Outlook 2023: After a History-Making Market Year, Here Are Key Questions to Consider

After Wall Street’s worst year in more than a decade, investors approaching December and the year ahead probably want to know if things will get worse before they improve.

It’s never a good idea to predict too far into the future. After all, few would have thought in late 2019 that a pandemic would soon lead to lockdowns, millions of tragic deaths, and financial and societal upheaval.

Still, as a long-term investor, getting ready for the new year isn’t a bad idea even when armed with what former Defense Secretary Donald Rumsfeld once referred to as the “known unknowns”—important questions we still don’t have answers to.

Though there’s probably things you’d rather do than check how your stocks did in 2022, the coming holidays could be a chance to pore over your portfolio and ask some of those key questions:

• What went right in 2022 (maybe not much), and what went wrong?
• How do your allocations look?
• Are you comfortable with those allocations or should they be changed to reflect market shifts?
• Is it time to rethink your sector exposure?
• Have your personal or investing goals changed since you last wrote them down?

Try to consider all that, if you can, before the ball drops in Times Square. Don’t let fear of coming face-to-face with your 2022 losses stop you. The markets go up and down, and bear markets happen. No one can avoid losing years.

Of course, it would help to know what you and Wall Street might face over the next 13 months.

Surprisingly—barring any major unforeseen geopolitical or market events— the future might bring slightly less uncertainty than the recent past. Volatility dropped sharply over the last month, and that’s no coincidence. It reflects a bit of uncertainty getting squeezed out of the market as certain pressing questions got answered.

Knowledge Up, Uncertainty Down

To that point, consider how much we know now versus a year ago.

Heading into 2022, there was incredible uncertainty about everything from midterm U.S. elections to COVID-19 to whether the U.S. Federal Reserve would hike rates and if so, when. The stock market was near all-time highs, but knowing what we know now, that might have been a time for more caution. Several years of rock-bottom interest rates around the globe and huge fiscal stimulus kept TINA—short for There Is No Alternative—humming along and making stocks seem like the most attractive investment.

TINA exited stage left very abruptly once 2022 got underway. Here’s some of what we learned during this rocky year, what we still need to learn and how these answers  might shape developments in 2023:

Jeopardy 2022

Fed Policy, Part 1: Hard to believe, but the Fed’s benchmark interest rate a year ago was essentially zero.

• Today, the benchmark rate rests between 3.75% and 4% after an unprecedented four consecutive 75-basis point hikes to counter the worst inflation in four decades. But at least investors now have a potential peak in mind, though it’s not certain exactly how high or for how long. The market is coalescing around a terminal, or peak, rate slightly above 5% by next summer, according to the CME FedWatch Tool. There’s even a chance of rates coming down a bit by this time next year.
• However, as Charles Schwab’s Chief Investment Strategist Liz Ann Sonders told Barron’s recently, “The market still needs to digest that the span of time between a final interest rate hike and a final rate cut, barring some crisis, is probably going to be longer than the normal span because they want to make sure inflation is down sustainably.”

The Election: Lack of certainty ahead of midterm elections led to some 2022 volatility. The “red wave” didn’t occur, but Republicans did take the House while Democrats held onto the Senate.

• For Wall Street, election results may deliver the best of all worlds politically in 2023. There’s a division of power between Capitol Hill and President Biden’s White House, and there’s division within the legislative branch itself.
• Gridlock in Washington is generally good for one reason—it can mean less chance of major tax, financial, or regulatory changes. That’s just the way many corporations like it.

COVID-19: We’ve come a long way addressing the pandemic, though China’s lockdowns continue playing havoc.

• At home, we can’t discount chances of higher caseloads or new variants this winter, but massive global lockdowns appear to be history.
• There’s less COVID-19 uncertainty heading into 2023 than the past two years.

Inflation: After hitting 40-year highs in mid-2022, the last two major inflation reports—the October Consumer Price and Producer Price Indexes—were milder than expected.

• Many analysts believe inflation has peaked, though few if any expect it to fall toward the Fed’s 2% goal anytime in 2023.
• Most do expect slower price growth ahead, and easier year-over-year inflation comparisons might calm the market, too.

The CBOE Volatility Index® (VIX): After rising into the mid-30’s earlier this year, the bellwether fell to near 20 by the Thanksgiving weekend. A lower VIX is one sign that nerves have cooled, perhaps setting the stage for more positive sentiment on Wall Street. But there aren’t any guarantees, because plenty of questions remain.

What Looms Ahead in 2023?

Knowing all this sets a base, even if doesn’t settle every question. Here are things to watch as December ticks down.

Fed Policy, Part 2: The market prices in 70% chances of a 50-basis-point rate hike at the next Federal Open Market Committee (FOMC) on December 13-14, according to the FedWatch Tool.

