The 2023 Recovery We Anticipate

What next? After last year’s parallel stock and bond market routs, we find that question is on many investors’ minds.^[i] In the very short term, anything is possible—near-term volatility is unpredictable, in our view. But we think stocks and bonds are primed to rebound this year as uncertainty fades and last year’s alarms prove to have overshot the emerging reality. How so? Read on.

Bear markets (typically prolonged, fundamentally driven declines exceeding -20%) are painful to endure, in our experience, and 2022 was no exception for US and world stocks in dollars. Whilst UK stocks and global returns in Sterling never reached bear market territory tied to currency swings, given that world stocks experienced a bear market last year, we think that distinction is important.^[ii] Late in bear markets, we find patience is usually rewarded, as our research shows recoveries begin with typically sharp V-shaped jumps. In our view, that likely occurs this year, which we think UK investors are likely to experience regardless of the downturn’s nature in Sterling. It may have already begun—since 12 October, the MSCI World Index is up 15.5% in dollars, even with December’s back-and-forth and last week’s slide.^[iii] In pounds, world stocks are also up 9.5% from their 16 June low.^[iv] Or maybe more downside lurks, from a new negative or investors’ working out some last spurt of angst. Recession (broad economic contraction) chatter amongst many commentators we follow certainly appears to be hitting sentiment hard now. Yet even if there is a recession, we don’t think it is likely to sway stocks materially. Markets—and CEOs—largely think a downturn is likely, based on available surveys and data.^[v] Stocks ordinarily bottom before growth returns, according to our hisorical analysis. In all of these scenarios, whilst the timing is impossible to pinpoint, we think the conditions are ripe for a new bull market to get cooking in 2023, as stocks’ three main drivers—politics, economics and sentiment—point positively.

Politically, the US presidential cycle’s third year supports better-than-average returns, in our view. Now, as always, MarketMinder Europe is nonpartisan, favouring no party nor any politician, with our analysis assessing political developments’ potential market effects only. So what matters to us isn’t the personalities or partisan particulars, but the fact that US midterm legislative elections brought a split Congress, with Republicans winning the House of Representatives and Democrats maintaining Senate control, ensuring political gridlock for the next two years. This ushers in what we call the Midterm Miracle for stocks. Our review of electoral history shows midterms often deepen gridlock, reducing the risk government enacts anything radical to upset markets, and that typical backdrop reigns now.

The nine months starting in midterm years’ fourth quarters are US stocks’ most positive stretch since good data begin in 1925—and the effect ripples globally, given their high correlation with developed markets in Europe and the Asia-Pacific region.^[vi] Last quarter was no exception, with the S&P 500 up 6.6% in dollars, in line with midterm Q4s’ average, whilst world stocks rose 9.8% in dollars.^[vii] We aren’t saying that is all midterms. But we suspect they contributed. In full, year three US stock returns typically follow through with the electoral cycle’s highest average return of 18.4% in dollars.^[viii] It also has the highest frequency of positive returns at 91.7%.^[ix] Except for 1931 (Great Depression) and 1939 (WWII’s onset), no third year has been negative from when reliable records start.^[x] Absent a world-shaking wallop no one foresees, the Midterm Miracle likely helps kickstart a new bull market sooner rather than later this year, in our view—again, if it isn’t underway now.

Another big reason: We think economic conditions will likely be better than widely thought. From business leader and company surveys to economist and consumer polls, we find there is widespread agreement recession is either here or soon to come.^[xi] Three-quarters of Americans thought recession was occurring last fall.^[xii] According to The Conference Board’s poll, 98% of CEOs see US recession in 2023.^[xiii] Based on our observations, the investment community has been near-universally on Recession Watch for months, after Q1 and Q2 2022 US gross domestic product (GDP) both inched lower—a watch that intensified later despite Q3’s 3.2% annualised GDP rebound.^[xiv] So if it happens, we doubt it would shock.

