PODCAST: Will 2023 Be A Year of Slow Growth, But Better Markets?
Dr. David Kelly and Jack Manley, Global Market Strategist, review 2022's turbulent investing landscape and discuss the outlook and opportunities for 2023.
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David Kelly: Welcome to Insights Now, a series of conversations designed to shine a light of clarity on the complex world of investing.
2022 has been a brutal year for investors with unusually large sell-offs of both stocks and bonds resulting in one of the worst years ever for balanced investing. However, 2023 may be the calm after the storm of this year, with market stabilizing, inflation receding, and the Fed nearing the end of its tightening cycle. Moreover, precisely because markets have been so battered, lower equity valuations and higher bond deals present some of the most attractive entry points for investors in over a decade. While recession is still widely predictive for 2023, markets are forward-looking and intend to recover before the economy does. A significant valuation and balances across markets mean there is more upside potential, the downside risk in investing today. For our last episode of this season, we're going to discuss some of the key takeaways from our investment outlook for 2023. We will also invite you to check out the full piece, which has been linked in the show notes. Joining me for this conversation today is my colleague Jack Manley, global market strategist for J.P. Morgan Asset Management. So Jack, welcome back to Insights Now.
Jack Manley: Thanks David. It's good to be here.
David Kelly: So let's briefly set some context, 2022 has been a year to forget for markets. But in order to understand what was going on beneath the surface, what events do you think drove market volatility this year?
Jack Manley: It's a good question, David, and I think that we can kind of break this question down into the things that we were anticipating and the things that maybe caught us a bit by surprise. Everybody knew that inflation was going to last. I don't think anybody really knew how long it was going to last, but everybody knew that hot inflation was going to persist through this year. So that was going to be a problem that we were facing. We knew that there was going to be a very significant fiscal drag on this economy because regardless of the outcome of the midterm election, it would be nearly impossible for the federal government to spend as much as it did last year or the year before with that kind of Covid era stimulus. We also knew that the Federal Reserve was going to be raising interest rates.
Perhaps we didn't know how aggressive that would be, how swift that move in rates would be, but we knew that was going to happen. All of those things were headwinds for the markets that we had kind of anticipated. But you can add a couple other things to the mix here that I think caught a lot of people off guard. The most obvious one, the thing that happened right out of the gate in 2023 was the Russian invasion of Ukraine. I don't think a lot of people were pricing in something like that 12 months ago, but clearly causing an enormous amount of volatility in markets, not just because of what it did to uncertainty and escalated geopolitical tensions, but because of the direct impact that it had on commodity prices, food, fuel, things that all of us need to consume one way or the other. You add on top of that, China and its insistence on maintaining this zero Covid tolerance policy that was very clearly detrimental to its own growth and to global supply chains. And I think you sum it up pretty nicely, David, 2022 was absolutely a year to forget.
David Kelly: Well, before we forget it entirely if we could, let's pretend there were 12 months ago and obviously there were things that were genuine shocks and surprises like Ukraine. But in hindsight, if you think back 12 months ago, what were the best investment opportunities at the time, and what were the risks out there for investors?
Jack Manley: Well, this is going to sound sort of like a joke, but I feel like parking cash wouldn't have been the worst thing in the world at the start of this year because nothing has really worked that well for you in 2022. A lot of this is just kind of a relative story, what hasn't done as poorly as something else. Now there are going to be a couple of exceptions to that. One of the great things that you could have invested in the start of this year would've been energy companies in the S&P 500 that have done very, very well kind of bucking the trend from the rest of the index directly relating to what's gone on with fuel prices this year, staying pretty elevated throughout the course of 2022. That was a good bet that you could have made at the start of the year.
You probably in that theme would've also liked to have been a little bit more overweight value relative to growth, especially some of those very, very growthy names, that kind of beneficiaries of growth at any price style investing. The rise in interest rates have obviously clobbered those companies disproportionately, I'd say. You'd also probably want to have been overweight US equities, not just because of the challenges that their own domestic markets faced this year because of things like the war or things like Covid, but also because of what's happened with the dollar. Strengthening so considerably on the back of geopolitical turmoil and rising interest rate differentials. So in overweight to us and overweight to value and in particular leaning a bit more into energy names probably would've been the best way that you could have approached this year, but I wouldn't say that most people were prepared for how that shaped out.
