2023 Market Outlook

Despite high inflation and rising interest rates, the U.S. labor market remains strong. If inflation continues to ease, an economic soft landing may actually be possible.

The U.S. economy produced jobs at a slower but still comfortable rate at the end of 2022, as higher interest rates and changing consumer habits downshifted the labor market without bringing it to a halt.

Employers added 223,000 jobs in December on a seasonally adjusted basis, which was in line with economists’ expectations although the smallest gain since President Biden took office.

The gradual cooling indicates that the economy may be coming back into balance after years of pandemic-era disruptions — so far with limited pain for workers. The unemployment rate ticked down to 3.5 percent, back to its level from early 2020, which matched a low last seen in 1969.

“If the U.S. economy is slipping into recession, nobody told the labor market,” said Chris Varvares, co-head of U.S. economics for S&P Global Market Intelligence, noting that the December number is still nearly double the approximately 100,000 jobs needed to keep up with population growth.

Stocks jumped on the news. The S&P 500 gained 2.3 percent, reflecting expectations that a slowdown in job growth and wage gains could reduce the pressure on prices and make the Federal Reserve less aggressive in raising interest rates.

Inflation is Key

Inflation appears to be cooling, but is still too high. The December inflation rate came in at 6.5%, which was the sixth monthly decline and a significant cooldown from the 9.1% rate registered last June.

If this trend continues, it will significantly lower the risk of a recession. However, if inflation remains stubbornly high, then the Fed will continue to move rates higher and further slow the economy–possibly pushing the economy into a recession.

Don’t Fight the Fed

2022 proved the old adage correct once again. The Fed aggressively raised rates, and the stock market collapsed. However, there is reason to be optimistic that 2023 will not be a repeat of 2022. Most importantly, Fed officials have signaled that they could be ready to pause their inflation-fighting campaign in late winter or early spring. 

Although Fed Chairman Powell has made it clear that the Fed is not anywhere near reversing course by cutting rates, simply pausing the current tightening cycle could buoy stocks.

Market Rotation

With higher interest rates likely to remain for longer, investors are now offered a higher risk-free rate of return. (i.e. The rate that can be earned on US Treasuries and cash.) This has some important implications for stocks. Not only are stock fundamentals regaining importance, but the market’s leadership profile is also changing.

The S&P 500 is a capitalization-weighted index, meaning that the stocks that have the highest valuation command the largest percentage of the index. Currently, four out of the top five largest components of the index are tech stocks: Apple, Microsoft, Alphabet (Google) and Amazon.

These are all great companies, no doubt. However, the dominance of tech stocks in the market is slipping. The tech-heavy S&P 500 has underperformed the equal-weighted S&P 500 by the largest margin since 2010.

The higher risk-free rate of return has brought stock fundamentals back into vogue. The likely beneficiaries are companies with strong profit margins and high free-cash flow. This would also include many international stocks, which, on average, trade at favorable valuations compared to the US market.

International Appeal

Wealth managers like SilverPeak Wealth preach the value of diversification. However, over the last ten years, diversification into international stocks (at the expense of US stocks) has only hurt investment performance. This may be changing.

Since the start of the fourth quarter, the MSCI EAFE index of international stocks has climbed roughly 20%–far outpacing the 8% gain on the US market. Of course, one quarter of strong performance does not constitute a trend, but there are reasons to believe that international stocks may continue to do well in 2023. 

International stocks tend to have higher dividend yields and lower price-to-cash-flow ratios than US stocks. And it is these characteristics that are most in favor now.

In addition, earnings growth is stronger outside the US, and analysts expect it to remain so in 2023. The year-over-year earnings growth for the S&P 500 companies in the most recent quarter was 4.1%, compared to 30.5% for companies in Europe’s STOXX 600 index. And, international stocks have lower valuations. As a result, international stock outperformance may have some room to run.

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