2023: Uncertain future but with it comes good opportunities
Contributed by Sani Hamid, Wealth Management Director, Financial Alliance Pte Ltd (The contributor can be contacted at firstname.lastname@example.org)
After a torrid 2022, the first few weeks of 2023 have seen strong gains across the board for equity – and even bond – markets. This rally is widely welcomed although events so far have not changed our overall view on what could unfold in 2023 for equity markets in general.
Let’s start with a simple diagram which will help understand what we may see unfold in 2023.
This diagram tells us that the shocks felt in 2022 were associated mainly with the aggressive rate hikes to counter surging inflation and the adjustments in many asset classes that became over-valued from a decade of excessive liquidity brought on by quantitative easing.
In 2023, we see a different set of shocks surfacing, that is: those associated with a slowing economy and higher interest rates. As a consequence, we expect a slowdown in the global economy. As a result, higher defaults and tighter liquidity will follow, among other consequences. For equity markets, this will mean lower earnings growth, possibly a contraction.
But for now, we are at a point where risk is perceived to be the lowest, as those associated with 2022 wane and those expected to arise in 2023 have yet to fully materialize. In other words, we are at a transition point, a “Goldilocks” period, some would say.
Nevertheless, this will not last.
In our view, the risk remains for 2023 to be yet another potentially volatile year, albeit the good news is that the bottom for this present downturn is likely to be found somewhere in the second half of the year.
Our base case is where the S&P500, used as a proxy for general markets, is likely to resume its decline from its current 4100 level to around 3000-3400. We assign a 60% probability of this happening.
We call this the “normal recession” scenario. In fact, many big names on Wall Street, such as Morgan Stanley & BlackRock, expect the S&P500 to move down to somewhere between 3000 & 3500. But at the same time, these investment banks also expect the S&P500 to close the year significantly off their low, effectively mapping out a V-shaped path. For example, Morgan Stanley expects the S&P to end 2023 at 3900.
One interesting thing to note about this V-shaped recovery path is that it fits into a pattern that has appeared a fair bit in recent years: after an initial sharp decline in Year 1, the trough of the V-shape recovery is typically found in the second half of Year 2.
The basic argument driving this move will be that, in the first half of the year, a downside revision in earnings will not only put a cap on further upside gains on the S&P500, but also result in it adjusting towards valuations that better reflect the recession scenario. Underlying this is the fact that the situation facing the consumer is bleak: higher mortgage payments, higher credit card balances, higher prices (inflation), a gradual increase in job losses, declining home prices, etc.
And what “valuations” would be better reflections of this environment? Declines in both earnings (-5% to -10%) and an adjustment for lower P/E multiples (14-16x) suggest that valuation-wise this would lie around the 2800-3400 region.
One often-asked question is whether markets could even exceed their October 2022 lows? The answer to this is “possible”. We attributed our second highest probability (30%) to it, and we deem it the “crisis” scenario.
Under this scenario, the assumption is that “something breaks”, thus resulting in a financial crisis. Applying the magnitude of declines seen in the crises of 2000 & 2008, where the peak-to-trough declines were 50% & 58% respectively, this scenario would bring the S&P500 to approximately 2000-2400.
Valuation wise, within our EPS vs P/E Matrix, this would translate into a further move to the top left-hand corner of the Valuation Matrix.
This scenario would entail an adjustment in the V-shaped pattern we have presented earlier: instead of the trough being in 2023, it would now be in 2024 or even later. Such a scenario, while rare, has occurred a handful of times since the early 1900s (see diagram below from Twitter).
We know some are asking “Why can’t markets rally from here?”
The answer to that is, some may.
We have been discussing our views by based on the S&P500 as a proxy. But there could be different circumstances out there affecting different regions and asset classes that may see them head in the opposite direction (gains) in 2023.
Among those we favour are:
- Emerging Markets, in particular China, Korea, and even Taiwan.
- Commodities, both hard & soft, especially gold.
But for the S&P500 & other markets/asset classes that have strong correlations with it, we believe that the pre-requisite for markets to rally further from where they are today is for the Fed to back down from its stated “higher for longer” monetary stance, which in our view, is unlikely. With US financial conditions having eased in recent months, we are of the opinion the Fed will do whatever it can to ensure inflation not only eases but reaches the Fed’s target. This entails keeping interest rates “higher for longer” and possibly accelerating their Quantitative Tightening (QT) schedule.
Notably, there is a defined correlation between the overall liquidity situation* in the US and the stock market (*defined as QT plus some other adjustments, such as the flows from the Treasury General Account and Reverse Repos) as we can see from the charts provided by Fidelity & Steno Research.
What does this mean for investors?
For investors who are already in for the long-run or are looking to establish a position in the market, declines in the market should always be seen as opportunities. What’s important of course is to pick value. Often, for many, it is to get into the market in a way that is flexible given the abovementioned views of market direction.
That is why our general advice would be to slowly ease back into the market via dollar cost averaging (DCA) instead of chasing current markets and going in lump-sum. We would advocate a 24-month DCA period. While this DCA period may overshoot the V-shaped trough we are expecting in the second half of 2023, it allows us to weather the possibility that markets could slip into the Crisis scenario we mentioned. If that happens, investors may want to stick with the DCA period. In the 2000-2003 crisis, such a strategy worked out very well as it managed to average an all-in price of 985 vs actual bottom of 768.
This 24-month DCA had also worked well in the 2008 crisis, which was shorter than the 2000 crisis. During this period, the strategy yielded an average all-in price of 1004, compared against the actual bottom of 666.
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