Happy New Year from the Carlson Group!
What’s Top of Mind for 2023?
A review of last year’s market results and thoughts on what the New Year may bring.
The word “historic” has been used so frequently in recent years that it has begun to lose its meaning. Even so, “historic” is the best word we know to describe financial markets in 2022. The following chart tells the story.
Bonds declined. Stocks declined. But what qualifies as “historic” is the fact that both stocks and bonds fell so much at the same time. The losses incurred last year by a Balanced portfolio of stocks and Treasury notes are exceeded only by losses suffered during the Great Depression.
What caused such a historic decline?
By now you know the story. High inflation spurred the Fed to aggressively raise interest rates. Rarely has the Fed raised rates so far and so fast (chart below). The Fed essentially pulled the rug out from beneath the feet of investors.
Thankfully, the Fed will likely stop raising rates in 2023. Thus, the new question will be not how high rates will rise, but rather how long rates will stay high.
Now that 2022 is behind us, let’s take a fresh look at markets, including each of the major “buckets” in portfolios – Cash, Bonds, and Stocks.
Cash
If there’s a silver lining to the Federal Reserve’s rate hikes, it’s that “cash equivalent” investments now offer their highest yields in over a decade.
But there’s a catch: one must know where to look.
Most banks today still offer low interest rates on savings deposits. That’s because banks are flush with cash and have little need to raise rates to attract new deposits (chart).
There are better alternatives today, in our opinion, including Treasury bills, CD’s, and money market mutual funds. Each involves unique considerations. Feel free to give us a call to discuss.
Bonds
After historic losses in 2022, the outlook for the bond market has improved, in our opinion. Interest rates have reset higher and the yield-to-maturity on the Barclays Aggregate Bond index (a measure of the overall bond market) is now a respectable 4.9%.
Within the bond market, we see three areas of opportunity:
- Short-Term Taxable Bonds, including Corporates and U.S. Treasuries. Short-term rates are higher than long-term rates today (a consequence of Fed rate hikes). Thus, investors can earn more income on short-term bonds than long-term bonds while taking on less risk if interest rates continue to rise.
- Intermediate and Longer-Term Municipal Bonds. Unlike taxable bonds, short-term municipal yields are low but longer-term rates are higher (see chart below). If this chart looks strange, that’s because it is! Fed rate hikes have skewed the bond market, which creates opportunities for investors.
- High Yield Corporate Bond funds. Following a year of rising rates and recession worries, high yield corporate bonds appear reasonably attractive. The Bloomberg High Yield Corporate index yields close to 9%. Additionally, high inflation has reduced the “real” cost for corporations to make their debt payments. This makes high yield bond funds worth the extra risk, in our opinion.
Lastly, although your “bond bucket” lost money in 2022, we’d expect better results this year if the stock market continues to decline. Whereas last year’s stock market decline was due to high inflation (which was bad for bonds) a further decline in 2023 would likely be due to a potential recession (which could be good for bonds). Thus, we recommend sticking with bonds.
Equities
The stock market outlook for 2023 is uncertain – as short-term outlooks always are!
On one hand, the risks for 2023 are well-known: the Federal Reserve could tip the economy into recession and spark another leg down for stocks. On the other hand, market declines like we experienced in 2022 historically have been a good long-term buying opportunity. Which you choose to focus on will depend on (and also reveal) your time horizon as an investor.
Our instinct is to look beyond the short-term risks toward the long-term opportunities. Afterall, we own stocks for the long run. As highlighted in December’s Top of Mind, we think market valuations are broadly attractive today, which should set the stage for solid long-term returns.
All of that being said, here are two short-term dynamics to watch:
- A potential recession in the U.S. A recession is possible following 2022’s aggressive Fed rate hikes. However, there is reason to believe a recession would be mild. Large-scale layoffs seem unlikely during the present labor shortage. Additionally, households and businesses still have rainy day funds that were set aside during the pandemic that could cushion the blow of a downturn. If a recession is indeed mild, then the fallout for corporate earnings and the stock market could be mild, too. Additionally, a fair amount of bad economic news is likely already reflected in stock prices.
- A potential rebound in China. Although the world’s largest economy (the U.S.) may sputter toward a recession in 2023, the second largest economy (China) may sputter to life as the country finally lifts COVID restrictions. It is hard to predict how global stock markets will respond to these opposing forces. Nevertheless, a rebound in China is a potential positive surprise in 2023.
Bottom line: 2023 brings plenty of near-term uncertainty for the stock market. But we feel there are long-term opportunities for investors who are willing to look beyond the short-term risks.
This Too Shall Pass…
Investors make mistakes when they confuse a temporary situation with a permanent one.
When times are good, investors are tempted to throw caution to the wind. When times are bad, investors are tempted to despair. In both cases investors do well to remember: this too shall pass.
2022 brought plenty of surprises, including war, high inflation, and aggressive Fed rate hikes.
Was that painful? Absolutely.
Is it permanent? Not likely.
2023 is sure to bring more changes and surprises to the financial world. Our goal is to help you be on the right side of them.
On behalf of the Carlson Group, Best Wishes for a Happy, Healthy, and Prosperous 2023!
Sincerely,
Kurt, Cassidy, Ken, Teresa, and Brian