation it acted aggressively, raising benchmark interest rates from 0.25% to 4.5% between March and December, the largest single-year percentage increase on record. Also, the central bank has been allowing its massive balance sheet to shrink as bonds in its portfolio mature, further tightening monetary conditions.

However, the job is not complete. Interest rates remain below the Fed’s preferred inflation measure, which implies that real rates are still negative. Rates will have to rise above the inflation rate and remain higher for a considerable period, suggesting additional hikes in February and March then holding steady for the rest of the year. While markets have fallen victim to bouts of magical thinking, the Fed has consistently affirmed its resolve not to repeat the mistakes that led to the stagflation of the 1970s.

Recession. Given the well-documented stubbornness of inflation, the Fed’s actions are likely to lead the US into a recession by mid-2023. Interestingly, if it occurs, it would be the most widely anticipated downturn in history.

Odds are the recession will be relatively benign, as the conditions are absent for a severe shock like the insolvency in the banking system leading to the 2006 financial crisis. In fact, the recession could prove so mild that GDP remains flat or declines only slightly for the full year 2023 while unemployment rises to 4.5%-5%. In the aggregate, households still have savings in the bank, but surging credit card balances and higher retail financing rates will retard consumer spending, which makes up 2/3 of the economy.

Stock market. Wall street analysts prefer not to discuss their 2022 market expectations, for good reason. Folks that predict stock prices play an important role in society: making weather forecasters look prescient. Goldman Sachs, for example, forecasted the S&P 500 to gain 10% during 2022, a far cry from the double-digit losses ultimately sustained. In their defense, the base case was for lower interest rates and transitory inflation that might have supported more robust returns but did not happen.

Predicting the level of stock prices would be equally futile in 2023, but we can take note of some headwinds. Higher interest rates and slowing demand will pinch corporate profits, estimates of which are arguably too optimistic already. This would increase downward pressure on stocks into the New year.

The better news is that the stock market typically bottoms before the end of a recession and some of the most rapid gains occur when sentiment is most pessimistic. If indeed the economy is emerging from recession by year end, stocks may have already sniffed out the nascent recovery and begun pricing in better growth for 2024. The bottom line for investors is that opportunity will be afoot.

Bitcoin. Seriously?

(Disclaimer: the preceding should not be viewed as a recommendation to buy or sell any security. Consult your investment advisor before investing in Dutch tulip bulbs, Cabbage Patch Dolls, or cryptocurrency).

Politics. Perhaps the biggest risk for the year ahead is not inflation or the stock market but Congress. While both houses passed an omnibus spending bill last week avoiding a government shutdown, some members are already rehearing for the biennial Theater of the Absurd featuring the debt ceiling. An archaic relic from WWI, Congress must periodically increase the statutory debt limit allowing the US Treasury to raise the money Congress has already spent. Failing to do so would precipitate a catastrophic default, but in recent years some members have leveraged this threat to extort attention to their own priorities. Such brinksmanship already cost the US its once pristine AAA credit rating. Another episode could exacerbate a mild recession into a crash landing and potentially erode the preferential status of the Dollar. This horror show is scheduled to open sometime around September. Here’s hoping it gets lousy reviews and closes early.

Some of these broad themes may help inform investors in rebalancing portfolios or underweighting certain sectors. But it bears repeating that while forecasts are a fun New Year’s tradition, they are always wrong, and the key to long-term investing success is maintaining consistency and discipline in the face of uncertain times.

Happy New Year.

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