Sunday, January 8, 2023

2023 Investment Outlook: When Will the Stock Market Recover?

With the new year now just out the gate, this week's edition of U.S. News Invested is particularly relevant for Big Picture enthusiasts as it offers insights on the new year's prospects for a market recovery.  Hope everyone has enjoyed their weekend. 

 

2023 Investment Outlook: When Will the Stock Market Recover?

Investment managers and strategists give their predictions for the upcoming year.

By Scott Ward

Reviewed by Rachel McVearry

Jan. 5, 2023, at 4:22 p.m.

Professional investment managers and strategists see some headwinds ahead for the market in 2023, along with some upside potential for patient, long-term investors. 

Investment forecasts are like ambrosia and upside-down fruitcakes at holiday gatherings: They're widely available, but it may take some discernment to know what exactly to do with them.

Still, much like the gentle hands that have prepared holiday delicacies for generations, investment management firms source and curate global data annually for investors' consumption.

As a backdrop, investors' current outlook on the market isn't merry, nor bright. The American Association of Individual Investors' Investor Sentiment Survey in late December revealed that only about 27% of investors have an optimistic outlook on the market for 2023. Nearly 48% of investors have a negative investment outlook.

Further, recent yield curve inversions among two-year and 10-year Treasury bonds appear to flash the red signal for a recession. The Federal Reserve doesn't see it that way and projects a mixed bag of a slow economy, falling inflation and a benchmark interest rate higher than 5% in 2023. For investors, part of the rub is the confluence of these dueling narratives: It's hard to see how both could be correct.

Professional investment managers and strategists see some headwinds ahead for the market in 2023, along with some upside potential for patient, long-term investors. Here are some key points from several experts at prominent investment firms:

  • Recession is still in the cards for 2023.
  • Fixed income looks more attractive.
  • Patient investors could be rewarded.
  • Diversification is key for better returns.
  • Review investment firms' capital-market forecasts.

Recession Is Still in the Cards for 2023

"We see further potential downside of 10% or more for equities entering 2023 given current valuations and based on our expectation for a recession," says Rich Weiss, senior vice president and chief investment officer of multi-asset strategies for American Century Investments. "Price-earnings ratios in the low double digits, or even high single digits, would not be unheard of if indeed the coming slowdown turns into an actual recession, especially with rates continuing to rise in the face of stubbornly high inflation."

Mike Collins, managing director and senior portfolio manager at PGIM Fixed Income, adds that "PGIM Fixed Income's base case is that there is a 40% probability that the U.S. enters a recession in the next 12 months. Other scenarios include a 25% probability for a soft landing in the U.S."

For context, much of the market volatility in 2022 and the angst in 2023 stems from the Federal Reserve's aggressive initiative to wrangle rampant inflation. As the Fed has raised its benchmark interest rate to a range of 4.25% to 4.5%, the highest level in 15 years, sizable market drawdowns have followed. Through Dec. 31, the tech-laden Nasdaq Composite was down 33.1% for the year, and the U.S. Aggregate Bond Index was off by about 11%.

Andrew Patterson, senior international economist for Vanguard, comments that "2022 was a rough year for equity and bond investors alike, with a 60/40 portfolio down roughly 15% (as of mid-December). The driver of these returns was significantly higher interest rates, which means that future asset returns are expected to be higher."

Fixed Income Looks More Attractive

PGIM's Collins adds, "After a record sell-off in fixed income in 2022, driven largely by Federal Reserve rate hikes, we expect a much more constructive year for fixed income in 2023. Since it appears that a peak fed funds rate of around 5% is fully priced in, the U.S. fixed-income market is offering an attractive starting yield level, with some modest room for price appreciation if the Fed begins to cut rates later in 2023."

The equity market, meanwhile, has priced in a big increase in interest rates (via a higher discount rate and lower earnings multiples), but it has not priced in the potential for a sharp decline in earnings expectations, according to Collins.

Patient Investors Could Be Rewarded

Beyond the framework of a potential slowdown in the U.S. economy and the prospect of a looming recession, whether shallow or not, some investment managers and strategists still see opportunities for patient investors. "Equities typically lead the economic cycle and, therefore, we would expect to see a rebound in stocks at some point in 2023 – possibly presenting investors with one of the best buying opportunities in a decade," says Weiss. "Net-net, we expect 2023 to be a very positive year for risky assets when all is said and done."

In December, American Century, PGIM, T. Rowe Price and Vanguard released capital-market return estimates for a variety of core asset classes in the coming three to 10 years:

INVESTMENT MANAGER

LARGE CORE U.S. EQUITIES

DEVELOPED NON-U.S. EQUITIES

U.S. CORE FIXED INCOME

DEVELOPED REITS

American Century (3-5 year estimates)

6.25%

7.5%

3%

7.25%

PGIM (10-year estimates)

7.76%

10.04%

4.72%

7.47%

T. Rowe Price
(5-year estimates)

8.7%

10.01%

5.7%

9.8%

Vanguard (10-year estimates)

4.7% to 6.7%

7.2% to 9.2%

4.1% to 5.1%

4.9% to 6.9%

Diversification Is Key for Better Returns

Kim DeDominicis, portfolio manager of target-date strategies in the multi-asset division at T. Rowe Price, says a key strategy for income investors in the coming years will be to "broaden out from just U.S. bonds to an international exposure and add additional asset classes that can help shield investors from rising rates, like short-term (Treasury inflation-protected securities) and floating-rate loans." DeDominicis believes this strategy will improve the overall return profile of fixed-income portfolios.

One way to think about investment firms' capital-market expectations is to view them as reasonably prospective, rather than predictive or prescriptive in nature. For example, if a 67-year-old investor needs a 6% return from her investment portfolio over the next two decades to sustain her retirement needs, including out-of-pocket medical and long-term-care expenses, what kinds of asset classes, taken together, can reasonably help her achieve that kind of outcome? Beyond core fixed income and equities across the globe, she can look for other asset classes that may also add value.

That said, PGIM's estimated return for a blended portfolio of 60% equities and 40% fixed income over the next decade is 7.55%.

Review Investment Firms' Capital-Market Forecasts

Pension-plan managers often use capital-market expectations to help shape their investment portfolios and plan for long-term funding needs. In September of this year, Cliffwater, an investment research firm, released a 21-year pension performance report that revealed "long-term pension returns are foremost determined by capital markets and not investment skill."

An important takeaway for individual investors who want to plan well for their own long-term funding needs: A broadly diversified investment strategy can be quite effective over time, and investment firms' capital-market forecasts serve as resources to help investors craft and implement this strategy.


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