January 2023 Market Update: A Deep Dive into CNR’s Economic and Investment Outlook
Summary of January 25 Market Update Webinar
Weaker Economy & Mild Recession Anticipated for 2023
While further volatility and potential downside risks are expected to dominate the first half of 2023, historic perspective provides optimism for longer-term returns, according to the January 2023 market update presented by the leadership team of City National Rochdale.
Our view is that there is a 75% chance of a recession this year, which is higher than the Wall Street consensus, said Paul Single, managing director, senior economist and senior portfolio manager for City National Rochdale. However, the recession is anticipated to be mild, due to the strong labor market, strong corporate and consumer balance sheets, and a healthy banking system.
High Interest Rates, Inflation & Volatility to Continue in 2023
While there are encouraging signs of inflation moderating, these trends are likely happening too slowly for the U.S. Federal Reserve, Single said. Officials remain particularly concerned about service inflation in labor-intensive services.
The Fed is likely to keep interest rates higher for longer to push wages down to 2.5% to 3.5% growth, which would be consistent with the goal of inflation at 2%, Single said.
CNR’s Adjusted Outlook
CNR Speedometers®, our forward-looking indicators for the next six to nine months, are all yellow or red this month.
“A little over a year ago, these were all green, and things have changed quite a bit since then, including the changes in both monetary and fiscal policy," commented Single. “All of this just means the slowdown in the economy is expected to continue, not that there's anything broken in our economy or any enormous imbalances in the economy." The slowdown in the economy, particularly of the housing market in 2022, is broadening to include a slowdown in consumer spending and the manufacturing sector, Single said. The combination of the slowing economy and recession fears is causing companies in the manufacturing sector to adjust their workforce and reduce overtime. However, ongoing labor shortages are likely to keep overall job losses below average recessions.
The main takeaways for 2023 are that inflation is moderating, the rising risk of recession and the Fed is likely to continue increasing rates, although at a slower pace than in the past year, Single said.
This economic outlook informs CNR's investment strategy.
“We expect a more challenging first half of the year, followed by a better second half to get us to moderately positive equity returns for the full year," said David Shapiro, senior portfolio manager for City National Rochdale.
“As a result, we're maintaining a defensive position, underweight on stocks, emphasizing high quality companies under strong management to help us get through and come out better on the other side."
Until the economy bottoms, equities remain vulnerable, Shapiro said. High quality and income-producing U.S. stocks appear most resilient to earnings and geopolitical headwinds, and Rochdale continues to avoid international equity exposure.
How Long Will the Bear Market Continue?
While we believe the U.S. bear market is nearing an end, there are many critical issues to watch that are likely to have an impact on the market's direction, including the path of inflation, Fed tightening and the ongoing risk of exogenous shocks. However, what concerns CNR most is that consensus earnings estimates continue to be too high.
Last quarter's earnings expectations have already been revised significantly lower, from a consensus estimate of positive 3.5% as recently as September 2022, to an estimated decrease of 4.6% in January 2023. The fourth quarter of 2022 is now projected to show the first negative earnings growth since the third quarter of 2020, Shapiro said. Margins due to rising costs are the prime driver of lower-than-expected earnings.
Despite this, investors still seem to be counting on a soft landing with overall 2023 earnings growth expectations at a relatively healthy 4%. CNR's outlook calls for 2.5% earnings decline on a weighted average basis, but in a scenario where the economy enters even a mild recession, they think earnings growth could potentially decline even further, up to 10%.
“We don't see a recession priced into values, so we expect more volatility to come," Shapiro said.
Will the U.S. Debt Ceiling Cause Volatility?
Another source of potential volatility that is anticipated to dominate news cycles for much of the early part of this year is the debt ceiling. While most market experts believe that the debt ceiling limit jeopardizes the economy, it is used by politicians on both sides as a powerful tool for government spending and policies, Single said.
Creating a Defensive Position During Market Volatility
Our strategy has been to de-risk equity exposure and take a defensive position. Equity income in durable and resilient companies has lower volatility and should outperform the market, Shapiro said. Dividend income averaged 6% in 2022 and is anticipated to maintain growth in the mid-single digits in 2023, according to our analysis.
While Fed policies around interest rates have received the most attention in the past year, the Fed's policy of reducing its balance sheet continues to have an impact on the economy, said Charles Luke, Rochdale's director of fixed income.
The Fed isn't selling Treasuries or mortgages, but it is allowing them to mature, which effectively shrinks its balance sheet. Interest rates and the mortgage market are closely tied to the Fed's balance sheet, which can add to more volatility, which is why active portfolio management is essential, Luke said.
During the third quarter of 2022, we suggested that investors might want to look into taking on more bond exposure, which Luke said continues to be good advice. Higher yields allow for a more diversified fixed-income allocation.
Will Defaults Increase Significantly in 2023?
While a deep cycle of defaults is not anticipated, they may approach historical averages in 2023. However, extreme low interest rates in 2020 allowed many companies to refinance their debt or take out debt inexpensively. That means the maturity wall is farther out than usual, Luke said. There's a window of about 18 months before most debt matures, which gives corporations breathing room even in the face of a mild recession.
While there's plenty of money in the economy and in private equity, companies will find higher rates and fewer private equity firms willing to lend in 2023, Luke said. Funding levels are half of last year's volume and funds remain significantly below target raises, according to research by City National Rochdale.
Potential for Returns in 2023
While it was a challenging year for most investors, one of the biggest surprises in 2022 was that bonds fell 13%, nearly double the next biggest decline on record. Historically, when fixed income declined by more than 5%, the average return 12 months later was 8%, which supports a shift to bonds for conservative positioning before a slowdown, Luke said.
While equity markets may continue to be vulnerable in the near term as economic growth slows, fixed income yields are at the most attractive levels in over 10 years. If we get any stabilization or rates drop based on the anticipation of slowing growth, returns will be positive, which supports CNR's current overweight position.
Overall, CNR sees a much more positive year for investors with balanced portfolios. “When GDP hits its low point, which we expect it to hit this year, on average after that we see limited downside," Luke said. “After about 12 months, we begin to see positive returns in a 60/40 portfolio."