Caution Ahead

If you think of the nation’s economy as a road and various performance indicators as a traffic signal, we enter 2023 staring at a yellow caution light. It’s not red—yet. But it could get there.

So say economists and wealth advisers whose collective wisdom in a New Year suggests that, in a business and investment climate battered in 2022 by higher interest rates, inflation, and a ridiculously tight labor market, the worst may be already behind us. That doesn’t mean we should expect a light-speed lift-off from borderline recessionary GDP levels; it does mean fears of another Great Depression—or even a repeat of the Great Recession—just might be unfounded.

“Our cautionary tone is centered on market volatility, the day-to-day grinding of  the capital markets,” says Bill Greiner, chief economist for Mariner Wealth Advisers. “My outlook for the U.S. economy, for both inflation and economic growth, GDP, has become more guarded—that’s a good way to frame it over the past half year, compared to summer.”

Six months ago, he said, his team was projecting a 35 percent probability of a recession descending on the nation within the next year; that’s up now to 55 percent. But it’s still nowhere near 100 percent. “I consider a light version of a recession to unfold, as compared to ’08-’09, which was a heavy balance-sheet-oriented recession,” Greiner said. “This is more an income-statement recession similar to 1990 and periods where the economy was in recess and left in eight or nine months, where markets didn’t correct by 40-50 percent like in ’08, but, top to bottom, more like 20-30 percent.”

Interest rates are at 10-year highs as the Fed attempts to strangle an inflationary beast more robust than any in 40 years. But there’s a consensus that, while the Fed sees more work to do on that front, the incremental changes won’t be as jarring as the 75-basis point hikes we saw in 2022. 

“We believe short-term interest rates will trend higher through mid-year with the Fed Funds rate likely peaking between 5 percent to 5.5 percent at midyear,” says Commerce Trust’s Scott Colbert. “Longer-term interest rates will also rise, gradually pulled higher by shorter-term rates, but peak much earlier in the year as the economy slows, inflation cools, and the probability of a recession increases.”

Longer-term rates will likely drift higher from where they are today, Colbert believes, but “we think we’ve already seen the absolute near-term peaks in longer-term Treasury rates last October when the 10-year Treasury rate closed at 4.25 percent and the 30-year Treasury rate at 4.40 percent.”

Stepp & Rothwell’s Ken Eaton doesn’t disagree. Even if the Fed does keep short-term interest rates higher for longer, he says, “the bond market is already putting pressure on longer-term rates because it has a pretty good idea of the rate that will bring the economy into equilibrium. Therefore, unless the Fed does something unexpected to impact long-term rates, like dump its inventory of mortgage-backed securities back into the market, we expect longer-term interest rates to stay stable or even fall from here.”

One big early driver of inflation in 2022 was the price of oil, which had taken a sharp upward turn in 2021 and was up 76 percent even before Russia invaded Ukraine in February. That drove another 60 percent pop in oil prices, peaking north of $126 a barrel. But projections of astronomic oil prices—$150 a barrel? $200? More?—were well off the mark, and in the first weeks of 2023, they stand about where they were a year ago.

That’s taken some of the bite out of inflation, but higher wages, considerable cash on hand for the nation’s wealthiest quartile, continuing strong demand, and lingering supply-chain issues will continue to pressure prices. The result? 

“In 2023, the Federal Reserve will continue to battle inflation and hike rates, reaching its terminal rate in the first half of the year, while inflation slowly dissipates,” said KC Mathews, chief economist for UMB Bank. “This will cause economic activity to slow, perhaps to a recession-like pace, causing financial markets to be choppy, yet producing positive returns.”

In short, he says, “We think the economic landing will be bumpy, experiencing a short-lived, mild recession … prepare for landing.”

Chris Kuehl, chief economist for Armada Corporate Intelligence, also points to rising wages and low unemployment as factors complicating the Fed’s task. Still another: the lingering pandemic.

“The potential wrinkle is China,” Kuehl says. “If they return to normal levels of production, there will be renewed congestion issues and higher transportation costs. On the other hand, the COVID outbreak could force another retreat, and the supply chain break will still be a factor.”

For investors, Greiner says, “services—companies that provide services, not goods, are well poisoned in general” for growth this year. “Consumers’ desire to spend on services seems to be pretty robust. … Companies reliant on export activity should do fairly well because the value of the dollar will be lower than right now, and that will make their goods and services more competitive than they are today.”

The flip side of that is anything touching housing—construction, remodeling, furnishings, and the like. But interest rates will have to stabilize, Greiner said, before the housing sector will see some traction. 

At Commerce, said Colbert, “we remain somewhat defensive on the stock market in general, favoring U.S. assets over international, and overlaying most of our stock-picking strategies with a focus on those stocks that have shown to have lower historic price volatiles, are somewhat defensive in nature and are generally of higher credit quality. We will likely remain somewhat defensive as we expect a U.S. recession will materialize in the back half of the year. 

Investors might find hope in his assessment that, if a recession takes hold, “this could provide better opportunities to buy stocks in general.” And on the bond front, he believes investment-grade bonds will outpace lower-credited securities in 2023. 

While Stepp & Rothwell doesn’t make sector bets or predictions, Eaton said, “we do think that higher-quality companies that have stable cash flows and are not dependent upon leverage through debt are more likely to do well until short-term interest rates moderate.”

Markets are forward-looking indicators, he noted, “so, as the probability that the Fed will start to ease increases, the stock prices of growth-oriented companies will likely benefit. As always, given that no one can predict the future, we believe that diversification is the key to long-term success, and we encourage our clients to continue to follow their long-term strategy regardless of the current economic circumstances.”