2023 investment outlook: A tale of two halves

December 20, 2022 | Market news

At a glance

We anticipate a choppy 2023 start giving way to a more favorable investment environment later in the year. The year’s first half centers on the U.S. Federal Reserve (Fed) and other central banks’ policy resolve, with investors weighing how stringent policymakers will be given recent interest rate hiking trends. Central banks face a challenging backdrop, with inflationary pressures remaining above historic levels but economic growth demonstrating slowing conditions, risking central banks increasing borrowing levels into a weakening economy.

We have shared a two-staged investment framework to explain current capital market reactions. The first stage reflects how markets react to interest rate changes, and the second anticipates how the economy adjusts to higher interest rates’ cumulative impact. When central banks target higher interest rates, newly issued government bonds reflect elevated yields, forcing other assets to reprice lower. With persistent interest rate hiking campaigns and relatively consistent central bank communication, we may be mostly through the first stage.

Our near-term caution rests within the second change. Higher interest rates reflect higher borrowing costs that act like a tax to credit-reliant consumers and businesses. Although the labor market remains strong and job openings exceed jobs sought, low labor force participation and diminished savings may thwart consumer spending. Businesses may, in turn, anticipate weakening consumer spending and limit expansion plans. As the economy endures higher borrowing costs, corporate earnings may be challenged relative to current estimates.

Eric Freedman, Chief Investment Officer, U.S. Bank

Global economy

Quick take: Higher interest rates and inflation pressures are weighing on the United States and foreign developed economies as we enter 2023. A COVID-19 recovery in China could be positive in the latter half of the year.

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    • The U.S. economy is likely to struggle at 2023’s outset due to Fed interest rate hikes, though slower inflation should help a second half recovery. Accumulated Fed interest rate hikes and souring consumer and business sentiment weigh on economic growth as we open 2023. Softer inflation and an end to Fed rate hikes should stabilize consumer and business spending into year-end.
    • High energy costs likely hold foreign developed economies in a recession for much of the year, while the Russia/Ukraine conflict remains a key economic swing factor. High energy costs are hurting consumer spending and cumulative interest rate hikes from the European Central Bank and the Bank of England dampen full-year growth prospects. Japan likely bucks this trend due to near zero interest rates by the Bank of Japan and improving consumer spending.
    • China’s economic prospects remain linked to a recovery from coronavirus practices, while major commodity exporters among emerging market economies may see softer growth on weaker prices. Better prospects are possible later in 2023 should China lift zero-COVID policies, perhaps with the distribution of a more effective mRNA vaccine, and global demand recovery supports commodity prices and the producing countries.

U.S. equity market

Quick take: Inflation’s persistence, path forward for interest rates and pace of earnings growth are keys to equities’ return potential in 2023.

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    • The potential for an economic slowdown or recession and lack of monetary and fiscal policy assistance tempers our optimism for meaningfully higher equity returns in the new year. We view U.S. equities’ return prospects as positive but muted relative to historical averages as Fed rate hikes and declining fiscal stimulus represent headwinds to overall equity returns. We deem it unlikely the Fed will reverse course and lower interest rates in 2023 and doubtful that Congress will pass legislation designed to jump start economic growth, creating headwinds to overall equity returns.
    • Dividend-paying and traditionally defensive sectors retain near-term appeal when weighing the prospects for a growth slowdown or recession. Roughly 17% of S&P 500 companies offer dividends yielding above the 10-year Treasury yield of 3.5%, as of December 16, 2022, providing investors with a diverse opportunity set of income-oriented equities. Meanwhile, companies in the Healthcare, Utilities, Real Estate, Consumer Staples, Financials and Energy sectors, on balance, present relatively stable growth profiles throughout varying economic environments, with many offering compelling dividend yields and dividend growth rates.
    • Secular growth sectors remain well-positioned for longer-term growth. Secular growth sectors, where technological advancements and demographic trends drive longer-term demand, were among the worst-performing sectors in 2022. Higher interest rates have increased borrowing costs and driven economically sensitive equity prices lower due to concerns associated with reduced demand, supply chain challenges and overall slowing in the pace of revenue and earnings growth. While the near-term outlook for these sectors remains unclear, the longer-term prospects are compelling due to 2022 price declines.
    • Technology is pervasive among all sectors. While currently largely out of favor, Information Technology is one sector that offers longer-term appeal. Fast is getting faster, and speed, scale and efficiencies require technological advancement. Additionally, the interaction of artificial intelligence, machine learning, e-commerce, cloud computing, data security and analytics provide a platform for new tools and outcomes that favorably position companies within the Technology sector.

International equity markets

Quick take: Tightening financial conditions and proximity to the ongoing Russia/Ukraine conflict remain headwinds for European firms’ profitability, while a potential China reopening in 2023 represents upside potential for businesses sensitive to global economic growth.

