Economic and Market Outlook for 2023
“Free money” hangover lingers but is mixed with opportunity
- Stocks traded lower over the last week of 2022 on the back of growth and inflation concerns as related to Federal Reserve Monetary Policy.
- We reiterate our price target for the S&P 500 and our earnings projection for 2023.
- We continue to see “the glass half full” as the end of a period of “free money” and overstimulation of the economy suggest better times could lie ahead for both equity and bond markets as the New Year progresses.
- Last week health care, utilities and consumer staples were the only sectors of the S&P 500 above their five-year averages, suggesting to us that cyclical sectors are a better value as we enter the New Year
The headline that to us seemed most repeated over the New Year’s holiday weekend was “S&P 500 suffers its worst loss since 2008.” It was an eye-catching headline for sure though not atypical considering 2022 was a particularly rough year for the stock and bond markets—especially in a Fed funds hike cycle that many market participants had longed for in 2021 but then fretted over throughout 2022 as the Fed moved to address levels of inflation not seen in 40-some years.
You just can’t please some people
The market theme du jour seemed to transition from “the Fed’s behind the curve” in 2021 to “...the Fed’s determined to push the economy into a recession and throw the stock market under the bus—(look out below!).”
We find some historical context helpful in assessing where the market ended 2022 and in projecting the direction it might take over the course of 2023.
Indeed 2022 was the S&P 500’s worst year since 2008 but stemming from a very different underlying cause. In addition, how it was addressed by policy makers at the Fed and on Capitol Hill as well as the magnitudes of the respective percentage declines of the S&P 500 in 2008 and 2022 were also markedly different.
In 2008 the fundamental cause for a maximum drawdown of 47.7% (the drop from the peak in a given calendar year to the low in the same year) was a financial paralysis caused by mortgage and lending practices at the core of a crisis that nearly sunk the US and world economies. For the whole year the S&P 500 lost 38.5% in 2008.
In 2022 the fundamental cause for a maximum drawdown of 25.4% and a full-year decline of 19.4% was the process of exiting the pandemic, stickier and higher than expected levels of inflation (complicated by global supply chain disruptions and further exacerbated by Russia’s incursion into Ukraine), China’s zero tolerance for COVID-19 policy (which shuttered cities as large as Shanghai—population 25 million), along with OPEC+ oil production cuts aggravated by domestic oil policy in the US that favored foreign over US oil production sources for much of last year.
If one considers the effect of behavioral economics we’d add the unfamiliarity with levels of inflation as high as 10–11% by many adults who were too young to have lived through the high levels of inflation incurred in the late 1970s and early 1980s elevated the concerns and response.
The difference between relying on text book interpretation or the anecdotal recall of others (often affected in tone by the opinions of a given author or individual’s viewpoint) versus having lived through it as part of the workforce and to experience the effects and positive results from Fed Chair Paul Volcker’s draconian measures in monetary policy in the 70s and early 1980s can lead to disparate conclusions about what today’s transition into the “next new normal” might look like.
Belonging to the former group of those who lived and worked through the earlier period of inflation our “back of the napkin” observation for the purpose of this market weekly commentary is that Fed Funds hike cycles are never much fun; they can produce different levels of discomfort and market volatility but ultimately have proven in the past to have positive effect for the economy and the markets in uncovering excesses stemming problems at their source and providing an exit regime that can lead to a sustainable economic recovery beneficial to the constituents of both Main Street and Wall Street.
Given such perspective diversification, right-sized expectations of asset class performance, and more than just a dollop of patience history suggests that 2023 will be a “work out” period for the economy not to run from but rather take advantage of in seeking out opportunities that result from periods of volatility when “babies get thrown out with the bathwater” (when good stocks—and other quality assets—get sold off during market tantrums and over reaction driven by negative projections seemingly “into infinity”).
Taking the aforementioned into consideration we reiterate our price target of 4400 for the S&P 500 by year-end 2023 or for a nearly 15% rise above the benchmark’s closing price of 3934 from last Friday. Our earnings projection of $230 for the S&P 500 calls for a P/E multiple of 19x with near flat earnings growth in 2023 (based on our projection for calendar year 2022). Our price target is based on a number of assumptions that include:
- Inflation stateside continuing to trend lower showing the Fed’s efforts are having effect in curbing untoward levels of inflation experienced since late 2021 through last year.
