2022 was a tough year for both equity and fixed income markets. It was a year marked by historically high inflation, resilient consumer demand, rising interest rates, an unrelenting war in Ukraine and a heightened level of uncertainty for investors. But with 2022 now firmly in the rear-view mirror, there are a number of burning questions on every investor's mind: how will this year be different from last? What will drive markets in 2023? And how should investors be positioned to navigate the road ahead?
Though some of the key variables that impacted markets last year will remain, the landscape has now changed quite a bit. Inflationary pressures have shown signs of easing, consumer demand is expected to slow, and the Federal Reserve (Fed) may be taking a more incremental and data-dependent approach to its tightening cycle.
The Fed is currently expected to raise its policy rate to 5.25%, but that is subject to change based on incoming data on inflation and jobs. This is in stark contrast to last year where we experienced the most aggressive pace of interest rate hikes by the Federal Reserve in 40 years.
The rationale behind this notable change in policy is that the impact of past rate hikes takes time to work its way through the economy. By pausing, the Fed can properly assess the impact of its past policy actions on incoming economic data to determine if their actions have had the intended effect. The unprecedented pace of rate hikes we have seen to date is an effort to slow demand in the economy, which has been a key driver for inflation. If inflation falls closer to the Fed's target, the Fed will have more flexibility to lower interest rates in the future to support growth.
The cumulative effect of all the tightening that has taken place thus far is likely to result in a softening of consumer spending. We are already seeing an impact through the slowing of demand for certain goods, and our expectation is for this trend to continue. Slowing demand is likely to have knock-on effects for the trajectory of corporate earnings growth and thus we believe it is increasingly important for investors to focus on resilient companies this year.
Now in an environment with slowing growth, and relatively high interest rates, which are expected to peak in the first half of the year, how should investors be positioned?
One area of the market that investors are turning to is the opportunity present in fixed income. With higher yields, fixed income investors are receiving a higher level of interest income. We would suggest investors consider taking advantage of elevated yields with exposure to a portfolio of high-quality fixed income securities, which may include treasuries, investment grade and municipal bonds. Any future rate cuts from the Fed could further benefit fixed income investors in the form of capital gains, as bond yields move inversely with price.
As for equities, there may be some opportunities present outside of the U.S. This is true for several reasons. For one, valuations for non-U.S. companies are much cheaper than what we are currently seeing domestically. In addition to this, things are looking brighter in other areas of the world compared to last year. For instance, Europe is a region that has been a lot more resilient than people expected. There were some significant concerns last year regarding Europe's ability to source natural gas supplies after Russia, its main supplier, reduced its flows to the region. However, they have managed to source sufficient natural gas supplies from other parts of the world, at least to get them through this winter, which had been the primary concern. In China, strict Zero-COVID policies were weighing heavily on demand. China has since loosened their policies which has helped to alleviate growth concerns and has been a boost for Chinese equities. Another factor at play this year that bodes well for international investments is a weakening dollar. The U.S. dollar appears to be fundamentally overvalued and, if the dollar continues to fall, this may provide a tailwind for international equities as foreign currencies strengthen against the weakening dollar.
More broadly, resilience and a focus on company fundamentals will be key this year, and so, we believe a tilt towards more value and dividend growth strategies may be beneficial for investors.
Keeping these factors in mind as the year progresses and the landscape changes, it is important to remember that the principals remain the same. Rather than focusing too closely on the direction of the market or the exact timing of policy changes, it is much more prudent to focus on your goals, to remain invested, and to be well diversified with an emphasis on quality.
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The information contained herein is current as of March 7, 2023 and is sourced from FactSet, MorningStar Direct and Bloomberg among others. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
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