2023 Investment Outlook: The Pivot and Beyond

By Peter Zaltz Chief Investment Officer, Gluskin Sheff + Associates

Following an extremely challenging 2022, we are faced with a financial markets landscape reshaped by aggressive central bank rate hikes. These actions, a response to the highest inflation in four decades, have triggered credit market outflows and lifted bond yields to their highest levels in a decade. On equity markets, the outsized valuations of a year ago are a memory, and key indexes remain mired in a cycle of bear market rallies and retreats.

The consequences—both intended and unforeseen—of this aggressive policy tightening will be the key factor affecting financial markets in 2023. The volatility that defined the past year will likely remain for much of the new year as these higher rates ripple through the economy, constraining demand and leading to a significant growth slowdown if not outright recession.

At this point, the majority of the tightening has already taken place, but we have only begun to see its effects. Deeper impacts on corporate performance and—most importantly—employment growth and wages will be necessary to bring inflation down towards target levels, and these have yet to materialize. Therefore, we believe policy rates in both the U.S. and Canada will remain at constraining levels for the bulk of the coming year, and possibly into 2024.

With asset classes trading at much more appealing valuations than they have in some time, we are beginning to look ahead to the moment when we will feel comfortable adopting a more aggressive risk-on approach. However, we are not there yet, and we anticipate continued market volatility until it is clear the Bank of Canada (BoC) and U.S. Federal Reserve (Fed) have confidence in lower inflation and no longer see a risk of long-term expectations becoming embedded in the economy. At that point, they will likely begin to stabilize interest rate increases.

Complicating the path to a broad market rebound are ongoing geopolitical factors. Most significant among these is the war in Ukraine, which has muddied the post-pandemic rebound in Europe and pushed prices of food and certain commodities higher, complicating global central banks’ task of fighting inflation. COVID-19 also continues to have an impact—albeit a diminishing one—most acutely last year through China’s zero-COVID policy, which set back the country’s recovery. The policy was loosened in December, but that has been followed by reports of surging infections, raising questions about how long it will take until the shift will result in a rebound in consumer demand.

Taking a longer-term view, it’s clear we are witnessing an end of an era in which low inflation and ultra-cheap money fueled growth in asset valuations. Following this current period of volatility, we envision a new normal of higher normalized inflation and interest rates than we have seen in some time. This will constrain valuations but should also improve returns on the fixed income portion of the traditional 60/40 portfolio, which has suffered from the ultra-low bond yields of the past decade.

The intended consequences of tighter monetary policy

The central bank tightening campaign of the past year has put policy rates at levels not seen since prior to the Great Financial Crisis (GFC) of 2008. As of Dec. 31, the BoC’s key overnight rate stands at 4.25%, and the U.S. federal funds rate is 4.50%. While roughly in line with long-term averages, they represent a significant contrast from the ultralow central bank rates that had been the norm since the GFC.

This shift in monetary policy has already had a significant impact on asset prices. For the year, the S&P 500 dropped 19.4%, its worst performance since 2008, and bond yields soared. The U.S. 10-year Treasury yield rose briefly above 4% for the first time in more than a decade and ended 2022 at 3.88%, up from 1.52% a year earlier. The move in 2-year Treasuries was even more extreme, with the yield rising to 4.41% from 0.73%, resulting in an extremely inverted yield curve.

In Canada, the market disruption was more subdued in 2022, as key stock indices were cushioned by the country’s relatively large exposure to commodities and smaller tech component, among other factors. Canadian bond yields rose rapidly over the first six months, but longer-dated notes stabilized as the country’s economic fundamentals began to deteriorate late in the year.

On corporate bond markets, spreads widened markedly through the year, from 92 basis points to 130 basis points in the U.S. and from 110 basis points to 161 basis points in Canada. This raised borrowing costs for companies as the market priced a weaker economic outlook. To this point, there have been few defaults, but there will undoubtedly be additional companies that struggle with higher interest costs and weakening demand in the coming year.

We also saw an extreme level of correlation on financial markets, with heavy selling of both equities and fixed income securities. This resulted in a challenging year for the traditional 60/40 portfolio, particularly early on, as there was little support from yields that began the year at extremely low levels.

In the coming year, the impact of these consequences will continue to broaden from a rates story to an economic growth story, as the tighter conditions resulting from higher rates work their way through the economy, reducing liquidity and potentially leading to a recession and job losses. While growth in Canada and the U.S. has remained stubbornly strong to date, we saw substantial inversion in both yield curves at the end of 2022. This is a strong recessionary signal as it shows investors moving money to longer-duration debt due to near-term economic concerns.

These consequences, while painful, have been by design; they are a necessary offshoot of the reduction in demand and liquidity triggered by higher policy rate hikes to lower inflation to more stable levels going forward.

But while the economic consequences of tighter policy are still gaining momentum, we have likely already seen the worst of the impact on financial markets. While we expect continued volatility in equity markets in 2023, this may be more pronounced over the first half, with the potential for a stabilizing in policy conditions later in the year.