- Expectations that China will have some success in a new round of economic re-openings as its officials provide some stimulus for the economy and loosen the stringent zero-tolerance COVID policy which has hurt their domestic economy and delayed the process of addressing supply chain disruptions which have challenged the economies of China’s trading partners around the world.
- Bearish sentiment remains widespread among market participants stateside not withstanding signs of resilience in the economy which could reduce the likelihood of a stateside recession or at least its depth and length should it be realized. The better the improvement in the inflation rate when the Fed either takes pause or pivots the less likely a hard landing.
- Consensus earnings projections for 2023 while still considered too optimistic in the view of the bearish community may in fact have been right sized by analyst revisions suggested with FactSet consensus valuations at the end of last week that show current forward valuation for the S&P 500 at 16.7x (11% below its five-year average forward multiple of 18.8x and 30.1% below its five-year high of 23.9x in 2020). Valuations of a number of other key stateside and international indices are currently well below their respective peaks and five-year average PE multiples as well.
- In our view the Federal Reserve’s policy toward inflation implemented in 2022 has begun to have a positive effect reducing the momentum that inflation has had since late 2021.
- While we do not expect the Fed to pivot or pause a process of rate hikes anytime soon; we do expect that it will temper increases of its benchmark rate going forward should inflation come down further.
- With seven rate hikes “in the bag” since March (0.25%), April (0.50%), four hikes of 0.75% each (June, July, September and November) and most recently in December (0.50%) some progress has been reflected in the economic data that could support a 0.5% on February 1 (the next scheduled FOMC meeting).
- In our view right-sizing expectations will continue to help investors navigate the Fed’s rate hikes that lie ahead in light of economic data which could offer periods of disappointment as the markets track the Fed’s progress in curbing this cycle’s high inflation rates.
Downside risks to our 2023 S&P 500 target and earnings projection:
- Geopolitical and global economic risk escalation sourced from policies driven by China and Russia.
- US corporate managements having difficulty in navigating an economic and trade environment that remains somewhat dysfunctional.
- A significant reversal in the economic progress that has been made thus far in exiting the pandemic period.
- Additional sizeable fiscal policy stimulus to the US economy.
- Should the Fed overshoot tightening and drive the economy into more than a shallow recession.
- Geopolitics with negative implications and impact for the global supply chain including: China COVID lockdowns, China incursion into Taiwan, a worsening situation of Russia’s incursion into Ukraine, OPEC Plus production cuts.
- A dramatic and sustainable broad resurgence in commodity prices as the world moves toward the next economic recovery and “the next new normal.”
Upside risks to our 2023 S&P 500 target and earnings projection:
- Oil production stateside picks up further should the administration pivot to favor domestic US oil producers to bridge the practical gap in the time line between current dependence on fossil fuel and eventual greater dependence on alternative energy.
- Inflation levels trend lower with consistency.
- Corporate earnings and revenue growth prove better than current corporate guidance and consensus analytical expectations.
- Real estate proves more resilient in the rising interest rate environment as prices temper some and interest rates stabilize.
- Supply chain dysfunction lessens as businesses begin to find some success in their diversification process away from one-country centricity.
- Commodity prices stabilize or fall (but not so dramatically to suggest a recession).
- The dollar moves further off its high perch as geopolitical risk lessens.
- An increase in workers returning to jobs left earlier this cycle as the recent inflation surge cuts into personal savings
The Overall Challenge
From our perch on the Market Radar Screen we find the biggest “hurdle to change” for the equity market is the most obvious in that the Fed is currently tightening policy rather than adding liquidity as it was when the US economy and markets were in the process of exiting the financial crisis or navigating the pandemic.
A key factor in achieving success this cycle will be the Fed’s terminal rate (the rate at which it stops raising rates and economic conditions when it takes such action).
The better the improvement in the inflation rate when the Fed either takes pause or pivots the less likely a hard landing.
In our view the end of free money (the end of super monetary accommodation by the Fed) has already begun to deliver the introduction of a period of “real money” wherein bond buyers get better yields when they buy a bond and bond issuers pay for the privilege of borrowing money.
Such an environment could usher in a cycle wherein leverage and momentum give sway to a period wherein economic and market fundamentals carry greater weight among market participants.
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