2023 Outlook: A Deep Dive into CNR’s Economic and Investment Outlook
Summary of December 15 Market Update Webinar
Evaluating Recession Risks During a Bear Market & Inflation
For most of 2022, City National Rochdale had predicted that economic volatility would remain higher for longer periods of time. While maintaining our "higher for longer" thesis during our December market update, there was also a note of optimism for 2023.
CNR still anticipates lower GDP, lower earnings and a lower S&P 500 fair value compared to some other forecasts. We also have higher-than-consensus expectations for inflation, interest rates and volatility, said Garrett R. D'Alessandro, CNR CEO.
However, D'Alessandro also anticipates that 2023 will be a “tale of two years," with the first half likely to see a mild recession and continued market volatility, and the second half seeing return to positive territory for both equity and fixed income investments.
Looking Back at the 2022 Economic Picture
Reviewing 2022, D'Alessandro explained that this was one of the most challenging markets experienced in years, with the traditional 60/40 balanced portfolio seeing its worst returns in half a century.
The CNR team was able to predict several important trends in 2022, such as anticipating the equity correction, and we de-risked portfolios by selling non-U.S. equities and focusing on quality U.S. stocks.
In addition, CNR avoided investing in speculative tech and cryptocurrency but included other alternative investments. We didn't anticipate the pace of inflation and interest rate increases, but neither did other analysts across the financial industry.
Also unexpected were the aggressive actions taken by Russian President Vladimir Putin and the magnitude of negative fixed income returns.
What's Ahead for the 2023 Economy?
CNR Speedometers®, our forward-looking indicators for the next six to nine months, are all yellow or red this month. However, our team provided reassurance that these outlooks aren't as negative as they first appear.
“There's no green on this page of Speedometers because of uncertainty about monetary policy, uncertainty about consumers, uncertainty about interest rates and uncertainty about corporate profits," said D'Alessandro. “They're not necessarily overwhelmingly negative, the yellow indicators just tell you we're uncertain."
He also pointed to an encouraging note: The Speedometers inflation dial has moved from red to yellow, reflecting CNR's belief that inflation has peaked. While still elevated, the inflationary trend over the next year will likely be lower, he said, making it less of a headwind to economic growth.
The CNR team anticipates GDP to pivot around zero for 2023 but believes the strong fundamentals in household and business balance sheets will help the economy weather what they anticipate to be a 60% chance of a mild recession.
Global Economic Outlook
The U.S. currently has the strongest economy in the world, which is one reason CNR has pulled all allocations from Europe. CNR's concern is that Europe will continue to experience high inflation, high unemployment and high energy costs. China's increasing state control, property bubble and difficulties with COVID-19 policies contribute to the concern about investing there.
The Fed's Battle With Inflation Continues
While inflation has shown signs of cooling recently, a prime contributor that has concerned the U.S. Federal Reserve is wage growth.
“The Fed has been very transparent that they want wages to come down to a range that's consistent with their inflation target of 2%," said Paul Single, CNR managing director, senior economist and senior portfolio manager. “If the labor market doesn't soften, the Fed will keep rates higher for longer."
Inflation pressures are expected to moderate in 2023, especially with food inflation coming down. Higher prices and higher financing costs are likely to slow consumer spending, too.
“Our view is that inflation is heading in the right direction, but it will take time to come down enough," said Single.
Investment Opportunities Exist Amidst Volatility
Investors have found some opportunities over the past year that should extend into 2023. Yields have been substantially higher on some fixed income assets. Investors can take advantage of higher short-term rates on investment grade bonds that have been close to 5% for a year and provide income with less risk, said Charles Luke, managing director and co-director of fixed income for City National Rochdale.
Owning high yield bonds is still beneficial over time, too, Luke said. CNR's team has also found success investing in alternative assets for more yield, such as direct lending, rail car leasing and reinsurance contracts, all of which are typically more stable than some other investments.
“What we're illustrating here is that opportunities for investors in bond markets have significantly improved through the year," said Luke. “With these elevated returns, we do expect bond returns to increase over the next three to five years."
Specific asset allocation decisions will depend on whether the U.S. economy is in a slow growth period or a mild recession. But over the long term, high-yield bonds are more appealing, Luke said. In a mild recession, short-term bonds and two-year Treasury notes are options to consider.
Research from Bloomberg and City National Rochdale show that fixed income investments can offset volatility and generally move higher as economic growth bottoms out. Fixed income yields will generally outperform the 10-year average if interest rates are more stable.
Investment Risks in 2023
While equity valuations have adjusted, consensus earnings estimates still are not reflecting a more challenging economic outlook and negative revisions to forecasts could be a source of further downside in the near term.
Among the other critical issues CNR is watching, that could have a negative impact on equity markets in 2023, is the possibility that interest rates go even higher and the potential for further exogenous shocks.
“We believe our core equity strategy is well-positioned for a mild recession and we've proactively lowered our exposure to companies and industries that are most at risk," said Tom Galvin, chief investment officer for City National Rochdale. “Conversely, we've increased our exposure to companies and industries that are more steady growers."
Mild Recession Likely in 2023
Among three likely 2023 scenarios - slow growth, a mild recession, or a normal recession - CNR believes a mild recession is the most likely. The leadership team is particularly watching labor and wages as an indicator for the economy in 2023, along with geopolitical risks.
“For the Fed to succeed in its battle against inflation, we need to see a sustainable decline in wage growth to about 2.5% to 3.5% wage growth," said Galvin. “If this proves challenging, the tightening process may have to be sustained and go higher."
While history and research provide optimism about future returns, investors should expect volatility and perhaps further downside risk in the near term.
“Rest assured, if a severe recession risk goes up, as fiduciaries with a prudent responsibility to manage your capital, capital preservation is still as important as capital appreciation and we have a plan," said Galvin.