In anticipation of our 10 for ’24, we look back and grade our forecasts from last year. 2023 saw surprising economic growth, in defiance of our expectations for a late-year recession. Our best call? Persistent inflation and the trajectory of Fed policy that left investors challenged with high volatility and a third year of disappointing traditional fixed income returns.
1. Inflation
While the worst inflation may be in the rearview mirror, a lot must go right to return inflation to the persistently low 2% inflation environment that prevailed for 20 years and came to an explosive end in 2020. We expect inflation to drop in an uneven, choppy trajectory to 3.5% year over year (y/y) by the end of 2023. An improvement, but for the Fed, still uncomfortably above the 2% target.
Score
A
Our inflation call was on point. While prices fell significantly from their July 2022 peak of 9.1% to 3.2% by October, the descent has been choppy, and we are far from a persistent 2%. Energy prices were a primary disinflationary force through the first half of the year but reversed course by Q3. Core inflation, which excludes food and energy, has decelerated slowly and was still up 4.0% y/y in October. Certain price pressures proved resilient through the year, including nondurables and shelter. Owners’ equivalent rent (OER) has been sticky, peaking at over 8.1% y/y and still up 6.8% y/y as of October.
Score
A
Our inflation call hit the mark: 2022 was a painful reminder of why everyone hates inflation. It eats into savings, wages and investment returns, all of which were eroded by inflation which peaked at 9.1% year over year in June, the highest since 1982. The topography of inflation shifted throughout the year, with prices for goods inflation easing in the second half of the year, as supply chain pressures subsided. Services inflation, however, accelerated into the end of the year as rents—a “sticky” kind of inflation—jumped to 6.9% y/y.
2. Recession risks loom large over markets
We expect the overarching uncertainty regarding recession to keep volatility high in 2023 and see a high probability of recession in the second half of the year.
Score
F
When we are wrong, we own it! While we were correct in our prediction that recession uncertainty would drive market volatility through the year, our recession call missed the mark. Not only did the economy grow, powered by a resilient consumer and government spending, but growth accelerated in the second half of the year and surged 4.9% quarter over quarter (q/q) in Q3. Despite strong spending activity, consumer sentiment has been gloomy—the University of Michigan Consumer Sentiment Index hovered in the doldrums below 70 since July versus an average of 97.0 in the three years leading up to the pandemic.
Score
A
Consumer spending provided positive momentum for growth in 2022, as expected. In the first half, household consumption rose 1.3% and 2.0% q/q in Q1 and Q2, even as real GDP contracted –1.6% and –0.6%, respectively. Going into the end of the year, consumer resilience remains striking, fueled by all the factors we listed. The University of Michigan Consumer Sentiment survey plumbed fresh lows in 2022, reinforcing that inflation remains a thorn in the side of household budgets.
3. Cyclical headwinds but structural tailwinds
Despite cyclical headwinds—including rising rates, falling housing affordability and constrained production—there are structural tailwinds, unique in varying sectors, which could continue to fuel demand and mean a recession is relatively mild.
Score
B+
This battle played out in both housing and autos largely as we expected. Many called for a sharp correction in housing prices, but despite high mortgage rates (which topped 8% in October), housing prices fell -1% from their prior June 2022 peak and have resumed their upward climb fresh highs. Supply remains suppressed by existing homeowners being locked in by low-rate mortgages, while demand is sustained by demographics and labor market strength. Structural tailwinds proved slightly stronger than we expected, which meant the economy was able to avoid a recession, even the mild one we called for.
Score
A
We were spot on here, as the economy added 4.1 million jobs in the first 10 months of 2022, and the unemployment rate hit 3.5%, matching the pre-COVID low. Wages as measured by the Atlanta Fed wage tracker have surged as high as 6.7% y/y, a big gain that still lagged inflation. While wages are off the high as the year winds down, they remain far above the Fed’s comfort level, and remain a problem for corporations as they try to manage costs as growth remains lackluster.
4. Strong labor market is on borrowed time
The labor market—a coincident indicator of recession—remains strong for now, but given our call for a mild recession in the second half of the year, we could see the unemployment rate rise to mid-5%, and 1.0 to 1.5 million jobs lost, a tough economic outcome.
Score
C
We underestimated the stamina of the U.S. jobs market coming into 2023, which by virtually all metrics, remained strong throughout the year. While initial jobless claims—our favorite indicator of labor market conditions—briefly jumped above 250,000 for several weeks in June—a threshold we had highlighted as one that could lead to a more significant increase in layoffs—it proved a head fake and claims trended sharply lower through October. The unemployment rate hovered around 3.5% for the majority of the year, ticking up slightly to 3.9% by October.
Score
A-
Policy was a mixed bag. While the People’s Bank of China (PBoC) did pass supportive monetary policy (reduced reserve requirements, cut prime rates and lowered mortgage rates for first-time home buyers), the government maintained strict COVID-related shutdowns and continued to crack down on tech and property sectors that hampered growth.
5. China’s rocky road to reopening
As the second largest economy, China’s growth prospects have big global implications and could put downward pressure on goods prices; however, the country’s full reopening from lockdowns may not be entirely smooth.
Score
B
We were correct in our prediction that China’s reopening from lockdowns would not be seamless. Instead of a gradual reopening, the sudden reversal of COVID restrictions in December 2022 drove a wave of infections and fueled chaos. The global economic impact of China’s reopening proved to be more lackluster than expected, as growth was thwarted by systemic real estate problems, low employment and weak consumer confidence. The country’s recovery momentum peaked in early Q2, with retail sales climbing 18.4% y/y in April before tumbling to 3.1% in June. While spending picked up slightly through the second half of the year, retail sales growth sat at only 5.5% in September.
