The 2023 Recovery We Anticipate

What next? After last year’s parallel stock bear market and bond rout, that question is on many investors’ minds. In the very short term, anything is possible—near-term volatility is unpredictable. But we think stocks and bonds are primed to rebound this year as uncertainty fades and last year’s fears prove to have overshot the emerging reality. How so? Read on.

Bear markets are always painful to endure, and 2022 was no exception. But late in bear markets, patience is usually rewarded, as recoveries begin with typically sharp jumps. We believe that likely occurs this year, if it didn’t begin with the global rally dating to October 12. Since then, the MSCI World Index is up 15.0%, even with December’s back-and-forth and the last few days’ slide.^[i] Maybe that was the V’s start. Or maybe more downside lurks, from a new fear or investors’ working out some last spurt of angst. Debt ceiling chatter is certainly trying to hit sentiment hard now. So are economic fears. Yet even if there is a recession, as many expect, it isn’t likely to sway stocks materially. Markets—and CEOs—largely expect a downturn, based on available surveys and data. Stocks ordinarily bottom before growth returns. In all cases, while the timing is impossible to pinpoint, we think the conditions are ripe for a new bull market to get cooking in 2023. Stocks’ three main drivers—politics, economics and sentiment—point positively.

Politically, the presidential cycle’s third year supports better-than-average returns. Now, as always, MarketMinder is nonpartisan, favoring no party nor any politician, with our analysis assessing political developments’ potential market effects only. So what matters isn’t the partisan particulars but the fact that midterms brought a split Congress, ensuring gridlock for the next two years. This ushers in what we call the Midterm Miracle for stocks. Midterms often deepen gridlock, reducing the risk government enacts anything radical to upset markets. The typical backdrop reigns now.

The nine months starting in midterm years’ fourth quarters are US stocks’ most positive stretch since good data begin in 1925—and the effect ripples globally. Last quarter was no exception, with the S&P 500 up 6.6%, in line with midterm Q4s’ average, while world stocks rose 9.8%.^[ii] We aren’t saying that is all midterms. But we suspect they contributed. In full, year three US stock returns typically follow through with the electoral cycle’s highest average return of 18.4%.^[iii] It also has the highest frequency of positive returns at 91.7%.^[iv] Except for 1931 (Great Depression) and 1939 (WWII’s onset), no third year has been negative from when reliable records start. Absent a world-shaking wallop no one foresees, the Midterm Miracle likely helps kickstart a new bull market sooner rather than later this year, in our view—again, if it didn’t start in October.

Another big reason: The economy likely exceeds expectations. Most everyone thinks recession is imminent. From business leader and company surveys to economist and consumer polls, there is widespread agreement contraction is here or soon to come. Three-quarters of Americans thought recession was occurring last fall.^[v] According to The Conference Board’s poll, 98% of CEOs see US recession in 2023.^[vi] The investment community has been near-universally on Recession Watch for months, after Q1 and Q2 2022 GDP both inched lower—a watch that intensified later despite Q3’s 3.2% annualized GDP rebound.^[vii] So if it happens, it wouldn’t shock.

But also, CEOs expecting recession prepare for it, blunting the impact and likely making it milder than most anticipate. As Fisher Investments founder and Executive Chairman Ken Fisher likes to say, “anticipation is mitigation.” Any contraction would likely be short-lived because wringing out past excesses drives recessions—and firms have largely done that already. Perhaps there is more to come, but the measures taken in advance suggest they would be mild and expected. Then, if there isn’t a recession, that would positively surprise.

Separately, overall and on average, households remain flush with cash. One timely way to see this: Despite fears to the contrary, the S&P/Experian Consumer Credit Default Index—which tallies default rates across autos, credit cards and first and second mortgages—was at 0.63 in December.^[viii] That is up from lows seen in 2021, but noticeably below any level seen from when data start in May 2004 through May 2020.

Many economists and pundits also misread supposed recession signs, like the inverted yield curve, raising the likelihood of a better-than-feared outcome. With overnight fed-funds and 3-month rates well above 10-year Treasury yields, many fear inversion screams recession. But most rest these claims on mere correlation without exploring causation. The yield curve normally matters because banks borrow short term to lend long, making short rates a proxy for funding costs and long rates a proxy for loan revenue. Inversion normally stresses loan profitability. But today, a flood of bank deposits provides banks ample funding at rates well below fed-funds. With long rates rising in 2022, lending is likely increasingly profitable. Bank lending has surged as a result. Yet few if any acknowledge this strong counterpoint.

The fixation on negatives to the exclusion of nearly everything else is a hallmark of what Ken calls the “pessimism of disbelief,” which we find runs rampant as bear markets end. For example, reflecting escalating recession fears last June, the University of Michigan’s Consumer Sentiment Index hit a record low from the series’ 1952 inception and has been pinned near there since. Besides consumer confidence, business and investment sentiment indicators across the world have plumbed new depths. But look at it from a market perspective. As legendary investor Sir John Templeton astutely observed: “Bull markets are born on pessimism.” When pessimism becomes excessive, overshooting reality far to the downside, and people widely ignore or dismiss signs of improvement, conditions for a bull market recovery’s initial V-shaped rebound are ripe.

All the negative sentiment has many overlooking a key point: Many of last year’s fears should fade. Take a major one: inflation. Input prices fell sharply in 2022’s second half, and they are now showing in inflation rates. The US consumer price index (CPI) peaked at 9.1% y/y last June (coincident with consumer gloom), but by December, it decelerated to 6.5%.^[ix] Meanwhile, core CPI excluding food and energy, which some think better represents inflation’s underlying trend, hit a high of 6.6% y/y in September and retreated to 5.7% in December. That should continue. And, since inflation expectations influence long rates, 10-year Treasury yields have followed suit, falling from October’s 4.2% peak to sit at 3.4% now.^[x] Since bond prices and yields move inversely, that should provide some relief to bond markets, too. Notably, credit spreads tracking corporations’ perceived financial health are narrowing as rates subside.

So our outlook for 2023 is bright—partly because many others view it dimly and can’t see the improving backdrop around them. We see a wide gap between reality and expectations today—ample fuel for upside surprise to drive a new bull market this year.