David Kelly: There has been a lot of pain as you described it, this is really just a matter of what the least worst outcomes for different assets this year. But usually when you have some pain in investing, there is some opportunity created. So if we look fast forward to where we are, how do market fundamentals look to you right now and do you think that most of the pain has now been already felt?
Jack Manley: So I think that's an important thing to say there about most of the pain already being felt. I would say there is a light at the end of the tunnel here. I would say that we are closer to the end of all of this mess than we are to the beginning, but I do not believe that we are fully out of the woods just yet. I do think there is more pain to feel as we move through 2023. We know the Fed is going to continue to raise interest rates. How much they're going to raise by is still I think up for debate. I think that the most recent dot plot released by the Federal Reserve and its December meeting was a little bit more hawkish than a lot of us were anticipating. So rates will continue to move higher. We know that it's going to take a little bit of time, at least for China to sort of downshift this Covid policy.
There is fundamental uncertainty about the war. Unfortunately, that will likely persist and the earnings shoe has not really dropped just yet for the equity market. That's something that we have to be paying pretty close attention to next year. But when you are looking at just how much pain you have experienced in both the stock and the bond market, and that is extraordinarily unusual, David, for things to have gotten this poorly for both assets at the same time. I would say that from where we stand right now, there is more upside potential than downside risk to investing today. That's kind of my mantra when it comes to positioning in 2023 given a fundamental backdrop.
David Kelly: So clearly, possibly some further pain to come, but there is a fair amount of opportunity. So let's dig into that. What areas of the market do you think look most attractive right now?
Jack Manley: So from a purely valuation perspective, you could probably make the argument that stocks have more of a long-term sort of growth potential than bonds do. That's just kind of the nature of the beast. We look at what's gone on with the equity market. It has sold off considerably in the U.S., valuations more or less back down in line with the long-term average. Yes, we can make this argument about earnings being a challenge next year, but what I think that does more than anything is really set up the need for active management in today's environment. It is not going to be impossible to generate earnings as a company in 2023. It's just going to be hard for us as investors to find them. So 2023 is probably not going to be a year for beta exposure in the equity market. I would want to be active in the space.
I would want to try to generate alpha through prudent sector security selection, but I am broadly constructive on equities. Within the equity space, I do think that because tech and tech adjacent names have sold off so much in response to higher interest rates. If we do get some more clarity on what exactly terminal Fed funds rate actually will be, and then all of a sudden we're going to have an idea of what the appropriate discount rate is that we can apply to future earnings growth. And while I think it's pretty clear, and we'll sort of knock on wood for this one, that growth at any price investing is dead for as long as rates are above 0%. Growth at a reasonable price investing is still very much a viable investment philosophy. And so I do think there is still room for growth in a portfolio.
On the value side of things, I am biased, but I do like financials. I think that there's a good valuation argument to be made there, but I think the fundamental backdrop is pretty supportive too. We're looking at a yield curve from a treasury perspective that is flat if not downright inverted. But if you think about how some of these big multinational banks generate profits, they are still able to borrow from you the depositor at very, very low levels, 1, 2, 3 basis points blend out to you for an auto loan or a mortgage at 600-700 times that amount. There is a pretty nice net interest margin spread there to be told for the financial services industry. I think the fundamentals work in favor of energy as well. Elevated prices, not a whole lot of CapEx capital getting returned to shareholders. On the bond side of things, it is a little bit more complicated.
I would say that for the first time in a while, you can actually make some money in fixed income and that's exciting. But I would also say that you are not being adequately compensated for taking a whole lot of credit risk in fixed income. Spreads are just not as wide as they should be, particularly in the high yield space, given the macro backdrop that we think we're going to be moving through in 2023. So what I would do if I were a fixed income investor is regardless of where on the yield curve I'm going, I'd want to be as high quality as possible and then I'd kind of divide my fixed income allocation into the income side and the protection side. And for income, you don't really need to take duration risk. In fact, you're being penalized for taking duration risk. So I'm going short duration, high quality, fixed income in the bond space for income.
