Mid-year 2023 market outlook for financial advisors

As memories of summer holidays fade, investors’ focus now shifts to the outlook for the final months of 2023.

During the first three quarters of this year, global equity markets benefitted from falling inflation and diminishing recession fears. Investors also shrugged off three consecutive quarterly reports of falling corporate profits, anticipating better earnings. The most disruptive forms of geopolitical risk failed to materialize, reinforcing the supportive backdrop.

But can the good times continue? By and large, we think so. But investors are also in a race against time. We believe there are three key things to focus on over the balance of 2023 – the lagged impact of rising interest rates, the expected path of inflation and interest rates and optimizing the balance between fixed income and equities in asset allocations. 

Debt has been a tailwind

By virtue of structural changes in corporate finance, the corporate sector has thus far been sheltered from the harshest impacts of an aggressive series of Fed rate hikes since early 2022. 

Mostly, that is because companies have increased the maturity of their debt and have converted more of their borrowing into fixed-rate obligations. Accordingly, despite the sharp rise in interest rates over the past two years, company debt servicing costs have not yet risen as much.

Most listed companies have also taken advantage of an inverted yield curve, with short-term rates above long-term rates. Companies with high cash balances (based on resilient earnings and prudent capital spending) enjoy higher interest revenues by parking their money in short-dated notes but with low-interest costs, having locked in lower rates via longer-term borrowing. The corporate sector is, in sum, playing an inverted yield curve to its benefit.

The fact that profits have been shielded from the impacts of monetary tightening helps explain continued company interest in hiring. It also points to a positive feedback loop between profits, employment and demand that, while not sustainable forever, has helped to support US economic growth.

The result is a more resilient corporate sector that is better able to manage through tightening cycles.  This resilience of earnings and growth has another key implication for investors—namely, reduced default risk. Credit risk is more nuanced. Individual defaults remain possible, and some will be unavoidable. But barring a freezing up of lending markets, we believe overall corporate default rates will likely be lower in this cycle than in prior ones.

Interest rates must fall soon

Still, this happy state of affairs cannot continue indefinitely. New borrowers and those needing to roll over existing debt will face the harsh reality of higher interest rates. In that sense, hopes for ‘soft landings’ for the economy and corporate profits require that interest rates come down, preferably sooner rather than later.

The good news is that most measures of inflation—goods prices, shelter costs and wages—have peaked and are declining. Falling inflation means that additional aggressive rate hikes are unlikely. But if higher interest expense and recession are to be avoided, welcome declines in inflation must soon be followed by falling interest rates. Otherwise, an eventual increase in interest expense will eat into consumer spending and corporate profits, potentially putting the expansion at risk of a corrosive rise in debt servicing.

For now, the resilience of the US economy is unlikely to be tested. We believe rising interest expenses will exert an inexorable but gradual economic impact – this is not about a ‘cliff event.’ But it is nevertheless true that the longer borrowing costs along the yield curve remain elevated, the greater the probability of a harder landing and a renewed profits recession. 

Investment opportunities remain abundant\

We anticipate that the incoming data on growth, inflation and corporate profits will remain largely benign, allowing equity and corporate bond markets to advance, albeit moderately, given that much good news is already discounted.

Attractive yields across various maturities and credit instruments offer the most compelling income opportunities in 15 years. And, as disinflation continues, downside risks for higher grade issuers (e.g., governments and investment grade corporate borrowers) will be contained. The risk/reward ratio, in other words, favors extending duration, even into high-quality corporate bonds. A likely slowing of economic activity and further declines in inflation should boost bond prices (and lower bond yields), offering investors the extra opportunity for price appreciation in addition to income. Moreover, with inflation moving below nominal yields, real returns have also become attractive.

Peaking market rates of interest also typically bode well for longer-duration equities.  Even after the 2023 mini boom in artificial intelligence investing, growth stocks and defensive companies with more stable sources of earnings (i.e., those cushioned from slowing economic activity) are likely to outperform more cyclical sectors and styles.

Finally, perhaps most importantly, the outlook is favorable for balanced portfolios. The big reason is falling inflation risk, which typically produces positive returns in bonds and stocks. But even if stocks falter on fears that earnings may disappoint as the economy slows, we believe high-quality fixed-income components should provide offsetting positive returns, boosting the overall stability of balanced portfolios. The outlook over the coming months should offer greater reassurance for investors nursing their 2022 wounds of joint stock and bond bear markets.

In sum, summer's end brings new realities, but the investment outlook remains encouraging. While investors may be tempted to “fade” the recent positive returns in 2023, fundamentals and valuations point towards favorable risk/reward dynamics.     

All investments involve risk, including loss of principal.

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