For a while, it felt like everything was going to the moon. The pandemic bust-boom-bust cycle has been a wild roller coaster ride. It is also the best reminder on how much markets can swing on sentiments alone both on the upside and downside. As we enter 2023, it is time to take a deep breath and remind ourselves to focus on the fundamentals.
Interest rates and availability of credit have always been a great driving force of the economy and financial assets. What shook the markets in 2022 was the rapid increase in benchmark interest rates in response to inflation. Therefore, the path for inflation is just as crucial for investment thesis in 2023.
Some good news on the inflation front:
It’s difficult to convince people inflation has peaked with everyday prices such as groceries remain elevated. However, we are seeing a definitive deceleration in the pace of growth in inflation and a peaking pattern has formed:
Housing costs in the November data was the highest upward driver of inflation, but this is a well documented lagging indicator and we have confidence lower housing costs will begin to show in the data in mid-2023 as we already see signs of lower rental costs and home prices in the U.S.
Another inflation worry is for higher inflationary expectations to settle into the economy. The wage-price spiral was very difficult to break during the previous inflationary period. Presently, there is very little indication that higher inflationary expectations have anchored in. The RBC economics team anticipates the core inflation will fall from 5% to 3% in 2023 and for the Federal funds rate to peak at 5-5.25% in 2023.
Recession Fears
2023 has become the most anticipated recession in history with so much written on recession expectations. Whether this period will meet the technical definition of a recession or not, it is evident that growth has slowed down significantly. With interest rates impact real economic activities in a lagging fashion, how much the economy will slow down remain to be seen.
The medium length of a bear market is 19months, with a medium decline between peak and trough of 27%. The correction we have experienced in 2022 was largely a result of higher interest rates and multiple compression. Expected earnings however have been revised downwards alongside as well. Since 1930s, S&P has established a cycle low roughly every 4 years driven by liquidity from central banks and the corresponding impact on the real economy. If the 4-year cycle holds, 2023 will remain a very volatile year with the expectations of an early upcycle to form in late 2023/early 2024.
After a period of excess, we see a renewed interest in quality in earnings, sustainable growth, and strong balance sheets. The gap between growth and value companies are narrowing. While it is possible for further downside from negative earnings growth from reporting companies, it is also likely for the markets to look ahead to 2024 should inflation comes down as anticipated and interest rates begin to trend lower as a result.
Rita Li works with individuals and business owners and healthcare professionals to provide tailored investment advice, risk management and financial planning. Her team comprises of professionals with in-depth taxation, insurance and legal expertise, together, they deliver a high standard of service to clients. Rita is a Chartered Financial Analyst CFA® and holds her MBA from Richard Ivey School of Business.