Despite worries, investors can be optimistic about 2023 returns

Money-wise, there was plenty to be worried about in 2022. Big increases in the prices of goods and services coupled with big declines in investment portfolios made last year extremely challenging for investors. The S&P 500 Index fell into bear market territory, losing 25% of its value from early January to mid-October. If you are like many investors and stopped looking at your statements by mid-year, you may have missed the fact that stocks closed the year on an upward trend despite continued concerns about whether inflation and the Federal Reserve’s response to it would send the economy into recession.

Investors with diversified portfolios no doubt noticed that their allocation to bonds did nothing to offset the stock market’s downturn. This is because interest rates skyrocketed from zero to over four percent in a short period of time. The federal funds rates controlled by the Fed began 2022 at 0%–0.25% and shot up to 4.25%–4.50% by year end. Since bond income payments had fallen so low in prior years, there was no income to offset the decline in bond prices driven by rising interest rates. Consequently, the Bloomberg US Aggregate Bond Index ended the year with a negative 13 percent return, its worst return in 97 years.

In the coming months, investors will remain focused on the Federal Reserve and how it will continue to implement its dual mandate of maintaining full employment in the economy while also keeping inflation in check. The Fed has indicated that it is fully committed to bringing inflation back to its long-term target of 2.0%. The challenge is that the Fed may increase rates too much or hold them too high for too long, throwing the economy into recession. This prospect of recession is what the stock market has been wrestling with.

The downturn in stocks suggests that investors expect a recession, or at least a significant slowdown in economic activity. What is unclear is whether that recession is still to come or has already passed. Looking solely at growth in Gross Domestic Product (GDP) which measures US economic output, we see that growth turned negative in the first and second quarters of 2022, but the downturn was mild.

Still, many economists are predicting that the 2022 blip in GDP is not the recession the stock market implicitly forecast when it fell into bear market territory. Rather, they expect a recession to come in 2023 or 2024. True, there are some signs of weakness appearing in measurements of the economy’s health. One key indicator is the fact that short-term interest rates are higher than long-term rates (the inverted yield curve) which is a signal of tightening credit. An inversion in the yield curve has preceded all recent recessions. However, in today’s post-pandemic environment, there are reasons to suspect that this relationship may not hold. Specifically, the labor market remains strong, and inflation appears to be coming down rapidly, perhaps enough to throw the inverted yield curve recession signal off. Recent monthly inflation readings have fallen closer to the Fed’s two percent target.

With inflation easing, it is reasonable to expect that the economy may avoid a recession. Even economists who are forecasting a downturn expect a brief and shallow decline in employment and economic activity. In the stock and bond markets, what we can expect in the near term is an environment in which bad news is good news. That is, any signs of weakness in the labor market or GDP may cause stock prices to go up in anticipation that the Fed can stop raising interest rates and eventually take them in the opposite direction. Continued declines in inflation readings can be expected to have the same effect. While the Fed is currently expecting the federal funds rate to close at 5% in 2023, an improving inflation picture makes this scenario unlikely.

​In turn, there is reason to be optimistic for both stock and bond returns. Stocks, as they are prone to do, will likely turn positive well before the specter of an impending recession disappears, providing solid gains to investors who were able to stay invested while things were less certain. Bond investors will benefit from higher income yields while rates remain high and might even expect capital appreciation when the Fed eventually does pivot back to reducing rates instead of raising them.