by Schwab Center for Financial Research
The Federal Reserve's ongoing commitment to raising interest rates to cool inflation is likely to lead to weak U.S. economic trends in early 2023. However, Fed policymakers have indicated they are looking to an eventual pause in rate hikes, possibly in early to mid-2023, and that it is likely the federal funds rate target will remain at its peak, or "terminal," rate for a while.1
In other words, there may be more choppiness, given that inflation is still a noticeable (although receding) problem, but the longer-term U.S. economic outlook has improved.
Source: Schwab Center for Financial Research
U.S. stocks and economy: How many more times, Fed?
Leading economic indicators are pointing to recession
Source: Charles Schwab, Bloomberg, The Conference Board, as of 10/31/2022.
It may seem counterintuitive, but employment weakness would be welcome sooner rather than later, as it would bring the Fed closer to "checking the box" of increasing slack in the labor marketâultimately helping put downward pressure on inflation and allowing the Fed to ease up on the brake it has been applying to the economy. If this occurred alongside a stabilization and/or turn higher in leading indicators, it would set up the economy for better days later in the year.
Global stocks and economy: Risk and recovery
Inflation is still stubbornly high. Central banks stepping down the pace of rates hikes is more about responding to weak economies than making strong progress on lowering inflation. Even though third-quarter economic growth was better than expected for many major countries in North America, Europe, and Asia, a global recession likely began sometime during the third quarter.
One important signal of an already-underway recession is the leading indicator for the world economy produced by the Organization for Economic Cooperation and Development. In this index, a drop below 99 tends to happen right around the start of a global recession. It's a repeating story, and it's below 99 again, signaling another potential recessionary period.
Global leading indicators point to global recession
Source: Charles Schwab, Organization for Economic Cooperation and Development, Bloomberg data as of 12/2/2022.
China's authorities are preparing to end the zero-COVID policies that have held back their economy for the past three years. In reaction, the MSCI China Index rose 29% in November, compared to just 5% for the S&P 500 Index. This surge in Chinese stocks has propelled outperformance of emerging-market stocks. Yetâin another example of counterintuitive cross currentsâthe potential reopening poses upside risk to inflation just as central banks appear to be stepping down their rate hikes. We will be watching developments carefully to assess the balance between the impact of reopening excitement and inflation worries on the stock market.
Fixed income: Bonds are back
Our optimism about returns for 2023 is based on three factors:
- Starting yields are the highest in yearsâin both nominal and real terms;
- The bulk of the Fed tightening cycle is over; and
- Inflation is likely to decline.
After a long drought, the bond market is awash in yields that are attractive relative to other income investments. A portfolio of high-quality bondsâsuch as Treasuries and other government-backed bonds, and investment-grade corporate bondsâcan yield in the vicinity of 4% to 5% without excessively high duration. Tax-adjusted yields in municipal bonds are also attractive for investors in higher tax brackets. In addition to the relatively attractive yields, higher coupons for newly issued bonds should help dampen volatility.
We expect the Federal Reserve to end its rate hikes in early-to-mid-2023 amid a soft, perhaps recessionary, economy that brings inflation lower. Given that outlook plus the year-end rally in bonds, yields may rebound early in the yield. However, the yield curve (the difference between short-term and longer-term Treasury yields) is likely to remain deeply inverted as monetary policy remains tight. Assuming the Fed sticks to its tight policy stance at the expense of economic growth, 10-year Treasury yields could fall as low as 3%. With that backdrop, we favor adding duration to bond portfolios during periods of rising rates, while staying up in credit quality.
Investor takeaway: Focus on quality
In global stocks, one way we've been defining quality is high-dividend payersâgenerally a sizeable dividend is a sign of financial strength and good cash flow. High-dividend-paying stocks have outperformed during past recessionary bear markets, and they outperformed again in 2022 across sectors and countries. So did short-duration stocks (that is, stocks of companies with more immediate cash flows, rather than cash flows in the distant future): They outperformed in 2022 both when the market was falling and in the fourth quarter when it rebounded. There can be no guarantees, but investors may be able to navigate 2023 by sticking with what has been working in both up and down markets during 2022.
We're similarly focused on quality in the fixed income market. Investment-grade bonds are likely to provide attractive yields in 2023 at lower risk than we've seen for several years. Current yields on riskier bonds, such as high-yield bonds, don't provide enough compensation for the extra risk, in our view. Things may change as the year progresses, but for now we recommend staying up in credit quality and increasing duration, keeping the average near your long-term benchmark.
2 Federal Open Market Committee, "Summary of Economic Projections," September 21, 2022.