The markets are starting to feel like Groundhog Day. Almost every month, it's a cadence of employment numbers, CPI, Fed, -- market reacts.
With inflation starting to trend down, even if only slightly, optimism has been making a comeback. That means moving our analogy to another charming rodent. It seems like the Fed is playing whack-a-mole with coordinated statements designed to tamp down expectations for a rate cut anytime soon. The Fed wants to keep asset prices lower to aid in slowing the economy and help it get inflation under control.
Looming over all this is the threat of recession as 2022's rate hikes are felt in the economy. The potential for more hikes – even smaller ones – may be necessary to keep inflation trending down but may also preclude a soft landing.
What is the likely impact on the market? Will we see a recovery in asset prices in 2023? Or will we be mired in a recession? The old saying is that as January goes with markets, so goes the year. But since nothing else has gone according to plan, it is worth it to take a look at the bigger picture.
Clarity Is the Watchword
Volatility in 2022 was largely caused by the policy uncertainty engendered by the Fed. The Fed started out the year with a minimal hike and a plan to telegraph small, incremental increases – the so-called “Fed ratchet” that would allow markets to adjust as rates rose. The invasion of Ukraine, ongoing supply chain disruptions, and a fiercely hot labor market kept upward pressure on inflation, and the Fed was forced to move far higher and much more quickly.
The markets hit bear territory and then bounced around from month to month as economic data, rate increases, and statements from the Fed made headlines.
Fed policy is becoming clearer as a terminal rate comes into sight, which should benefit asset prices. Markets tend to rally as investors have more clarity on the future.
Is a Recession an Endpoint or Bump in the Road to Recovery?
The likelihood of a recession is high, but not a deep one. The economy will likely need to process the 450 basis points of rate hikes we saw in 2022, which means slower growth and higher unemployment. The ongoing strength of the labor market means that even if wage pressure abates and wages continue to come down, the sheer numbers of those with jobs will keep things ticking over enough to compensate for a period of slower growth and push through to a continued recovery.
The National Bureau of Economic Research (NBER) reports that since World War II, the average recession has lasted for ten months. The COVID recession is the shortest, at a mere two months. What will the 2023 recession clock in at? A shallow recession that is over and done during 2023 is certainly possible.
The Fed continues to reiterate its focus on reducing inflation and is indicating it will not cut rates. However, circumstances change situations. The reality of recession may indeed be enough the Fed to put more trust in a rapidly declining inflation trend and offer up a rate cut.
How Should Investors React?
For investors, attempting to track the Fed tightly or radically shift a portfolio to accommodate an early rally, a potential recession, and then a sustained recovery seems like a bit of a timing challenge. Consider a key stat: Almost 80% of the best days of the S&P 500 Index happened during a bear market or the first two months of a bull market.1
Missing even a few of the best days in the market can cut into return, and with asset values already down, it's important to participate in as much of the recovery as possible.
The Bottom Line
After a volatile 2022, investors are understandably concerned about the direction of markets and the economy. There's clearly more to come in 2023, but clarity will return with inflation falling rapidly and the Fed nearing the end of the rate increase regime. With it, a calmer environment may usher in a sustained recovery. Investing for the long term, and staying the course, are even more meaningful when asset prices have a bit of a hill to climb to get back to where they were. But markets do revert to the mean and increase over time.
- Sources: Ned Davis Research, Morningstar, and Hartford Funds, 2/22.