2023 Market Outlook: A New Problem Emerges

While the markets are still very focused on the battle with inflation, a new problem is going to emerge in 2023 that is going to take its place.  The markets have experienced a relief rally in November and December, but we expect the rally to fade quickly going into 2023. 

Inflation Trend and Fed Policy

I’m writing this article on December 15, 2022, and this week, we received the inflation reading for November and the Fed’s 0.50% interest rate hike.   Headline CPI, the primary measure of inflation, dropped from 7.7% in October to 7.1% in November which is a meaningful decline, most likely signaling that peak inflation is behind us.  So why such a grim outlook for 2023? One word……History.  If you look at the historical trends of meaningful economic indicators and compare them to what the data is telling us now, the message to us is it will be nothing short of a Christmas miracle for the U.S. economy to avoid a recession in 2023.   

The Inflation Battle Will Begin at 5%

While it's encouraging to see the inflation rate dropping, the true battle will begin once the year-over-year inflation rate measured by headline CPI reaches the 5% - 6% range.  Inflation most likely peaked in June 2022 at 9% and dropped to 7.1% in November, but remember, the Fed’s target range for inflation is 2% - 3%, so we still have at least another 4% to go. 

RECESSION RISK #1:  If you look back through U.S. history, the Fed has never successfully reduced the inflation rate by more than 2% WITHOUT causing a recession.  We have already dropped by 2%, and we still have another 4% to go.  

I expect the next 3 months to show meaningful drops in the inflation rate and would not be surprised if we are in a 5% - 6% range by March or April, largely because supply chains have healed, the economy is slowing, the price of oil has come down substantially, and the job market is beginning to soften.  But once we get down to the 5% - 6% range, we could see slow progress, which could end the party for investors that are stilling in the bull rally camp.

The Wage Growth Battle

We expect progress to be halted because of the shortage of supply of workers in the labor force, which will keep wages persistently higher, allowing the US consumer to keep paying higher prices for goods and services, which will leave us with higher interest rates for longer.  Every time Powell has spoken over the past few months (the head of the Federal Reserve), he expresses his concerns that wages remain far too high.  The solution is simple but ugly.  The Fed needs to continue to apply pressure on the economy until the unemployment rate begins to rise which will bring wage growth level down to a level that will allow them to reach their 2% - 3% target inflation range.

Companies Are Reluctant To Let Go of Employees

Since one of the major issues plaguing US businesses is trying to find employees, companies will be more reluctant to let go of employee with the fear that they will need them once the economy begins to recover.  This situation could create an abrupt spike and the unemployment rate when companies are finally forced to give in all at once to the reality that they will need to shed employees due to the slowing economy.

Rising Unemployment

Another lesson from history, if you look back at the past 9 recessions, how many times did the stock market bottom BEFORE the recession began? Answer: ZERO.  So, if you think the bottom is already in the stock market but you also believe that there is a high probability that the U.S. economy will enter a recession in 2023, you are on the wrong side of history.

When we look back at the past 9 recessions, there is a common trend.  As you would expect, when the economy begins to contract, people lose their jobs, which causes the unemployment rate to rise.  In all of the past 9 recessions, the stock market did not bottom until AFTER the unemployment rate began to rise.  If you think there is a high probability that the unemployment rate will rise in 2023, which is what the Fed is targeting to bring down wage growth, then we most likely have not seen the market bottom in this bear market cycle.

JP Morgan has a great chart summarizing this point across the past 9 recessions.  While it looks like a lot is going on in this illustration, each chart shows one of the past 9 recessions. 

The Purple Line = Unemployment Rate

The Black Straight Line = Where the stock market bottomed

The Gray Area =  The recession

In each of the charts below, observe how the purple line begin to rise and then the solid black line follows in each chart.  That would support the trend that the bottom in the stock market historically happens after the unemployment rate begin it’s climb which has not happened yet.

A New Problem Will Emerge

While the markets have been super focused on inflation in 2022, a new problem is going to surface in 2023.  The economy is going to trade its inflation problem for the reality of a weakening U.S. consumer. 

The Fed will be successful at slowing down the economy via their rate hikes, which will eventually lead to job losses, weakness in the housing market, a slowdown in consumer spending on goods and travel, and less capital spending.  Those forces should be enough to deliver the two quarters of negative GDP growth in 2023, which would coincide with a recession. 

The Fed Will Have Its Hands Tied

Normally, when the economy begins to contract, the Fed will step in and begin lowering interest rates to restart economic growth.  However, if the inflation rate, while moving lower, is still between 4% and 5% when the economic slowdown hits, the Fed will not be able to come to the economy’s aid with fear that premature reductions in the fed funds rate could reignite inflation which is exactly what happened in the 1970s.

The recession itself will eventually bring inflation down to the Feds 2% inflation target, but while it’s happening, it’s going to feel like you are watching a train wreck in slow motion, but you can’t do anything about it. Not a great environment for the stock market.

Length of the recession

The next question I receive is, do we expect a mild recession or severe recession? I’ll be completely honest, it’s impossible to know. A lot will depend on the timing of when the economy begins to contract and where the rate of inflation is. The longer it takes inflation to get down to the 2% range while the economy contracts, the longer and more severe the recession will be.  This absolutely could end up being a mild recession but there’s no way to know that sitting here in December 2022, looking at all of the challenges that lie ahead for the markets in 2023.

An Opportunity For Bonds

Due to the rising interest rates in 2022, the bond market has had one of the worst years in history. Below is a chart showing the annual returns of the aggregate bond index going back to 1970.

We have never seen a year where bonds are down 11% in a single year. It’s our expectation that this trend will reverse course in 2023. When interest rates stop rising, the Fed pauses and eventually begins lowering rates, that should be a positive environment for fixed-income returns.  Where bonds failed to give investors any type of safety net in 2022, I think that safety net will return in 2023. We are already beginning to see evidence of interest rates moving lower, with the 10-year US Treasury yields moving from 4.2% down to the current rate of 3.5% over the past 45 days.

Warnings From The Inverted Yield Curve

While a number of the economic indicators that we watching are flashing red going into 2023, there are very few that tell the story better than the inverted yield curve. Without getting into all the technical details about what an inverted yield curve is, the simple version of this explanation is,  it's basically the bond market telling the stock market that trouble is on the horizon.   Historically, when the yield curve inverts, The US economy enters a recession within the next 6 to 18 months.  See below, a chart of the yield curve going back to 1970.

Each of the red arrows is where the yield curve inverts. The gray areas on the chart are the recessions.  You can see very quickly how consistent the yield curve inversion has been at predicting recessions over time. If you look on the far right-hand side of the chart, that red arrow is where we are now, heavily inverted.  So if you believe that we are not going to get a recession within the next 6 to 18 months, you are sitting heavily on the wrong side of history and have adopted a “this time it's different” mentality which can be dangerous.  History tends to repeat itself more times than people like to admit.  

Proactive investment decisions

Going into 2023, I think it's very important to be realistic about your expectations for the equity markets, given the headwinds that we face.  This market environment is going to require very proactive investment decisions and constant monitoring of the economic data as we receive it throughout the year.  A mild recession is entirely possible. If we end up in a mild recession, inflation drops down into the Feds comfort range due to the contracting economy, and the Fed can begin lowering rates before the end of 2023, that could put a bottom in the stock market, and the next bull market rally could emerge.  But it's just too early to know that sitting here in December 2022 with a lot of headwinds facing the market. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.