Review the latest portfolio strategy commentary from Mike Gibbs, managing director of Equity Portfolio and Technical Strategy.
As the calendar turns to 2023, we believe that equities in the year ahead will be heavily influenced by the degree of inflation moderation, central bank policy and the amount of demand destruction inflicted by central banks on the economy (in order to bring inflation down).
We do believe that inflation will moderate over the next year, but clear and convincing evidence is also likely to take time. It is becoming evident that core goods inflation is moving lower (i.e. manufacturing supply has met demand and commodity prices have declined since mid-2022). However, the tight labor market (still excess jobs demand vs. supply) is resulting in elevated wage growth which is contributing to stickier core services inflation. Leading indicators suggest this dynamic should improve over the next year, which will allow the Fed to back off; but this is also likely to come in conjunction with economic weakness in our view. And investor focus will shift from inflation concerns toward pain inflicted on the economy.
We expect a mild recession in 2023, as swift Fed tightening (450bps of hikes in 2022) acts with a lag on the economy. The effects are already showing up in some areas, i.e. the housing market where mortgage applications are now at 25-year lows (due to the surge higher in rates). Bank lending is becoming tighter, CEO confidence is low, economic leading indicators are negative, the yield curve is inverted, and layoffs/hiring freezes are being announced. While recessions are painful, we do believe it will be mild-i.e. we do not see widespread excess on corporate and consumer balance sheets, supply has been hard-pressed to meet demand this cycle (inventory levels are low), and banks are very well-capitalized. Moreover, we believe inflationary pressures will ease.
This economic weakness will result in earnings weakness, and we take a below consensus view on 2023 S&P 500 earnings ($215 estimate vs $230 current consensus). However, stocks also discount the future – and we believe a lot of negative news has been priced in already. On average historically, recessionary bear markets have resulted in a -33% S&P 500 decline over 13 months – but we are already -25% over 11 months into this one. Additionally, equities are likely to bottom in advance of the economy and fundamentals. For example, earnings bottom 8-9 months after a recession ends historically, while valuations bottom 2-6 months prior to a recession’s end (often when headlines and sentiment are worst).
While we are not convinced that a mild recession has been fully priced in at this point, we do believe that we are in the late stages of this bear market and expect the S&P 500 to be climbing by year-end 2023 – resulting in our current 2023 S&P 500 target of 4365 (probability-weighted). We expect volatility to persist into the new year, and believe that the bottoming process and recovery may be elongated. Therefore, it is important to maintain balance in portfolios between managing risk while also keeping an eye on the longer-term opportunity. With this in mind, we recommend refraining from chasing the rally periods and build exposure to favored areas in the weak periods as long-term risk/reward improves.
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