January 17, 2023

For investors that own a mix of equities and bonds, 2022 was a challenging year in the financial markets. While most people are accustomed to the occasional stock market downturn, the fixed income component of their portfolio usually provides a cushion during such periods. Last year, however, we witnessed the sharpest pullback in the bond market in decades. The primary cause of the financial market turbulence was persistently high inflation that led central banks to increase interest rates at the fastest pace since the early ‘80s, when inflation was at a double-digit pace.

Bright spots were few and far between. The clear winners, however, were energy stocks.

2023 Outlook

Looking ahead, as 2023 progresses, investors are likely to hear more talk of a potential recession. We maintain the view that we first expressed in April 2022 that we believe a modest US economic downturn should occur sometime this year (Canada’s downturn is likely to be deeper due to more heavily-indebted consumers, but global stock markets are driven more by the US economy due to its size and influence). While a looming recession may cause anxiety for some, it is crucial that investors properly assess what this means for the stock market.

It has been said that “financial markets live in the future”. That conveys the idea that stock prices should reflect what the average investor expects companies to generate in earnings over the coming years. Thus, as the probability of a recession increases, those earnings expectations should decline, impacting the price of stocks. Hypothetically, if all investors had a perfectly accurate crystal ball that correctly foretold of a recession one year before its onset, stock prices should have already declined to reflect that coming event long before it begins. If, however, it turns out that the expected recession is avoided or that its severity is less than what was predicted, stock prices could actually rise, even in the midst of a modestly contracting economy.

Since stock prices are driven by expectations and how those expectations change over time, it is always worthwhile evaluating what most investors currently anticipate. One crude way of gauging whether recession risks are widely known and, thus, priced into stocks is by observing how often the term “recession” is searched online. The below chart illustrates a surprising result: in 2022, people performed more Google searches on the term “recession” than they did during the 2020 pandemic-induced economic contraction.

It should surprise no one that those spikes in recession searches (May, June and October 2022) coincided periods of notable weakness in the S&P 500 Index. As fears of an economic downturn were rising, investors were lowering their earnings expectations, which hurt stock prices.

Professional forecasters also lowered their outlooks as economic data continued to soften amidst sharply rising interest rates. By December, a Bloomberg survey of 38 economists pegged the likelihood of a recession at 70%, up from less than 40% in June. For these reasons, some have said that any downturn in 2023 will be “the most anticipated recession in history”.

If this is a well-anticipated recession, what does that mean for future stock prices? In theory, if investors and analysts have already lowered their earnings expectations to reflect a downturn – as in our hypothetical crystal-ball scenario – stocks should have little reason to decline. In fact, since mid-October, when many investors were concerned about recession risks and investor sentiment was extremely depressed, some of the most economically-sensitive stocks have begun to outperform the broader market (semiconductor manufacturers, materials producers, industrials and home builders are up more than 20% versus the S&P 500’s 12% gain since October 14).

This is not to argue that all of the risks to the stock market are behind us. Central banks could still raise rates farther than necessary, causing a deeper-than-expected recession. And while 2023 earnings estimates have come down, analysts are still forecasting a 4-5% increase over 2022 levels, which may be too high if a modest recession sets in.

Potential Upside Surprises

But when contemplating the potential risks, one should spend an equal amount of time considering the events that have an equal chance of turning out better than expected. If some economists are correct and we avoid a recession or it is milder than most anticipate, earnings expectations will have to rise. Earnings could also get a boost if the lifting of China’s “Covid-Zero” restrictions results in stronger-than-expected economic growth. On the geopolitical front, while it is not in our forecast, the Russia-Ukraine conflict could end, which would bring down energy and agricultural prices, helping to ease recession concerns and lift general sentiment. And, of course, inflation could fall faster than expected, which would ease investor concern about overly aggressive central banks.

Investing Amidst Uncertainties

There is no guarantee regarding whether a recession occurs, nor its depth. For some investors, those unknowns create anxiety. One should remember, however, that in the near term there have always been and always will be economic and geopolitical uncertainties. Over time, however, for quality companies, there tend to be more tailwinds to earnings growth than there are headwinds. And earnings growth over time – not recessions, central bank actions or wars – is what ultimately drives the long-term performance of stocks as the below chart illustrates.

So whatever events play out in the near term, we shall remain focused on constructing portfolios that are built on a foundation of solid companies with excellent long-term earnings potential.

If you have any questions, please do not hesitate to Contact us!