But if I'm looking for protection, quality of course is still playing a role. But that's also where we want to extend our duration a little bit. Given that the Fed is going to continue to raise rates, I don't think we want to go all in on duration. I wouldn't be buying 15, 20, 30 year bonds. But looking at something sort of a little bit more intermediate, 3, 4, 5 years kind of feels like the sweet spot from a protection perspective. So as you said, David, a lot of opportunities out there, you just kind of got to know where to look.
David Kelly: So those are the opportunities. What would you steer clear of in the year ahead?
Jack Manley: I think that any sort of growth-y company that is dependent on free money to survive is going to stay under pressure this year. And the Fed has just wrapped up, I hope, a decade plus long experiment in monetary policy. And it has seen what has happened as a direct result of rates at effectively zero, of mortgage rates at just north of 2%. Massive asset price bubbles that we are still dealing with right now as these things start to get unwound. So if you are a young, unprofitable company with no real prospects of earnings in the next five years or so, I would not really count too much on price performance from those places for as long as rates are off the floor. So that is certainly something I would avoid as we move through 2023, growth at any price investing style beneficiaries I don't think are really going to work. That to me is probably my highest conviction player or lowest conviction I guess I should say in terms of where I want to avoid allocation. Everything else feels kind of okay as long as you know where you're looking.
David Kelly: So let's look at a traditional 60/40 portfolio. That means having 60% of your money in stocks, 40% of your money in bonds. This has been an unusually lousy year for 60/40 investing. In fact, it looks like it's turning out to be the worst year since 2008 overall, and probably the only time, really a decade, that we've seen bonds actually making a sell-off in equities worse. Do you think, given this very disappointed performance, that there's still a case for 60/40 investing going forward?
Jack Manley: This has been a painful year for balanced investors and a lot of us could never have imagined just how painful the bond market would be, and we could not have imagined that fixed income would actually amplify the poor performance that we were already seeing out of equities. And David, the way that I've been thinking about this recently, and I do think it's sort of a helpful framework to have when it comes to this asset allocation conversation, the talk about a 60/40 portfolio. Are bonds broken? Do they no longer play a role in investing, is to say that I think we need to kind of rewire our brains a little bit when it comes to how we think about fixed income as ballast in a portfolio. The very simple way to think about this is that fixed income protects you against equity market volatility.
The stock market sells off, that money moves into bonds, all of a sudden bond prices move higher, yields move lower. You make money in fixed income. But maybe a better way to think about fixed income, especially in today's world, is that instead of protecting you objectively or by design against equity market volatility, fixed income actually protects you against macroeconomic volatility. In the sense that if you get a recession and the Fed is forced to cut interest rates maybe by a little, maybe by a lot, we see rates move lower. We see yields get dragged down lower across the curve. Bond prices rise when yields are falling and you make money in fixed income. And I'd say coincidentally, that usually is going to line up with an equity market selloff. Macroeconomic volatility will typically translate into equity market volatility, but not always. And if we think about what was going on this year, we were not in a recessionary environment where the Fed was forced to cut interest rates to stimulate growth.
It was the exact opposite. An overheating economy, red hot inflation running at multi-decade highs. The Fed embarking on its most aggressive rate hiking cycle in decades, raising rates very, very quickly. And when rates are rising, prices fall and you lose money in fixed income. So I don't want to tell anybody that what's happened this year has been pleasant. It has not been. And I also don't want to say that anybody could have really called just how swift, how brutal, how painful Fed policy would've been for the bond market this year. I don't think anybody was expecting 14, 15, 16% out of a decline, out of high quality U.S. fixed income. But I would say, given the macroeconomic backdrop of an overheating economy and the Fed raising rates, bonds kind of did what they were supposed to do, for better or for worse. And so my answer to your question, David, is there still a role for the 40 in a 60/40 portfolio?
I would say absolutely. I don't think bonds are broken, and I think we're in a really interesting position right now, where the byproduct of all this pain that we felt is that yields, as we talked about earlier, for the first time in a long time are actually pretty substantial. You can clip a pretty healthy coupon out of fixed income and that yield is going to provide you buffer against interest rate volatility. I think the fixed income story can be summed up really nicely by something I said earlier, more upside potential than downside risk in bonds, especially if you take a little bit more a duration exposure.
David Kelly: Obviously, let's then keep talking about those better prospects that we're talking about here. So as we look forward to 2023, do you think the biggest investment themes of 2022, such as inflation, rising interest rates, and of course recession fears, are those going to continue to dominate in 2023?
