Despite concerns over high inflation, recession, and turbulence in the banking sector, markets managed to climb in the first quarter of 2023. The discussion below explores the factors behind this move, what investors should focus on over the next 12-18 months, and how they should position their portfolios.
I would characterize Q1 as markets climbing the wall of worry. The year began with uncertainties about Europe's energy challenges, the impact of another China lockdown, and negative sentiment in equity markets. However, markets managed to overcome these concerns in January, and by February, stronger than expected economic data emerged. The stronger economic data caused the market to recalibrate the path for interest rates higher, putting downside pressure on both equity and fixed income markets. However, in March, the Federal Reserve (Fed) had to address both inflation and financial stability concerns because of the banking crisis, prompting several actions by the Fed and other institutions to shore up confidence. As a result, this created the conditions for an end-of-quarter rally. It is noteworthy that the areas of the market which showed poor performance in 2022 experienced a rebound and outperformed during the first quarter of 2023, such as technology and growth stocks.
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As we move past Q1, investors should remain vigilant regarding two factors that will drive markets over the next 12-18 months: Fed policy and economic growth. The Fed remains focused on reducing inflation to their 2% target and therefore maintaining tight financial conditions until the job is done. Although the banking crisis may have affected its policy path, we expect the Fed will take an extended pause by maintaining the Fed Funds rate in a range of 5% to 5.25% for the rest of 2023. We expect economic growth to soften over the next few quarters as the impact of cumulative interest rate increases and tight financial conditions are felt by consumers and businesses. These developments will impact corporate profits, and corporate fundamentals will likely weaken over the next 12 months. In response to this, we expect the Fed to begin cutting interest rates in Q1 2024, eventually bringing the Fed Funds rate closer to 3% by the end of 2024. Our view is that the markets are not fully accounting for the weakness in economic growth that we anticipate over the next year.
Given this outlook, we recommend investors prioritize higher-quality assets in both fixed income and equities and consider active management strategies. TD Wealth is constructive on fixed income as investors can earn a relatively high level of interest income with the potential for capital gains, as interest rates gradually move lower over the next few years. On the equity front, it is important to maintain a defensive approach and focus on high-quality companies with strong balance sheets that can continue to grow their cash flows, earnings, and dividends, even in a slowing growth environment.
In times of uncertainty and elevated market volatility, TD Wealth believes risk management, portfolio diversification and a focus on higher quality investments will serve clients well. Although we may face some challenges in the short-term, it's very important to stay invested with time in the market, rather than trying to time the market.
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The information contained herein is current as of May 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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