Question:  

What are your thoughts on the economy for the year ahead?

Answer: 

As the calendar turns to 2023, financial markets will be influenced by how soon inflation responds to central bank policy around the world. The expectation is for inflation to slow over the next year. We’re already seeing inflation on core goods moving lower (supply is closer to meeting demand).

The tight labor market (more available jobs with less supply of workers) is pushing wage growth and contributes to higher inflation for core services. Leading economic indicators suggest this phenomenon should improve over the next year, which may allow the Fed to back off from rate hikes; but could also bring economic weakness as the focus shifts from inflation to slowed growth.

These undercurrents suggest a mild recession in 2023. Rate hikes take time to accomplish the desired effect of slowing the economy. The housing market is one area already showing the influence of Fed actions with mortgage applications at 25-year lows due to higher interest rates.

Bank lending is becoming tighter, CEO confidence is low, economic leading indicators are negative, and layoffs/hiring freezes are being announced. While recessions are painful, this one should be mild for several reasons. On the upside, there isn’t widespread excess on either corporate or consumer balance sheets, banks are well-capitalized, and supply is adjusting to meet demand this cycle.

More good news is that the prices of core goods are showing signs of gradually moving lower and supply is beginning to equal demand following the pandemic. This should lead to slowed price appreciation. However, it will take time for inflation to moderate as seen by the differences between spending on goods and services within the Personal Consumption Expenditures (PCE) Index.  

Wage inflation from the core services (hospitality, travel, finance, medical, and retail) sectors keeps the labor market tight. The demand vs. supply imbalance in the job market shows an estimated 1.7 job openings for every unemployed person. This puts upward pressure on wage growth (to attract and retain employees), which in turn causes companies to raise prices to maintain profitability. This dynamic will work itself out over time with wage strain moderating, allowing the Fed to back off. But this will take time and likely cause some degree of economic weakness.

Since it appears that Federal Reserve Chairman Jerome Powell is more concerned about not tightening enough rather than overtightening, a recession is likely over the medium-term. In times of increased volatility, higher-quality investments with strong fundamentals that are less sensitive to end-demand are typically favored. 

Coping with challenges ahead

Looking ahead, companies will face some challenges. Balance sheets and profits will likely continue to feel the squeeze from higher labor, financing, and input costs. Wage increase cost concerns are likely influencing layoff announcements from various technology companies. 

While companies are still benefiting from interest costs that have hovered near generational lows for more than a decade and have front loaded borrowing, rising rates will certainly impact consumers and corporate borrowing plans in the future. Though we’ve seen improvements in supply chain issues, inflation will most likely stay higher, even if it stabilizes or retreats, and for longer than consumers or markets are accustomed to having this unwelcome draw on their cash flow. This will continue to impact global growth. Expectations remain for a potentially challenging market environment over the near to medium term. 

Going into the New Year there are compelling arguments for markets to be up, down, and sideways. We’re here to monitor transition points for inflation, corporate earnings, signs of growth, and a more balanced labor market; all factors that influence stock performance and the path we’ll take into 2023. Financial markets and stock prices tend to discount the future meaning that some of the negative news is already priced into markets, yet volatility is expected to continue into the new year. 

The bottoming process and recovery will take time. That’s why it’s important to maintain balance in portfolios, manage risk and keep an eye open for longer-term opportunities. A financial plan absent of emotion may help manage risk. Stay focused and plan accordingly.