The Return of Normal

by Kevin McCreadie, MBA, CFA®, CEO, and Chief Investment Officer, AGF Investments Inc.

While volatility is expected to continue in the early part of 2023, the Fed and other central banks are poised to end their respective tightening cycles in the coming year, opening a path for markets to rally with more conviction. But the return to more "normal" interest rates means the next bull market, when it arrives, will likely look much different from the last one driven by ultra-accommodative policies that were put in place following the Global Financial Crisis more than a decade ago.

“Cautious optimism” may be the most overused two words to explain investor sentiment right now, but there’s no better way to express how many of us feel heading into 2023. Over the past year, we’ve been through the proverbial wringer, suffering bear markets in both stocks and bonds as central banks torridly raised rates to fight an inflation rate that has proven anything but transitory – and has not been this high in decades.

And while the rally in equity markets in the late fall seems like a sign of better days ahead, it also feels too good to be true and that more time is needed before the worst of the upheaval is finally behind us.


No doubt, it’s a fragile mindset with which to start the New Year, but a more confident take on the future direction of markets could still be weeks away. The key lies predominantly in the actions of the U.S. Federal Reserve and its global counterparts going forward. Investors need reassurance that the current tightening cycle is coming to an end. But it’s no longer enough to believe the Fed will lessen the magnitude of its rate hikes later this month. That’s already largely priced in.

Instead, what’s needed to push markets discernably higher from here is a true readiness on the part of the U.S. central bank to pause on further increases altogether. And to do that, it likely needs more convincing evidence that inflation is under control and will continue to fall on a month-over-month basis towards a level that is more in line with the Fed’s target of 2% on average over time.

That doesn’t mean the Fed needs to reach this goal or else. The threshold for a pause is probably an inflation rate close to 4% or 5%. But that’s still no easy task, and the longer it takes to get to that range, the greater the risk of markets becoming unsettled again. After all, if the Fed continues to raise rates much longer, even at a slower pace, the spectre of a recession only looms larger.

In fact, while unemployment remains relatively benign in the United States and many other countries, deteriorating global Purchasing Manager Indexes and negative-trending earnings revisions both suggest the current climate of higher inflation and higher rates is already taking a toll on the economy and could point to a more serious downturn in economic activity very soon.

Of course, central bank policy isn’t the only uncertainty that investors will face next year. The potential implications of today’s increasingly tense geopolitical backdrop must also be considered. This includes, in particular, the ongoing war in Ukraine, which has fuelled not only Europe’s energy crisis and continuing destabilization of its economy, but also fiery protests in China that have broken out against the country’s severe pandemic restrictions and lend more instability to arguably the world’s most important economic growth engine.

Given these dynamics, it’s hard to see a definitive path higher for markets, at least during the first few months of next year. In turn, investors should expect much of the same volatility experienced over the past 12 months, with range-bound fluctuations in equity prices and bond yields remaining the norm until the Fed and other central banks signal their intent to end the current tightening cycle – likely next spring or early next summer.

Once that happens, the path will open for markets to rally with more conviction, and it is very likely that major stock indexes around the world end 2023 higher than where they started.

That said, the next bull market in equities won’t have the same flavour as the last one. Thanks to the normalization of rates over the past year, the era of easy money defined by near-zero interest rates has now been replaced by a macro backdrop that is more typical of what investors experienced in the past.
This “return to normal” will not only have an impact on stock markets and the types of opportunities they afford, but also affect how bond markets perform and are perceived by investors. Indeed, for the first in over a decade, we can find adequate yield without having to take undue risk to get it.

All in, then, we believe 2023 will be another year of transition, but one that should end well for investors who maintain a balanced approach. In this environment, a bias towards equities within a 60/40 portfolio remains the most prudent allocation for now. Specifically, we are overweight the developed markets and see more opportunity arising in the United States and Japan than in Europe, Canada or emerging nations over the next few weeks – if not longer.

That’s not to diminish the role that fixed income should play in a portfolio. Bonds are surely more attractive than they were a year ago, largely because of higher yields, but also because of the downside protection they may offer if the economy deteriorates further and falls into recession. Moreover, alternative sources of return, including hedges on equities, may help investors navigate some of the volatility that is expected in the New Year, while also helping mitigate losses in the process.

While “cautious optimism” may not sound like a ringing endorsement for what’s ahead, we should be feeling a whole lot better about markets by this time next year.

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