'To V or not to V is NOT the question'
2023 outlook to us looks like more of the same as "rocky landing" proceeds.
As the end of a difficult year for investors looms just a few short trading weeks ahead, many clients are asking about what’s to come. Regrettably, our outlook remains “more of the same.” While markets try to outguess themselves on when various indicators that have driven us through a volatile 2022 will peak and roll sharply over, we are encouraging our clients to avoid falling into the trap of thinking that everything is a “V.” For sure, that has been the primary lesson of the last 15 years, with V-shaped tops and bottoms in markets, the economy and Fed policy seemingly the norm. First there was the 2007 real estate bubble collapse, then the 2008-09 Lehman crisis debacle and the Fed’s dramatic response to it, next the 2012-13 euro crisis and the ECB’s dramatic “whatever it takes” response, and most recently the 2020 Covid-induced lockdowns/global economic collapse, the Fed’s equally dramatic “buy everything” counter and the V-shaped recovery that ensued. So, it’s easy to understand why, this time around, everyone on Wall Street is trying to assess when inflation peaks then plummets, when the economy drops like a stone thanks to the Fed’s tightening, when the Fed responds by slashing rates, and when the economy dramatically recovers and resumes its growth trajectory. Alas, we wish it were so easy.
At Federated Hermes, our own view is more nuanced. While we do believe inflation has peaked for sure, we see supply-side constraints in labor and commodities continuing to keep consumer price inflation uncomfortably high. And while we think the Fed is likely to shift soon to smaller rate hikes than it’s been feeding us, and even at some point to pause its hiking cycle, we see very little chance of a rate cut anytime in 2023. Scattered layoff announcements to date and forthcoming, particularly in the bloated tech space, will provide only modest relief, in our view, to the structural forces keeping labor markets tight and wage pressures ongoing. And labor market tightness, cojoined with household and financial sector balance sheets that remain unusually strong, means a standard, sharp economic pullback is unlikely. Rather, we anticipate another “muddle through” year in 2023, with the ongoing “rocky landing” producing real GDP prints bouncing around 0%, and a plethora of earnings disappointments, especially among the tech darlings of the Covid boom.
Overall, we anticipate the S&P 500 will trade next year within a broad range as optimism around the “V” fades, resumes and fades again, and are maintaining our 2022 guidance of 3,400 as the bottom end of that range and 3,900 as the top. We continue to keep our balanced portfolio models conservatively positioned, modestly underweight stocks but more importantly, max underweight growth stocks and max overweight value/dividend stocks. Likewise, with short rates likely to drift higher and no Fed pivot in sight, we remain near max underweight bonds, preferring money markets instead.
The rest of this memo unpacks some of the key elements of this outlook:
- Inflationary forces unlikely to be easily tamed this time around The causes of current high inflation prints we’ve all been suffering over the last 18 months are, unfortunately, not all of one source and likewise not easily snuffed out. On the one hand, a number of the Covid-response policies here and elsewhere, particularly the trillions spent on Covid relief funds, the multitrillion dollar expansion in central bank balance sheets and the maintenance by the Fed of a zero interest-rate policy for far too long than needed are all now shifting in reverse, and that’s a good thing. Together, these pullbacks on demand stimulus already are beginning to bring most inflation indicators off their peaks. The problem, though, is that the inflationary pressures we are facing are not just due to excess demand; they are also being driven by insufficient supply, particularly of workers, the fuel to the U.S. economy. During the Covid years, the U.S. labor force shrank from 164.6 million to 156.5 million and didn’t return to its previous peak until this past August even as the economy expanded from $21.7 trillion in Q4 2019 to $25.7 trillion through Q3 2022. With baby boomers retiring by the millions, and many younger workers reluctant to enter the workforce or take full-time jobs, this gaping differential between growth in the economy and the labor force has made many companies reluctant to cut back on workers as they normally would when the economy slows. So, the labor market remains tight and upward pressure on wages high even as the rocky landing continues. A similar case can be made for most commodity prices, particularly in energy, where investment cutbacks over the last commodity bear market have kept markets constrained and prices buoyant. Ironically, the Fed’s interest rate hikes have only made financing new oil exploration more costly, not less.