Jack Manley: I think they will continue to be important. I can certainly hope that at least some of those are going to diminish in their importance. If we think about what's going on with inflation, I think there is a light at the end of the tunnel. We know that base effects comparisons are becoming more favorable, which should help to put some downward pressure on those year over year figures. We know that energy prices have moved down a little bit and that is helping considerably. We know that China is at least, in theory, reopening, which should be good for global supply chains. So is inflation going to be higher than 2% for the rest of this year? Probably. But is it going to be 7, 8, 9% like what we experienced this year? I don't think so. So is it still relevant? Sure. Is it as problematic as it was this year? Probably not.
Would we be talking about interest rates next year? Certainly. But if we're looking at what the Fed is projecting to do in 2023, we're only looking at one or two more rate hikes likely to the tune of 50 to 75 basis points. And it's not going to be fun, but it's a very small amount relative to what's already happened this year, and I don't think the Fed plans on going much above that. I frankly think the Fed will likely land at around 5% or so. But I think that we will continue to talk about where rates are and the direction of rates, especially in the first quarter of next year. But all the pain that we felt this year from a rates' perspective, I don't think we should expect to experience again next year. The one thing that may persist or may even get worse, David, from what you mentioned there, is recession risk. Because this economy right now seems to be in reasonably good shape, but as we know, the consumer is the engine of growth for the U.S. economy, contributes to the lion's share of GDP.
If the consumer is happy, the economy does well. And while the consumer has been happy for quite some time, we are seeing some cracks in the armor. We are looking at the personal savings rates that are declining to near all-time lows. We know that all that money that got mailed out over the last couple of years, a lot of it has been spent already. We know that inflation is eroding away at purchasing power. We know that the Fed is trying to engineer some demand disruption from a labor perspective, which could mean an uptick in the unemployment rate. I think the conversation around recession next year crystallizes a little bit. I think it becomes more salient. So whereas the rate conversation may die down a little bit, the inflation conversation may die down a little bit. I think the conversation about recession risk is really what we're going to be talking about as we move through at least the first half of next year.
David Kelly: So we're finally closing the book on 2022. This is our last podcast for 2022. But finally, could I ask you what lessons did we learn for 2022 and when we're thinking about investors New Year's resolutions for 2023, what could we take from 2022 to help us?
Jack Manley: Well, I think it's kind of funny. Because there is a lesson that I would say I certainly learned this year, and I think a lot of investors learned this year, which is don't fight the Fed. But I think it's funny because that's a lesson that's learned every time the Fed does something like this. This is not a new phenomenon for us. You've heard that expression before, don't fight the Fed, but this time it was going to be different. This time things would go the way that we thought they should go as opposed to what the Fed was telling us, and that just hasn't been the case. So I guess there is a lesson there, which is regardless of what you think about monetary policy, the Fed is going to do more or less what it promises to do, so get out of the way if necessary.
That is a big takeaway. I would also say, David, and this is sort of a high-level view on asset allocation or on investing, that diversification does matter. Because if you had put all of your eggs into one basket, let's say you were all in on the international trade at the start of this year or all in on the growth at any price trade in the U.S. at the start of this year, you would've gotten burned. Let's say you were all in on the Bitcoin trade at the start of this year, you would've gotten burned. The benefits of diversification are manifest, even this year that was challenging for both stocks and bonds. You are afloat because or at least you're doing better because of that diversification in a portfolio. So while it may be very tempting to overweight significantly to one particular asset class or another because it feels like the next big new thing, the long-term story I think has been and always will be the need to allocate across these assets to broadly diversify.
David Kelly: Thank you for joining us, Jack. Now, thank you all for listening. This concludes our fifth season of the Insights Now podcast, and thank you to all our listeners who've joined us along the way. We'd love to hear your thoughts and any suggestions you may have on our podcast as we plan for our next season. You can reach out to our team market insights at mi.questions@jpmorgan.com. We'll also provide the email in the show notes for this episode. Our next season will kick off in February, other than I invite you to read or listen to my notes in the week ahead podcast, where every Monday I share commentary on the latest in the markets in the economy till you stay informed for the week ahead. For even more time and insights, you can also follow and subscribe to my content on LinkedIn.
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