A new year marks a new beginning, but for now the story remains the same for equity markets. Rapid Federal Reserve (Fed) tightening in order to fight high inflation in 2022 will work with a lag on the economy in 2023. This is already showing up in some economic indicators, such as housing where mortgage applications are at 25-year lows. Additionally, banks are tightening lending standards, CEO confidence is low, some layoffs/hiring freezes are being announced (particularly in the Tech sector), and leading economic indicators are negative. We believe the odds are high that a recession occurs in 2023, but we do expect it to be mild.
The big R-word can be scary and it is human nature to recall some of your most recent experiences. However, we view the current environment as far different than the 2000 dotcom bubble and 2008 financial crisis (two of the worst market drawdowns in history). A unique characteristic of the current cycle (coming out of the COVID shutdown) is that supply has been very hard-pressed to meet demand. Inventories are low, and we do not see widespread excess on balance sheets that can often plague economic downturns. Banks are also well-capitalized (much has changed since the credit crisis), and importantly we do believe inflation is set to come down (but will take time) over the coming year which will ease financial strains.
This lends itself to a recessionary bear market likely more similar to historical averages, which have seen S&P 500 contractions of -33% over 13 months. We have already experienced a -25% drawdown over 12 months and believe that this bear market is in its late stages – although sometimes bear markets end with that last capitulation selloff. Regardless of potential downside or volatility in the coming months, the long-term risk/reward skews heavily in investors’ favor. And we remind investors to not lose sight of the bull market opportunity on the other side of the current weak trend. Bull markets can last 4-5 years and appreciate 152% on average. We do believe that equities will be climbing by year-end 2023, despite lower earnings, due to multiple expansion (as stocks discount the future) and use a probability-weighted S&P target of 4365.
Over the coming months, investor focus will likely shift from inflation concerns toward economic damage. We believe a lot of negative news has already been priced in and see underlying technical improvement over the past several months. However, the S&P 500 still remains in a downtrend for now. Volatility is likely to persist, and the bottoming process and recovery may be elongated in this environment. With this in mind, we recommend being patient and pragmatic with positioning- use the weak periods as opportunity (with a long-term perspective) and refrain from chasing the rally periods.
Best wishes for a healthy and prosperous 2023!
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