2023 economic and market outlook: The narrative shifts

The U.S. economy appears to be in the late stage of expansion, with strong economic activity but labor and supply chains remain constrained. These factors have set the stage for ongoing inflation pressures. The labor market is very tight, with a low unemployment rate of 3.7% in November and a wide gap between the number of job openings and unemployed persons seeking work, roughly two-to-one, according to the most recent data release. While wage gains have been strong within a tight labor market, they continue to be outpaced by rapid inflation. That helps explain why many consumers are dipping into savings or tapping credit cards to fund their spending.

The persistence of high inflation is a consequence of many pandemic-related factors, such as disrupted supply chains, record fiscal stimulus, and easy monetary policies that fueled consumer and business spending. The outbreak of war in Ukraine earlier in 2022 worsened supply constraints, especially for food and energy, and contributed to sustained inflation. Some of these pressures eased in the latter half of the year as consumer spending shifted from goods to services. Going into the new year, disinflation in the prices for goods expects to continue, but as services spending remains robust, the overall level of consumer price inflation should ease gradually.

Federal Reserve ripple effects

The Federal Reserve remains focused on reducing inflation toward the central bank’s target level of 2.0% in the medium term. As the latest inflation readouts are nowhere near that target, more rate hikes from the Fed are expected in 2023, although at a slower pace than seen in 2022. As of this writing, market expectations call for a path of Fed rate hikes to a range of 5.0-5.25%, then a pause through the remainder of 2023. Aggressive Fed tightening has hit the housing market most noticeably and rippled through financial markets. Higher costs for corporate borrowing have soured investor sentiment toward technology stocks as these firms tend to be debt intensive. With investors placing a lower premium on sales growth, 2023 will likely present a more significant dispersion of stock returns in the broader market than we’ve seen in recent years.

Value stocks performed well in 2022 as fundamentals came into focus and powered the rotation away from growth. This trend will likely continue in the first half of 2023 as long as the Federal Reserve keeps interest rates restrictive and recessionary headwinds continue to mount. Consensus earnings estimates for 2023 remain high; revenue growth has been much higher than earnings growth, which suggests pressure may build on profit margins as we head into the new year. Investors should focus on the fundamentals, including positive earnings revisions or surprises, strong balance sheets, free cash flow, and dividend growth. Among stock market sectors, consumer staples, financials, healthcare, and utilities may help investors stay well-positioned in the first half of 2023, while consumer discretionary are poised to face difficulties.

Responding to recession risks

Looking ahead, Nationwide Economics foresees a confluence of factors pushing the economy into a moderate recession starting mid-2023. Elevated inflation, rising interest rates, and diminished levels of excess savings should slow the current pace of consumer spending. Corporate earnings growth may decline as profit margins compress further and top-line revenue growth slows on cooler consumer spending. Consequently, firms may be forced to curtail hiring and pull back on capital expenditures. The eventual job losses are likely to contract consumer spending, leading the economy into a recession in the second half of 2023.

Possible outcomes of slowing economic growth would be moderating inflation and an end to Fed rate hikes. For stock investors, that could mean continued market volatility. Investors seeking to manage volatility can explore strategy-based “smart betas,” which often evaluate companies by fundamentals such as dividends or cash flows, or factor-based smart betas, which examine specific characteristics of stocks such as momentum or low volatility. Market trends in 2023 favor active management and smart beta strategies generally allow investors to focus on building portfolios aligned with their investment objectives.

Credit selection and quality will likely be crucial for bond investors into 2023. However, corporate credit fundamentals provide an exciting backdrop for fixed-income investors. As such, the return potential for fixed income looks compelling, given higher yields across different maturities. Strategies that focus on duration In a bond environment that’s shifting from aggressive Fed rate hikes to a potential pause later this year may offer return opportunities in investment-grade bonds, municipal bonds, and mortgage-back securities.