In Canada, the market continues to be undervalued across all sectors, and should see gains as the year progresses. While Europe may end up facing recession, we still envision upside, particularly among financials. We also believe the likelihood of a winter heating crisis is low, and that the market is currently pricing in a scenario that may be too negative. U.S. equities may take a bit longer to build positive momentum and will be heavily dependent on how quickly central bank policy is able to bring down inflation. We would expect energy and healthcare to be strong sectors and would favour companies with high and stable profit margins and high free cash flow.

In credit, we believe the worst is over in the investment grade bond market, and we can even envision fixed income outperforming equities over the course of the year. We do not expect significant spread compression in 2023, but yields are higher than they have been since at least 2010, which means we are being well paid even as we wait for signs of a Fed pivot. Within the sub-investment credit space, we continue to focus on higher quality issuers—those with less leverage and greater financial flexibility—to weather a slowing economic environment as the Fed continues to tame inflation.

The challenge for central banks

In our 2022 outlook, we spoke about the risk of central bank policy error. Looking back now, we can say the Fed and BoC did indeed wait too long to begin tightening, which has forced the central banks to act more aggressively than they would have liked over the past several months. But the jury is still out on whether they have done enough, too much, or too little, as these assessments can only be made after the fact.

It is clear the Fed very much wants to avoid doing too little, as Chairman Jerome Powell noted more than once last year that history cautions strongly against prematurely loosening policy. The ‘history’ in question would be the decade-long price spiral of the 1970s, which allowed inflation expectations to become entrenched and forced an overwhelming and crippling Fed policy response.

The pressing question then is how long rates will have to stay elevated to slow the economy enough to bring inflation down to the 2% inflation targets of the Fed and BoC. The challenge for central banks—a bigger issue for the Fed than the BoC, given recent data—is that some of the factors driving inflation higher are on the supply side, and less likely to respond directly to shifts in monetary policy than demand-side factors.

These supply-side factors have evolved over the course of the most recent cycle. In 2021 and early 2022, global shipping and manufacturing issues triggered by the initial pandemic shutdown were a major inflationary factor, and Russia’s invasion of Ukraine early last year caused a rapid rise in many commodities—including oil and gas—and disrupted European food markets.

While rising food prices continue to be an inflationary driver—made worse by droughts and ongoing truck driver shortages—global supply chain issues have largely receded, as have many commodity prices. However, these factors could re-emerge if there are additional external shocks from weather, global trade, or other geopolitical events, including a reimposition of China’s zero-COVID policy.

In their place, rising wages has emerged as the most pressing issue for the Fed and BoC, a result of surprisingly tight labour markets during the economic reopening. In the U.S., wage inflation has hovered around 5% over the past several months, well above the 2% level considered sustainable over the long term. Despite signs the North American economy is slowing, the most recent jobs data show demand for workers still far exceeds available supply. This means employees are poised to continue to demand higher wages in the coming months.

If this tightness in the job market persists, the nightmare scenario is a wage spiral, in which expectations of paying higher wages prompts companies to raise their prices, leading to more wage demands by employees, and so on. This may not be the most likely outcome, but with unions also flexing their muscles more than they have in years, the Fed may find a path to get inflation down to the 4%-5% range over the next several months, but then struggle to get it down to the 2% target, even as still-high policy rates continue to slow the economy. In that case, the Fed might have to break the back of the job market to reset wage expectations, delaying the eventual markets rebound.

It is also conceivable that as central bankers navigate their way through the current environment, they may decide to rethink the 2% target, perhaps opting instead for a range that gives them more leeway to allow for higher inflation and accommodative policy.

Another troublesome issue for the Fed is investors betting against the prospect of continued restrictive central bank policy. This is illustrated by the Goldman Sachs financial conditions index, which tracks borrowing costs, equity moves and exchange rates to gauge the tightness of U.S. financial conditions. As shown below, conditions tightened sharply over the first nine months of 2022 as policy rates were pushed higher. However, in October and November conditions actually eased, even as the Fed imposed two rate hikes totaling 125 basis points.

This means the tighter conditions imposed by the Fed were not being passed along to the broader market, and suggests many investors believe slowing growth may prompt the Fed to pause early despite still-high inflation. We think this is an incorrect interpretation of the Fed’s approach, and that continued loose conditions will only force the central bank to keep rates higher for longer.

Looking ahead to the pivot

The significant repricing on financial markets last year has left equity and credit valuations at much more appealing levels than we have seen in some time. However, we are being patient in assessing when to take on more risk. Interest rate hikes typically require up to a year to take full effect, and it will be several months before the most recent increases are fully felt. It can be tempting to look at the current Fed funds rate of 4.25-4.50% and believe the monetary tightening cycle is far along. However, that year-end level disguises the fact that, averaged over the course of 2022, the rate was just 1.88%.

Another reason for continued patience is illustrated by the capital market line, which plots expected market returns of various asset classes against their risk. In a healthy investment scenario, risk and return rise together, resulting in a positive sloping line. However, as shown below, the capital market line as measured in December was only slightly positive. Historically, a line at this shallow slope shows a reason for caution, not aggression. Looking at the below graph, the current line is not far off the line in July 2007, which was the equity market’s peak before the steep 2008 selloff of the GFC. When the market eventually bottomed in March 2009, we saw a much steeper line, indicating more favourable risk/reward conditions that would be proved out in the ensuing market rally.

