This theme of peaks and troughs may seem at odds; a more optimistic view on equities in the face of what may be a recessionary environment. In our view, we feel any economic contraction is more likely to be mild rather than severe. Within that broad theme, here are our key expectations for 2023.
Inflation and interest rates are likely near their peak
We’ve seen a significant shift in both inflation and inflation expectations. Central banks began 2022 by insisting that inflation was transitory, only to then raise interest rates to bring inflation down. The rapid increases in central bank rates through 2022 are likely near their end; the Bank of Canada and the U.S. Federal Reserve may have one or two more rate hikes before they pause and allow them to work their way through the economy.
Equity markets may be near a trough as valuation starts to matter again
As we look ahead to 2023, we believe the valuation gaps that exist across asset classes may become a greater focus for investors. While valuation is a poor predictor of short-term performance, it does suggest the potential for international equities (including emerging markets and Canada) to outperform U.S. equities over the medium term.
Asset class correlations may be at their peak
The major equity markets and bond markets moved in the same direction in 2022. These correlations tend to break down after a period of time, so in 2023, economies will likely move along their market cycles at different paces. We believe this will open up more diversification opportunities across asset classes.
A return to income in fixed income
The challenges that faced fixed income investors in 2022 have led to a better outlook for bonds in 2023. Interest rates and bond yields are at levels not seen in over 10 years, and we believe this will allow for an improved return profile over the next decade.
Will this be a RINO economy: Recession in name only?
The data suggests a likely recession in the U.S. in 2023. Typical recession indicators, such as falling housing starts, an inverted yield curve and the Conference Board’s Index of Leading Economic Indicators falling negative, started appearing in the middle of 2022.
We believe there’s also a strong risk of recession in Canada, parts of Europe and Asia. We’re already seeing signs of a slowdown in global manufacturing activity. The question is, how long and how deep of a recession might it be?
We believe this may be a recession in name only. Typically, recessions come about following an excess within the economy. This recession followed an excess of money supply in 2020 and 2021. However, that excess has gone, and that, coupled with healthy labour markets in North America, could lead to a gentler economic contraction.
For historical comparisons, we would point to the recessions of 1970 and 2001, which were shorter and much milder than the historical average.
Nevertheless, we’re seeing a contraction in manufacturing activity globally and starting to see a contraction in export growth in China and South Korea, the latter typically being a bellwether for global economic growth.
In Canada, any economic weakness is likely to be around the housing market, given how it’s more sensitive to changes in interest rates than other areas of the economy. Similar to the United States however, we believe the strong labour market may make for a milder recession.
We fully realize that labour is a lagging indicator in a recession (job losses typically come at the end of a recession rather than the beginning). However, we consider that there’s been a demographic shift, with the numbers leaving the labour market exceeding those entering. Therefore, the unemployment rate, which typically spikes during a recession, may remain low in this exceptionally tight labour market.
A year for resolving uncertainties
Overall, we don’t believe that potential recession risks will overshadow fixed income and equity opportunities in 2023, thanks to the reset of market valuations, interest rates and return expectations in 2022. The last three years have been unprecedented with respect to the global pandemic, 2020 market crash, central bank response, recovery, market rally, inflation and eventual reset.
We believe 2023 will be about resolving uncertainties. We feel that much of the recession has already been factored into equity and bond market valuations and that investors will be rewarded with an improved market environment.