The year ahead

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   By Guest Blogger Ryan Lewenza

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We’ll be happy to close the books on 2022, and bring on a potentially more profitable 2023. While we correctly predicted a year of high market volatility, triggered by higher interest rates, we did not foresee Vladimir Vladimirovich Putin’s invasion of Ukraine, now the biggest war in Europe since WWII, and China’s heavy-handed zero-Covid policies. These three factors significantly weighed on the global economy and financial markets in 2023.

As of December 29th, global and US equities are down 20% this year, while the TSX declined a gentler 8%, due in part to higher energy share prices. So, after a disappointing 2022 what’s in store for 2023?

Similar to last year, interest rates will likely remain a key driver for the economy and markets. When will the Fed and Bank of Canada (BoC) end its rate hikes? For that inflation will be critical, which we believe has peaked and will slowly abate in the coming year.

US headline inflation, which includes food and energy, has already peaked and has slowed for a fifth straight month since peaking at 9.1% y/y in July (now at 7.1%). Core inflation, which strips out food and energy, has remained ‘sticky’ but we believe core will also start to come down next year. We’re seeing a number of inflation and economic indicators that are rolling over including used car prices, shipping freight costs, housing and commodity prices that should help to alleviate some of the inflationary pressures. Critically will be slower wage growth, which is likely as the labour market softens in response to the higher interest rates.

In our view, inflation has peaked and will slowly decline in the coming months. This will allow the Fed and BoC to take the foot off the pedal and stop hiking interest rates, which we believe could occur in Q1/23. This could then ignite a recovery in bond and equity prices.

Inflation and Interest Rates Surged During 2022

Source: Bloomberg, Turner Investments

But let’s be clear, the markets will remain volatile as central banks continue to hike rates early in the year and with the prospect of a recession occurring sometime in 2023.

Interest rates have surged this year with the Fed (and BoC) hiking rates by roughly 4% this year. Typically the Fed hikes rates by an average of 2.75% in past cycles and over a much longer period. Rising interest rates impact the economy with a lag of roughly 6-9 months. So, the rate hikes in 2022 are likely to be a drag on the economy in 2023. Moreover, with the aggressive rate hikes, this has led to an ‘inversion’ of the US yield curve, which is when short-term interest rates rise above long-term rates. As seen in the chart below, an inverted yield curve almost always precedes a recession.

However, we believe a recession, should it occur, could be shallow and short-lived as the labour markets in North America remain incredibly strong, which supports consumer spending (70% of the US economy). This is not 2000, 2008, or 2020 when we witnessed severe recessions. What we’re currently experiencing is what we call a ‘cyclical downturn’ in response to the rising interest rates. When rates peak and start to come down, it should help usher in a stock market recovery.

History of Yield Curve ‘Inversions’ and US Recessions

Source: Bloomberg, Turner Investments

The chart below captures the important relationship between interest rates and stock prices, which supports our thesis that declining interest rates (note: I’m referring to long-term interest rates) is bullish for stock prices.

The chart shows the strong (negative) correlation between rates and the stock market. In the chart I overlay US interest rates with the P/E ratio for the S&P 500. One important note is that interest rates (green line) are inverted on the chart to better show the relationship. As interest rates surged this year, this weighed on stock prices and led to a compression of the P/E ratio. Play this relationship forward. If interest rates peak next year as we expect, this should lead to a recovery in the stock market and an expansion of the P/E ratio. This is what we see driving stock prices higher next year.

US Interest Rates and the S&P 500 P/E Ratio

Source: Bloomberg, Turner Investments

We’ve been penning outlook reports and making market predictions for years now, so we know how challenging of an endeavor this is, especially against a backdrop of a global pandemic, sky-high inflation, a devastating war in Europe etc. So we spend a lot of time thinking about the risks to the outlook and what could go wrong. In that vein we see two key risks for 2023:

• First, is the potential economic slowdown/recession next year and the impact this could have on corporate profits. Currently, S&P 500 earnings are projected to rise by 6% next year, to US$230/share. If the slowdown is deeper than we anticipate then earnings are surely to be revised lower, which would be a headwind for the stock market.
• Second, is the Ukraine war and more broadly is geopolitics. Will China invade Taiwan? Will tensions between the US and China continue to deteriorate? Will Russia double down on its unjust war with Ukraine, potentially bringing in additional countries like Belarus? What will these factors then do to the current energy and food crisis? There is no shortage of geopolitical issues that could negatively weigh on the economy and markets.

Finally, there are a number of other positives heading into 2023 that suggests a recovery next year. They include:

• First, there are two very bullish market cycles for 2023 – the Presidential Cycle and US Mid-term Election Cycle.
• As seen below, the third year of the US President’s term in office tends to be the best for stock returns with the S&P 500 up on average 16% and is positive 88% of the time.
• For the US Mid-term Election Cycle, the US midterms are demonstrably bullish for the markets next year based on the historical data. We looked at the last 15 US midterms going back to 1960, and in every single case the S&P 500 was positive in the following 6 and 12 month period. In fact, the average return 12 months after US midterms for the S&P 500 is 16%.
• Second, back-to-back negative years for the US stock market are very rare. Over the last 50 years we’ve only witnessed two periods (‘73/’74 and the 2000s tech crash) where the S&P 500 posted negative returns for two consecutive years.
• Lastly, if interest rates decline next year we could see a nice recovery in bond prices as well, which would bode well for balanced portfolios next year.

After these challenging years it’s important to stand bank, get some perspective and look at the big picture. Markets and portfolios have done quite well in recent years. Stock markets rise 75% of the time so down years are going to happen. There is a naturally occurring cycle for the economy and equity markets and we’re currently in the bottoming phase of that cycle. But as the sun rises every day in the east, and the winter solstice brings on longer days in the spring and summer, so too will this cycle turn with better days ahead. It’s not a matter of if the economy/markets will rebound, rather when, which if all goes according to plan should be in 2023.

In my next post I’ll highlight some key investment themes for next year to help position you for the year ahead.

Years 3 of the Presidential Cycle are best for Stock Returns

Source: Bloomberg, Turner Investments

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.