by Mark Keller, CFA, Bill O’Grady, and Patrick Fearon-Hernandez, CFA | PDF

Summary of Expectations:

• A recession is highly probable in 2023. Our base case is a garden-variety recession.
• Three factors could trigger a deep recession: a. Falling nominal home prices; b. A financial crisis; c. A geopolitical event
• One factor that could mitigate the downturn is investment spending, especially on manufacturing plants and equipment. Manufacturing has been depressed for over three decades and the prospect for reshoring and building redundancies could support the economy. We suspect this factor will tend to be longer term in nature, but it could begin next year.
• We expect inflation to ease in 2023, but the Federal Reserve’s preferred narrative on inflation control and how inflation was quelled in the 1970s could increase the odds of a policy mistake.
• Long-duration Treasuries are signaling faith that the FOMC will curtail inflation even at the cost of a deep recession. This faith has led to a deep inversion of the yield curve. Credit spreads are expected to remain well behaved. This good behavior is mostly a function of the short business cycle, which has not been long enough to support the usual deterioration of credit standards.
• Increasing concerns about market liquidity are a risk to the Treasury market. The liquidity issues may signal that the size of the deficit is too large for the current auction distribution system. Either the system needs to be reformed or the deficit reduced.
• Strictly based on our modeling, our S&P 500 operating earnings forecast for 2023 is $179.61 with a year-end multiple of 17.1x. However, remaining excessive liquidity and the usual rise in the multiple during recessions increase the odds that the multiple will offset the expected decline in earnings. Depending on the depth of the recession, a decline in the market to 3520-3071 is possible, and as we note below, from there, a recovery to the 4100-4300 range is likely. Obviously, the key to equity market behavior is the timing of the recession and Fed behavior. We expect small caps to outperform, although this outperformance will likely be tempered by the recession. Value is expected to outperform Growth. Although U.S. markets may outperform in the first half of 2023, the relative outperformance of U.S. stocks will occur in the very late innings. We look for dollar weakness to develop over 2023, which will tend to be supportive for foreign stocks.
• Although we are bullish long-term on commodities, it is common, even in secular bull markets, for prices to decline during recessions. We expect to maintain modest positions in commodities, but as the dollar weakens next year, commodities should benefit. An economic recovery will support commodities as well. Again, the timing of the downturn is important.

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