But also, in our experience, CEOs anticipating recession probably prepare for it, blunting the impact and likely making it milder than most commentators we follow anticipate. As Fisher Investments founder and Executive Chairman Ken Fisher likes to say, “anticipation is mitigation.” We think any contraction would likely be short-lived because wringing out past excesses drives recessions—and firms have largely done that already. Perhaps there is more to come, but the measures taken in advance suggest to us they would be mild and anticipated, so then if there isn’t a recession, that would positively surprise.

Take UK GDP for example. Since its Q3 contraction, we have seen many outlets, including the Bank of England (BoE) and Office for Budget Responsibility, project the UK to enter recession in 2022 and stay there for most of 2023.^[xv] On 13 January, the Office for National Statistics revealed UK GDP grew 0.1% m/m in November, adding to October’s revised 0.5% rise.^[xvi] Yet reports we read couldn’t resist finding clouds in the silver lining. Some dwelled on the fact heavy industry slipped -0.2% m/m, driven by manufacturing output’s -0.5% slide—with only services’ 0.2% rise driving GDP higher.^[xvii] Rather than call that a good sign that the sector representing about 80% of UK output is in better-than-expected shape, the coverage we reviewed widely considered one-off factors (like the World Cup) largely responsible, with living costs likely continuing to weigh.^[xviii] Against this backdrop, we don’t think it would take much for reality to come out a shade lighter than the prevailing gloom.

We also think many economists we follow misread supposed recession signs, like the inverted yield curve (when short-term bond rates top long-term yields), raising the likelihood of a better-than-feared outcome. With the BoE’s Bank Rate and 3-month Gilt rates above 10-year yields, many of them warn inversion spells recession.^[xix] Perhaps. But in our view, they rest these claims on mere correlation without exploring causation. Our research shows the yield curve normally matters because banks borrow short term to lend long, making short rates a proxy for funding costs and long rates a proxy for loan revenue, so inversion under these conditions would likely stress loan profitability. But today, we see a flood of bank deposits provides banks ample funding at rates below the Bank Rate.^[xx] With long rates rising in 2022, lending remains profitable—and bank loan growth positive as a result.^[xxi] Yet few commentators we read acknowledge this counterpoint.

Fixation on negatives to the exclusion of nearly everything else is a hallmark of what Ken calls the “pessimism of disbelief,” which we find runs rampant as bear markets end. We see it today. For example, reflecting escalating recession fears last June in America, the University of Michigan’s Consumer Sentiment Index hit a record low from the series’ 1952 inception and has been pinned near there since.^[xxii] Besides consumer confidence, business and investment sentiment indicators across the world have plumbed new depths.^[xxiii] But look at it from a market perspective. As legendary investor Sir John Templeton astutely observed: “Bull markets are born on pessimism.”^[xxiv] When pessimism becomes excessive, overshooting reality far to the downside, and people widely ignore or dismiss signs of improvement, we think conditions for a bull market recovery’s initial V-shaped rebound are ripe.

All the negative sentiment has many commentators we follow overlooking a key point, in our view: Many of last year’s alleged risks are fading. Take a major one: inflation. Input prices fell sharply in 2022’s second half, and they are now starting to show in inflation rates.^[xxv] The US consumer price index (CPI) peaked at 9.1% y/y last June (coincident with consumer gloom), but by December, it decelerated to 6.5%.^[xxvi] Meanwhile, core CPI excluding food and energy, which some think better represents inflation’s underlying trend, hit a high of 6.6% y/y in September and retreated to 5.7% in December.^[xxvii] UK consumer prices haven’t cooled as much, peaking at 11.1% in October and ticking down to 10.5% in December, but with price pressures easing globally, we see inflation likely continuing to retreat.^[xxviii] And, since inflation projections influence long rates, 10-year developed market yields have followed suit, with global benchmark US Treasurys’ falling from October’s 4.2% peak to sit at 3.5% now.^[xxix] Since bond prices and yields move inversely, we think that is likely to provide some relief to bond markets, too. Notably, credit spreads tracking corporations’ perceived financial health are narrowing as rates subside.^[xxx]

So our outlook for 2023 is bright—partly because most commentators we follow view it dimly and can’t seem to see the improving backdrop around them. We see a wide gap between reality and sentiment today—ample fuel for upside surprise to drive a great year for markets.