What the Markets’ New Tailwinds Could Look Like in 2023

Editor’s note: This is part two of a three-part series about what the economy and markets could look like this year. Part one is Will Rising Interest Rates Lead to Soft Landing or Recession? Part three is Five Investment Strategies to Focus on in 2023.

In the first part of this series, we considered the potential of the Fed’s 2022 rate hikes in bringing the economy in for a soft landing, concluding that if the Fed continues to enact more aggressive hikes than expected, it will be detrimental to the economy.

As 2022 wrapped up, the Fed’s rate hikes had undoubtedly begun to broadly impact the economy. Consumer confidence, retail sales, homebuilder sentiment and new housing starts are all down. The Purchasing Manufacturing Index (PMI) has declined to 46, suggesting the economy may already be in recession. But there is some good news suggesting that investors have reasons to be optimistic in 2023.

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Inflation Leveling

In November, headline inflation cooled, rising just 0.1% for the month (0.2% for core), bringing year-over-year inflation down to 7.1%. In December inflation cooled once again, coming in with prices dropping month-over-month for the first time (-0.1%) since May 2020, at 6.5% year-over-year. Six months of consecutive slowing indicates inflation probably peaked back in June. More important, headline inflation of 0.1% in November, if sustained, suggests an annualized run-rate of 1.2% headline inflation over the next 12 months, a significant decline from 2022’s highs.

Indeed, the consensus calls for inflation to fall to somewhere around 3% to 4% by the end of 2023.

Finally, energy prices have come down significantly from their June highs, and gasoline prices are lower today than they were a year ago, a powerful tailwind that only adds to the disinflationary forces already building throughout the economy.

Lower Valuations Present Opportunities for Value Investors

Valuations for most asset classes are more attractive today than they’ve been in years. Negative returns on both stocks and bonds in 2022 have succeeded in bringing down market valuations from their 2022 highs and, in the process, improved the market’s overall financial health.

The S&P 500 now trades at 16.6 times next year’s earnings vs. the 22 times earnings that it traded at this time last year. The market predicts the Fed will begin cutting rates in late 2023; the Fed predicts they’ll begin in early 2025. As a result, it’s not a stretch to expect multiples to again rise once the Fed pauses increases and, ultimately, reverses course on interest rates.

The S&P 500 trading at 17-18 times earnings by late 2023 — about 5.5% higher from today’s level — seems quite realistic. Building a portfolio of historically high-quality companies trading at these lower valuations is a good strategy for positioning for a recovery that could deliver rewards after valuations hit an inflection point.

Good Bond News for Diversified Portfolios

The same can be said for fixed income valuations. Bonds today offer investors the highest yields they’ve seen in nearly a decade. At the end of 2021, the two-year Treasury yielded 0.73%; a year later, it yields 4.17%.

While the yield curve across a range of bonds may be steeply inverted, investors today have opportunities in short-duration fixed income that simply didn’t exist 12 months ago — a major breath of fresh air for diversified portfolios and income-oriented investors. Should the Fed pause and eventually begin to cut rates in late 2023 as the market forecasts, diversified portfolios with allocations to bonds would again be well-positioned to benefit.

Finally, this also suggests that investors could begin adding back longer-duration bonds to their portfolios, probably later in 2023.

10% Return for S&P 500 a Real Possibility by End of 2023

Earnings growth should be another positive tailwind for equity markets next year. Earnings drive stock prices. And in today’s market, with its newfound emphasis on fundamentals, earnings really matter. Short of a recession — a very real possibility — consensus estimates are for about 5% earnings growth for S&P 500 companies in 2023. That’s certainly less than what it was in years past, but still respectable.

When combined with the potential for a 5.5% increase in the S&P 500’s valuation (from 16.6x to 17.5x), that equates to a potential 2023 return for the S&P 500 Index of about 10% from today’s values for a year-end target of 4,200.

Market Returns Tend to Be Quite Positive in Years Following Significant Declines

If there’s one silver lining to 2022, it helped re-ground investors in the basics. Fundamentals matter, predictions should be taken with a healthy dose of skepticism, and prudent planning prevails in the long run. Finally, market history is on the side of the optimists.

Historically, market returns following relatively sharp declines have been quite good. Since 1926, stocks have averaged 12.5% returns in years following declines of 10%, while average returns increase to 22.2% in years following declines of 20%. The S&P 500 fell 18% in 2022. While history repeats, it does tend to rhyme, and this is a tailwind tune that could propel investor returns in the year ahead.

Certified Financial Planner Board of Standards Inc. (CFP Board) owns the CFP® certification mark, the CERTIFIED FINANCIAL PLANNER™ certification mark and the CFP® certification mark (with plaque design) logo in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.

Mercer Advisors Inc. is the parent company of Mercer Global Advisors Inc. and is not involved with investment services. Mercer Global Advisors is registered as an investment adviser with the SEC. Content is for educational and illustrative purposes only and does not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Some of the research and ratings shown in this presentation come from third parties that are not affiliated with Mercer Advisors. The information is believed to be accurate, but is not guaranteed or warranted by Mercer Advisors. Past performance may not be indicative of future results. Diversification does not ensure a profit or protect against a loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client's investment portfolio. Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any particular benchmark. Forecasts are not a reliable indicator of future performance. Forecasts, projections and other forward-looking statements are based on current beliefs and expectations. They are for illustrative purposes only and serve as an indication of what may occur. Given the inherent uncertainties of risk associated with forecasts, projections or other forward statements, actual events, results or performance may differ materially from those reflected or contemplated.