The current slope indicates investors are not getting the incremental expected return one would normally envision for taking on higher risk. We expect over the first half of the year we will see a material change in market pricing that should begin to make the risk/return scenario more appealing.

As the year progresses, we do expect to reach a point—potentially in the second half—when we will decide to embrace more risk and shift our strategies to a more aggressive stance. Along with a more positive capital market line, there are four conditions that we would like to see in place before we would consider taking that step: a substantial inversion of the yield curve (as measured by overnight rates versus 10-year yields), more widespread earnings downgrades, a few months of meaningfully lower inflation data, and most importantly, substantial evidence of a weaker labour market.

We have begun to see some progress in meeting these conditions, most notably in the inversion of both the U.S. and Canadian yield curves. However, U.S. inflation remains elevated, and as discussed earlier, the labor market is still tight and continues to exert substantial upwards price pressure. Given this, we believe we are still in the midst of a bear market.

That said, markets rarely move very far in one direction without small reversals, and we saw seven S&P500 rallies of more than 5% in 2022. But we believe these are simply bear market rallies, and that many investors are still too bullish on asset prices given where we are in the tightening cycle. It’s important to remember that bear market rallies are not uncommon. In fact, in the last five bear markets, there have been on average seven rallies of 5% or more, and we expect the type of volatility we’ve seen to date will continue throughout the cycle.

When we do feel comfortable in taking a more aggressive approach to risk, we would pivot back into assets that will have seen significant price-to-earnings compression following the further deterioration of economic and corporate fundamentals we expect over the coming year.

In the U.S., this would mean embracing more cyclically exposed businesses, which we began avoiding in 2021. These could include industrials and financials, and other sectors where companies have considerable operating leverage to the economic cycle. In Canada, we would favor economically sensitive sectors such as industrials and materials, which we would expect to be attractively priced during a downturn. We would also look to add selectively in financial services and energy.

In our international strategy, we are comfortable with our positioning in Europe, but we would be drawn to increasing our emerging markets exposure in Southeast Asia and Latin America (e.g., Mexico) to benefit from the post-downturn economic recovery. We also could increase our exposure to Japan, as the country’s economic fundamentals are strong, and we would expect the yen to strengthen in a weakening U.S. dollar environment.

For our investment grade credit strategy, we would continue to focus on companies that have ample liquidity and offer sufficient credit spread to generate an appropriate rate of return.

In the sub-investment grade credit space, we would look to sectors that could benefit from a more balanced labour market, such as services and healthcare, which saw attrition during the pandemic and experienced margin pressure due to labour market conditions. We would also look for opportunities in the housing sector, which has been heavily challenged by the higher rate environment and should benefit from the eventual loosening of monetary policy.

With so much uncertainty over the path of U.S. inflation, it’s also possible we will not hit a risk-on decision point in 2023. There is also the potential for significant exogenous shocks—as we saw last year with the Russian invasion of Ukraine—and the ever-present threat of a resurgent COVID-19, which could weigh on markets and delay the onset of the next bull market.

The return of duration

Last year may ultimately be looked back upon as a time when investors were forced to pay the price for the enormous liquidity injections needed to keep the economy afloat during the pandemic. But the silver lining may be to put a bookend on the era of ultra-cheap money that has persisted since the GFC. In its place we may find a healthier overall market environment, with government debt instruments once again paying an attractive yield, growth stocks trading at more modest price-to-earnings ratios, and central bank rates steadying at a level that gives policymakers the ammunition to ease monetary conditions when necessary in order to stimulate the economy. This transition is very much unfolding, and there are sure to be additional bumps in the road.

Regardless of the timing of the Fed pivot, it is clear to us 2023 will be a year to fully embrace fixed income investments. Given the enormous outflows in credit last year, a stabilization in yields—and thus, the ability to earn the coupon without the fear of significant price erosion of the bond—is likely in the coming year. This could involve shorter-dated instruments initially, but we will soon be at a point where we will push back into longer-duration fixed income, which will be poised to benefit from the inevitable loosening of monetary policy once central banks determine inflation is under control.

This will enhance the appeal of fixed income as an asset class, and likely will recharge the traditional 60/40 portfolio, even as companies deal with higher overall borrowing costs than they have faced over the past decade.

If conditions evolve as we currently expect, we will hope to be confident in embracing a more aggressive risk-on approach in the second half of 2023. However, it is worth remembering that financial markets tend to react to inputs long before the broader economy does, and that when we do decide to take a more aggressive approach, it will likely be against a backdrop of higher unemployment and generally weak economic signals.

For now, we continue to hold a cautious view as we do not feel the market is adequately compensating investors for taking on higher levels of risk, particularly in the face of so much economic uncertainty. From a portfolio perspective, we continue to favor lower risk assets, specifically lower duration higher quality credit and treasuries that are paying us a reasonable yield as we wait and see how the year unfolds.