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    • A subdued 2023 earnings outlook supports our cautious stance on foreign developed and emerging market equities’ return prospects. The unsettled Russia/Ukraine conflict, China’s ongoing COVID restrictions and central banks’ tightening monetary policy to combat elevated inflation remain material headwinds for global economic growth and foreign companies’ 2023 profit outlooks. High interest rates and energy prices continue to erode consumers’ purchasing power, while high input and financing costs impair companies’ profitability potential. The risk of renewed European gas shortages in the 2023-2024 winter further highlights the wide range of potential outcomes in the year ahead.
    • Recent positive equity price performance warrants attention, but we view the rally’s durability with skepticism. Despite challenging macroeconomic conditions and exceptional uncertainty emanating from the Russia/Ukraine war, analysts have left foreign developed earnings 2023 estimates little changed from the beginning of 2022. Tightening financial conditions for businesses and consumers challenge analysts’ current 2023 earnings growth forecasts; if analysts’ expectations prove overly optimistic, we remain concerned about renewed asset price weakness, with stock prices following potentially downgraded earnings forecasts lower.
    • China’s uncertain COVID policy path remains a two-sided variable for foreign market prospects in 2023. Restrictive zero-COVID policies have severely constrained overall domestic activity, impairing larger e-commerce, financial services and entertainment companies’ revenue growth streams. Additionally, China’s slowdown continues to weigh on major firms providing key technological and industrial goods to the global economy. While timing regarding a durable zero-COVID policy easing remains unclear, a 2023 economic reopening would provide upside earnings potential for emerging market firms, highlighting China’s COVID policy path’s two-sided impact on 2023 outcomes.

Bond markets

Quick take: High-quality bonds offer the highest yields in more than a decade and may guard portfolios against slowing economic growth. Increasing Treasury yields in 2022 dragged down bond prices but improved future potential returns. Corporate and municipal bond yields over Treasuries also rose, further boosting our outlook for income opportunities in 2023. We anticipate opportunities in longer-term bonds may become more compelling in 2023 if inflation slows further and economic headwinds from restrictive Fed policy and worsening liquidity conditions drag on growth.

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    • Tighter monetary policy remains a headwind for riskier assets, with uncomfortably high inflation keeping pressure on the Fed to hike interest rates at least into early 2023. Treasury yields incorporate expectations that the Fed’s target rate will peak around 5% in mid-2023 then fall to 4.3% by the end of 2023. The Fed also plans to continue reducing its bond holdings, referred to as quantitative tightening. Allowing $95 billion in Treasury and mortgage bonds to mature each month without reinvesting the proceeds may eventually strain market liquidity conditions, because private investors must absorb more bonds.
    • Short-term Treasury yields should increase as the Fed raises interest rates, but slowing growth and inflation may eventually anchor long-term yields. Rising Fed rates should place direct upward pressure on short-term yields. However, high-quality short-term bond returns should improve in 2023 given their coupon payments are the highest in more than a decade. Further deceleration in growth and inflation and a peak in the federal funds rate should help longer-term high-quality bond returns later in the year.
    • High-quality corporate and municipal bond issuer fundamentals should withstand decelerating earnings and tax revenue growth. Corporate and municipal bond issuers locked in low borrowing costs in 2020 and 2021. Investment-grade issuers should retain ample ability to service their cheap debt in 2023. High yield issuers’ ability to make debt payments tend to be linked to broader economic conditions, though strong credit fundamentals limit the prospect of a large default wave in 2023.
    • Mortgage bonds not backed by the government and reinsurance offer additional sources of attractive income. High mortgage rates should remain a drag on the housing market into 2023, but yields on mortgage bonds not backed by the government have already adjusted near their highest levels in over a decade with investors reducing allocations during 2022. Reinsurance, also referred to as insurance-linked securities, continues to offer compelling yields. Insurance premiums minus insured losses from natural disasters drive returns and remain uncorrelated with typical economic cycles that drive stock and bond returns.

Real assets

Quick take: Rising borrowing costs may offset positive income growth in the real estate market, hampering returns. A slowing economy creates an opportunity for infrastructure assets paying consistent dividends but pressures commodity prices.

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    • Real Estate underperformed the broader market in 2022, with rising interest rates offsetting positive property market fundamentals. A less volatile interest rate environment should provide more price stability for real estate investment trusts (REITs), allowing investors to earn the dividend yield plus some price appreciation in 2023. REITs re-priced significantly in 2022 and now trade at cheaper levels relative to their fundamentals.
    • Decelerating growth and inflation in 2023 likely mean investors prefer investments with consistent and growing cash flows, such as global infrastructure. Global infrastructure includes companies operating in utilities, toll roads, transportation and communications infrastructure, energy storage and transportation. More pronounced deceleration in global economic growth to open 2023 provides a challenging backdrop for commodity prices, despite relatively tight supplies. Should the Fed pause rate hikes, perhaps in 2023’s second half, prices could rebound, with current inventories for oil, industrial metals and even grains remaining low compared to the past decade.

Alternative investments

Quick take: Hedge funds are navigating the rapidly evolving capital markets landscape for opportunities. Tactically oriented managers who stay nimble and can trade quickly are well suited for this environment. We see longer-term value in strategies that hold securities for longer to unlock value amid market dislocations that present equity hedge fund managers with investment opportunities in their respective sector focal areas such as Technology and Healthcare.

