Finance, Inflation is finally starting to decrease, and there are indications that interest rates may soon reach their highest point. As a result, some experts argue that now is a good time to reenter the market, despite the possibility of an impending recession.
Last year, the economy faced unprecedented inflation rates and aggressive interest rate hikes by the Federal Reserve, leading to substantial losses in investment portfolios.
Both stocks and bonds, which typically have an inverse relationship, experienced significant declines, causing major setbacks for the widely used 60/40 portfolio allocation strategy. Morningstar's U.S. Moderate Target Allocation Index, a benchmark for the 60/40 portfolio, recorded its most substantial annual decline since 2008, dropping by 15.3%.
However, the outlook for 2023 appears to be different, offering investors hope for the recovery of their retirement savings. David Russell, the vice president of market intelligence at TradeStation, suggests that the tide of inflation is now turning.
This shift is evident in both the bond market and the stock market, with money flowing into bonds, the S&P, and Nasdaq. As a result, the 60/40 strategy may regain its effectiveness, providing opportunities for investors to rebuild their portfolios.
What happened last year?
Last year, there were significant developments in the financial landscape. Inflation reached its highest point in 40 years, prompting the Federal Reserve to implement a series of interest rate hikes. In total, the short-term benchmark fed funds rate was raised by an impressive 425 basis points. This included three consecutive rate hikes of 0.75 points each, aimed at curbing inflation. When interest rates rise, the cost of borrowing increases for both individuals and businesses, which, in turn, dampens demand, slows down the economy, and mitigates inflation.
The surge in interest rates also had a direct impact on bond prices. As rates climbed, the value of older bonds decreased because their coupon payments became less attractive compared to the higher rates offered by new bonds entering the market. Consequently, bond prices dropped.
A notable and uncommon occurrence took place as a result of the combination of high inflation and aggressive rate hikes: Both stocks and bonds experienced simultaneous declines in value. According to investment firm BlackRock, such instances where stocks decline while bonds fail to provide a counterbalance have been rare throughout history. Since 1929, there have been only three years in which bonds did not increase in value when stocks experienced a downturn. The most recent occurrence before last year was in 1969, as noted by BlackRock.
What if there's a recession?
In the event of a recession, some experts believe that it may not have a significant impact due to the prevailing negative sentiment and widespread anticipation of a downturn. Peter Essele, the head of portfolio management at Commonwealth Financial Network, suggests that the market has already priced in the possibility of a recession, leading to a sense of desensitization among investors. He refers to it as the "most over-forecasted recession," implying that people have become accustomed to pessimistic forecasts.
Surveys conducted last year indicate that a considerable portion of the American population and business executives already believed the economy was in a recession or heading towards one. This prevailing sentiment of economic downturn has contributed to a mindset of preparedness for the worst-case scenario.
Essele further suggests that in such situations, stocks typically reach their lowest point approximately 60% into a recession. However, he believes that the current recession, if it occurs or has already occurred, may experience an earlier or shallower bottoming-out process. Some economists also point to recent data indicating a slower economy, but the possibility of avoiding a recession altogether or experiencing a mild one.
In summary, the already prevalent expectation of a recession and the preparedness of individuals and businesses may mitigate the potential impact and lead to a quicker recovery or a less severe downturn.
What could this mean for investors in 2023?
For investors in 2023, the outlook depends on several key factors. If inflation continues its downward trend, and the Federal Reserve pauses its rate hikes as anticipated, some strategists suggest that it could be an opportune time to reenter the market. The important aspect is the clarity surrounding the endgame for rates and inflation, according to Peter Essele, head of portfolio management at Commonwealth Financial Network. Knowing where the Fed stands in terms of rate hikes and inflation can provide a more stable environment for investors.
Market turbulence is often driven by unpredictability rather than the specific level at which the Fed decides to halt rate hikes. Therefore, having a clearer understanding of the central bank's intentions can help stabilize the markets.
Additionally, if the economy does enter a recession, some strategists speculate that the Fed might begin lowering interest rates in the latter part of 2023. This potential rate cut could act as a stimulus for the economy. This viewpoint aligns with the expectations of many investors, as reflected in the CME's FedWatch tool, which indicates that a quarter-point rate cut is anticipated in November.
In summary, if inflation continues to decrease, the Fed adopts a pause in rate hikes, and the market has already factored in negative news, it may present a favorable environment for investors to reengage. Furthermore, the potential for a rate cut in the event of a recession could provide an additional boost to the economy.
What might be good investments?
According to experts, there are several areas that could be favorable for investments. If there are indications that 10-year yields have reached their peak or are close to it, housing stocks are expected to gain strength. Homebuilders, in particular, are predicted to perform well due to strong and consistent demand for housing in the country.
Another sector that experts find promising is steel makers and metals companies, which have previously underperformed but could benefit from upcoming infrastructure projects. These companies might see an upswing in their performance as investments in infrastructure increase.
Furthermore, the combination of high home prices and high interest rates discouraged buyers in the past. However, if home prices decline, people may be more willing to purchase properties with the expectation of refinancing in the future when interest rates are lower. Jon Klaff, the general manager of investment platform Magnifi, suggests that a recession could potentially trigger a drop in home prices, making them more attractive for buyers.
Bonds, especially for retirement portfolios, are also considered a good investment choice. With the current higher yields available, bonds have become more appealing. Jason Kephart, the director of multi-asset ratings for Morningstar Research, believes that the increased yields make bonds a more attractive option for investors.
As with any investment decision, thorough research and consultation with a financial advisor are crucial to make informed choices based on individual circumstances and market conditions.