• December’s meeting will offer investors a new dot-plot showing where FOMC members believe rates will head in 2023. For now, the likely scenario is rates topping out between 5% and 5.25% next June or July. Keep an eye on the new dot-plot for what sort of peak rate the Fed sees. It was 4.6% at the September meeting, but it may have to tick higher unless the Fed is more optimistic than the market.
• Also monitor the Fed’s latest economic growth, unemployment, and inflation projections for 2023 and beyond. The median FOMC projection in September was for weak 2023 Gross Domestic Product (GDP) growth of 1.2%, with unemployment at 4.4% (up from the current 3.7%) and core Personal Consumption Expenditures (PCE) inflation of 3.1%, down from 4.5% in 2022. Updated Fed economic projections could play into thinking about how high rates rise in 2023.
• Short-term rates climbed to multiyear highs in 2022, reflecting the Fed’s hawkishness, but long-term rates didn’t climb as much. That’s set up a sharply inverted yield curve, a scenario that historically indicates recession ahead. Inflation caused this, but Schwab analysts think the Fed’s tightening could have an economic impact in 2023, possibly easing inflation.

Wrapping Up December Data: Before the Fed’s next meeting, we’ll have another round of inflation and jobs data.

• Investors will no doubt watch this closely, too, and it could have an impact on the Fed’s December and future rate decisions.
• Another thing to keep in mind is a possible U.S. rail strike as soon as December 9 that could put supply chains back in chaos in the coming year.  

Continuing Recession Fears: Aside from Fed policy, the biggest question facing investors in 2023 is whether there’ll be a U.S. recession.

• Maybe it’s better to ask if we’re already in one, since recessions usually aren’t recognized until after they start. The housing market has been very soft lately, often a sign of wider problems in the economy.
• As of late November, the job market remains strong, a major argument against recession. However, a host of large companies, especially in the info tech sector, recently announced layoffs. We’ll see if those job losses start to show up in the data.

 Incoming Job Data, Q4 Earnings:  The Fed has specifically said it’s trying to cool the labor market, but some fear that could trigger a recession.

• If so, investors may have to rethink current expectations for 2023 corporate earnings growth, which many analysts think are too high near 5.5%.
• Recessions often cause double-digit overall annual earnings losses. We’ll get a better idea in January during Q4 earnings season whether Wall Street needs to tone down full-year earnings projections, Briefing.com noted.
• If earnings estimates start to drop, it may make major stock indexes look overvalued. Price-earnings (P/E) stood near 17 for the SPX in late November, down from well above 20 a year ago but still a premium to the long-term average near 16. If the “E” part of P/E drops in 2023, the “P” part may need to fall, as well.
• In a worst-case scenario, such as a severe recession, earnings could slide by double-digits. That would likely send stocks sharply lower.
• However, if earnings stabilize near current levels, it could indicate that the stock market may not have much downside left.

Shoppers and Sentiment: Consumer spending forms about 70% of the U.S. economy, and despite modestly good sales increases in stores over the Thanksgiving holiday, strong shopper sentiment going into 2023 could be question mark. Here’s why:

• If the Fed significantly cools the labor market next year, spending could chill, Briefing.com adds. Though retailers closer to the luxury end of the spectrum like Macy’s (M) and on the lower-income side like Walmart (WMT) sounded optimistic heading into Q4, some stores in the middle like Target (TGT) and Kohl’s (KSS) have expressed concern.
• Uncertainty tends to dampen the “wealth effect.” Briefing.com points out that people who’ve seen their investment portfolios dip may not feel as confident making discretionary purchases or taking fancy vacations. These decisions play into economic growth and earnings scenarios.

Continuing slowing in the housing market, which took a dive in 2022, will likely close pocketbooks along the way.

Dollar’s Direction: Fed rate hikes and weakness in overseas markets sent the U.S. dollar to its most powerful rally in 20 years.

• The U.S. Dollar Index ($DXY) has been above 100 for seven months, something not seen since 2002.
• If dollar strength persists, it’s likely a powerful weight on U.S. 2023 earnings potential.
• But if the dollar’s recent descent is part of a longer-term trend, it may take some pressure off Wall Street. A softer U.S. labor market, if it comes, might help ease dollar strength further.

Sector Watch: So-called “growth” sectors like communication services, consumer discretionary, and info tech were among the worst 2022 performers, and real estate got rocked by rocketing mortgage rates.

• Energy led all sectors year to date through November but falling crude oil prices in recent weeks called that rally into question.
• Fixed income, which often performs well in years when stocks do badly, didn’t keep up its end of the bargain in 2022. But some analysts say the high current yields have begun attracting more buyers to the bond market.
• If there’s a recession, more investors might gravitate toward bonds and so-called defensive sectors like health care, utilities, and staples in 2023. That’s been the historic pattern, but keep in mind the market tends to run ahead of the economy, so some of these sectors have already had a nice run.

Whichever way sectors go, look for “market breadth” in any 2023 rallies for signs that the gains may have staying power. If gains are limited to a few mega-caps while the rest of the market lags, that’s not the best sign.

’23 Resolutions: Consider Your Risk Tolerance

We learned quite a lot in 2022, but investors shouldn’t be sanguine or try to predict all the trends affecting markets in 2023. Keep asking questions and consider what you know, check your risk tolerance, your current allocations and any changes in your life that might affect your goals. Then decide if you need to re-position for the new year.

Once 2023 begins, prepare to stick to your plan even if things get volatile. Being in the market tends to work better than jumping in and out for long-term investors, and no one can perfectly time entries and exits.

Happy trading,

Shawn