- With inflation sticky, the odds of a V-shaped Fed pivot toward easy monetary policy seems unlikely In recent years, the sharp shift toward easing monetary conditions has almost always occurred in environments of low to zero inflation prints combined with major, systemic financial system crises. We see neither of these as likely to be forthcoming. Beyond the continued inflationary forces noted above, we’d add that the U.S. banking system post the 2008 meltdown that nearly destroyed it is now the healthiest it’s been in a very long time. Capital ratios are distinctly higher, in many cases by a factor of 2x. Likewise, the share of illiquid assets on the books, a key vulnerability in 2008, is now almost nil. And deposit funding, the most stable source of bank funding in a crisis, is at levels far above the 2008 lows. So, as much as a “good crisis” would be welcome in some sense by the market bulls, one is not likely. (Witness how little the ripples have been, at least so far, from the meltdown in some of the obvious Covid bubbles, such as crypto and meme stocks.)
- And the Fed playbook has shifted A big characteristic of the “V world” we’ve now left behind has been a Fed focused, almost obsessively at times, at not repeating the mistake of the 1930s’ Fed, which kept policy too tight throughout and began tightening it too quickly as the economy tried to recover. This prolonged the Great Depression, prompting a generation of economists led by Ben Bernanke to spend their formative years in economic doctorate programs studying these mistakes with a goal of not repeating them. So, with policymakers biased against premature tightening, it was no wonder that Vs abounded. Not so this time around. Earlier this year, Chair Powell finally dusted off the studies of the 1970s’ Fed, a period of supply-driven inflationary pressures which the central bank massively underestimated for most of the decade, resulting in moves to ease policy prematurely that led to a prolongation of the inflationary pressures. Powell has clearly gotten on board with this idea and former Chair Paul Volcker’s painful decision in 1979 to shift decisively to a period of “higher for longer” interest rates that finally slayed the inflation dragon. With this playbook in front of Powell, we see very little chance he’ll shift gears dramatically or even hint that he might. (Fed watchers beware—hopes of easier guidance at December’s post-FOMC press conference are not coming.)
- This adds up to less than good news for earnings The picture above implies relatively low real economic growth ahead, with continued tight monetary policy and continued tight supply conditions in key input markets, particularly labor and commodities. Consumption, fueled by ongoing tight labor markets and still strong household balance sheets, is likely to remain strong though gradually weakening as real buying power gets pinched. Earnings are likely to be the fudge factor to make everything fit, and our 2023 forecast of $200 in earnings on the S&P remains well below consensus; the latter has moved down from$246 to $234 over the past 12 months but is still a solid 15% too high. The bulk of the earnings pain, we fear, will come from the big FAANG stocks (Facebook, Apple, Amazon, Netflix and Google aka Alphabet) that remain nearly 25% of the S&P and, in our view, still have far too much of Covid-induced pull-forwards in their base numbers.
- The clarion call for investors “to lock in high long-term yields” is therefore, in our view, premature With a V very unlikely, we think there is little need for investors to shift quickly toward longer-term maturities in their bond portfolios. With short-term rates above long-term yields and the Fed still in hiking mode, investors are likely to do much better than they have in over 15 years by keeping a high cash balance. A time will come to shift back into bonds, but for now why take the risk, which seems skewed at best toward higher, not lower, yields.
- And within equities, dividend payers remain preferred For similar reasons, we see no need at this time to shift back into long-duration growth stocks. Despite the fact they are down more than 25% year-to-date and in some ways are “on sale,” we think that sale is likely to go on for some time, with the discounts getting potentially bigger as earnings expectations continue to come down to earth. While most of the decline in growth stocks so far has come from the impact of higher bond yields on their discount rates, the next anvil to fall, we fear, will be the impact of the rocky landing on their earnings. And when those earnings come in, investors may also begin to reassess the P/E multiples they are paying for them, this time not just because the risk-free rate is higher, but because the longer-term growth forecast is lower. So, we’re sticking with our defensive dividend payers. These stocks generally operate in areas of the economy where pricing power is decent and demand relatively stable, which can make them more rocky-landing resistant. And in a world where cash is once again king, who is to argue with a stock that rewards its investors more with the potential for a stable and growing cash dividend stream than with the promise of future gains which may prove elusive?
So, while we love a good Shakespearian drama as much as the next person, and in particular wish that our good friend Hamlet had found a better way out of his dilemma, the realist in us suspects that hoping in 2023 for a V-shaped rebound in inflation, Fed policy and the markets will likely prove to be a fool’s errand. Rocky landings can be boring one moment, scary the next and exhilarating later—until the “Rinse, repeat” cycle starts anew. The best way to manage through them is remain resilient, defensive and yes, confident. We’ll have better times, eventually. Just probably not in 2023.