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    • Macroeconomic uncertainty favors defensive positioning. We anticipate hedge funds will continue to have less overall net exposure (the difference between the aggregate value of the portfolio invested long less the portfolio invested short) to the equity and credit markets. However, we do not conclude managers will avoid risk, instead using the defensive posture as a starting point from which to tactically lean net long or short and pursue high conviction opportunities.
    • Fixed income strategies are compelling as the economic cycle continues to unfold. We anticipate an increase in credit downgrades as credit ratings agencies lower borrowers’ creditworthiness due to deteriorating fundamental conditions; hedge fund managers skilled at trading around credit events will have ample chances to generate profits. We also anticipate a greater number of idiosyncratic credit opportunities to surface, including distressed debt, where managers invest in securities of companies otherwise unable to refinance their debt or meet restrictions on existing debt covenants.
    • We remain positive on macro strategies’ forward prospects due to anticipated changes in economic growth rates, interest rate levels and currency values. Our positive outlook spans discretionary macro strategies, which are based on managers’ outlooks for various asset classes, as well as systematic macro strategies that apply quantitative rules to identify trend persistence or reversal.

Private markets

Quick take: Private markets were resilient as riskier assets re-repriced in 2022, but we anticipate private company revenues and profits will face pressure if economic conditions deteriorate further in 2023.

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    • Large capital pools raised over the past few years and strong balance sheets could mitigate private markets’ downside under deteriorating economic conditions. Also, private market fund managers are operational experts in their respective investment focal areas and can help companies better adjust to changing economic conditions.
    • We expect continued slowing in private markets activity. Global mergers and acquisitions (M&A) deal volume declined by 29.8% year-over-year in 2022 and deal announcements, a leading indicator for future deal activity, slowed over the course of 2022, suggesting that M&A activity will continue to cool further in 2023. Meanwhile, initial public offering (IPO) activity declined by 44% over the first three quarters, limiting opportunity for private market fund managers to exit their investments. Amid this slowdown, we remain focused on resilient business models and secular transformative trends while being open to relative value opportunities in 2023.
    • Long-term secular trends in the Healthcare and Technology sectors remain intact and recent price declines provide attractive entry points for private investors in the quarters ahead. Early-stage growth equity and lower middle market buy-and-build strategies are becoming even more interesting.
    • Private debt offers attractive risk-adjusted returns for investors while managers may find opportunities to acquire otherwise good businesses with broken balance sheets in a special situation strategy known as “debt for control.” Under this strategy, a lender takes a debt position in a business with a plan to convert that debt to a controlling equity position.
    • Within private real assets, we see compelling opportunistic real estate strategies that invest across sectors based on relative value differences. Supply constraints in the Energy sector also present attractive dynamics depending on the investment strategy.

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This commentary was prepared December 2022 and represents the opinion of U.S. Bank Wealth Management. The views are subject to change at any time based on market or other conditions and are not intended to be a forecast of future events or guarantee of future results and is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable but is not guaranteed as to accuracy or completeness. Any organizations mentioned in this commentary are not affiliated or associated with U.S. Bank or U.S. Bancorp Investments in any way.

U.S. Bank and its representatives do not provide tax or legal advice. Your tax and financial situation is unique. You should consult your tax and/or legal advisor for advice and information concerning your particular situation.

Diversification and asset allocation do not guarantee returns or protect against losses. Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio.

Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for investment. The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the stock market in general.

Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer-term debt securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in high yield bonds offer the potential for high current income and attractive total return but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer’s ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes but may be subject to the federal alternative minimum tax (AMT), state and local taxes. There are special risks associated with investments in real assets such as commodities and real estate securities. For commodities, risks may include market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults). Hedge funds are speculative and involve a high degree of risk. An investment in a hedge fund involves a substantially more complicated set of risk factors than traditional investments in stocks or bonds, including the risks of using derivatives, leverage and short sales, which can magnify potential losses or gains. Restrictions exist on the ability to redeem or transfer interests in a fund. Private capital investment funds are speculative and involve a higher degree of risk. These investments usually involve a substantially more complicated set of investment strategies than traditional investments in stocks or bonds, including the risks of using derivatives, leverage, and short sales, which can magnify potential losses or gains. Always refer to a Fund’s most current offering documents for a more thorough discussion of risks and other specific characteristics associated with investing in private capital and impact investment funds. Reinsurance allocations made to insurance-linked securities (ILS) are financial instruments whose performance is determined by insurance loss events primarily driven by weather-related and other natural catastrophes (such as hurricanes and earthquakes). These events are typically low-frequency but high-severity occurrences. Private equity investments provide investors and funds the potential to invest directly into private companies or participate in buyouts of public companies that result in a delisting of the public equity. Investors considering an investment in private equity must be fully aware that these investments are illiquid by nature, typically represent a long-term binding commitment and are not readily marketable. The valuation procedures for these holdings are often subjective in nature. Private debt investments may be either direct or indirect and are subject to significant risks, including the possibility of default, limited liquidity and the infrequent availability of independent credit ratings for private companies.

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