Score
D
Monetary policy shattered the precedent of the past 30 years with the most aggressive rate hike cycle since the 1980s. At the start of the year, the Fed was expected to raise rates a total of 75 basis points. At time of writing, the Fed has instead delivered four 75 bps rate hikes for a total of 375 bps so far, with another 125 bps expected by the middle of next year. Our expectation that long-term rates would remain below 2% for much of the year proved wrong, as the 10-year Treasury rose as high as 4.25% in October of this year.
6. Fed rate cuts to remain elusive
Markets may have mistakenly priced peak hawkishness too low, as they have for all of 2022. Moreover, the scope for rate cuts may be more limited in 2023 than prior cycles, as we do not think inflation will conveniently return to the 2% box of prior decades. This will likely continue to keep volatility, particularly in long-term rates, elevated next year.
Score
A
We were spot-on here. Coming into 2023, markets were expecting the Fed to stop short of a 5.00% Fed funds rate and to cut 50 bps–75 bps by end-2023. As we anticipated, markets were off base. The Fed hiked rates 100 bps to 5.50% and as Fed Chair Powell recently made clear, the Fed has no intention of cutting rates anytime soon, as indicated by the removal of recession forecasts from their latest set of economic projections in September. Markets spent the entire year trying to will Fed dovishness into existence, while the Fed continued messaging to the contrary, increasing their forecasted terminal rate in each of the three sets of economic projections in 2023.
Score
B+
We were right that the energy sector presented a good opportunity at the start of 2022, but did not foresee the black swan event of Russia invading Ukraine, which had enormous implications for investors. While the long-run implications of the transition to green energy remain in place, higher gas and oil prices in 2022 caused the energy sector to surge 72% year to date, by far the best performing sector within the S&P 500.
7. Long-term yields: Twin peaks?
It is important to appreciate the risks of buying long-term fixed income when the Fed is still raising rates, stepping back as a buyer of Treasuries, and inflation remains stubbornly high. Looking ahead, Treasury yields may revisit the highs of prior months and trade sideways in a wide band for much of 2023.
Score
A+
This was one of our strongest calls of 2023. Fed rate hikes, quantitative tightening, rising real interest rates and a focus on larger auctions to fund the U.S. government deficit combined to push the 10-year close to 5% in October. Traditional fixed income has struggled to sustain a positive total return in 2023, despite interest rates that have hit 15-year highs and have provided improved income for the first time in decades. This has served as a painful lesson in the implication of two-way price risk after investors suffered traditional fixed income being down –13% in 2021 and –1.6% in 2020.
Score
C-
Cryptocurrencies will continue to be a focus in 2022, as the size of the market grows and institutionalization of the asset class will become more entrenched. While its correlation to traditional assets must be watched closely, we continue to view it as an intriguing space for diversification and growth.
8. Credit spreads to widen, but total returns positive
We acknowledge the most likely path forward for spreads is wider. However, despite our call for spreads to widen, we think credit markets will generate positive total returns in 2023, as increased income should offset price declines.
Score
B
We were partially correct here. Returns in credit—both high yield and loans—were positive in 2023, but spreads did not widen as we expected; they remained relatively contained through the year. Despite surging long-term interest rates and growth concerns, corporate fundamentals remained supportive with low levels of leverage and high levels of interest coverage helping to keep default rates below 2.5% for high yield compared to the historic average of 3.2%. As a result, high yield credit spreads remained relatively flat from the start of the start of the year and prices for high yield bonds and leveraged loan rose 4.47% and 10.0%, respectively, through October.
Score
B-
This call was disrupted by the Russia-Ukraine war that sparked an energy crisis and sent the European economy reeling, and China’s Zero-COVID policy that hamstrung EM returns. While European and EM stocks outside of China have indeed outperformed their U.S. peers year to date on a local currency basis, the combination of an aggressive Fed rate hike cycle and geopolitical instability caused the dollar to strengthen sharply and dented foreign returns for U.S. investors. Ultimately, these valuation gaps actually widened during 2022.
9. Timing the trough as margins feel the heat
We believe equity markets will struggle to meet lofty earnings expectations as margins face pressure from moderating sales growth and still-elevated costs. A durable market rebound may first require capitulation on earnings, rather than simply a rates peak. Commodity sectors look attractive as “upside hedges” should the economy remain resilient.
Score
B-
2023 was a peculiar year for equity markets. S&P 500 operating margins indeed declined from 16% to around 14.5%, and while the economy has grown at a rate higher than almost anyone expected, full-year 2023 earnings are set to disappoint relative to January expectations. Returns on the average stock of just 2% year to date (YTD) reflect this outcome, but we admittedly did not foresee the impact of the AI narrative nor the Magnificent 7 gaining 72%. Commodity sectors were down slightly for the year, knocking us down a half letter-grade.
Score
B
If we’re being honest, the B might be a little generous. Our conviction that credit fundamentals would remain solid was accurate. Strong nominal growth has led to solid revenue and EBITDA figures, corporate leverage is near all-time lows, interest coverage ratios are at all-time highs and default activity has remained benign. We were correct in our assertion that this backdrop would keep spreads relatively maintained—loans and bonds saw peak spread widening of 238 bps and 275 bps, respectively—but we certainly failed to predict the carnage inflicted on credit prices this year in the face of rising interest rates.
10. Dear 60/40, it’s not me, it’s you
After a good run, we need to break up with the 60/40. While it used to offer balance and stability, both equity and bond performance disappointed in 2022, and we are not optimistic the 60/40 can make it up to us. It’s time to go in an alternative direction.
Score
B
The traditional 60/40 portfolio left investors somewhat heartbroken last year. On the surface, the “60” side offered solid headline gains of over 20% YTD by Thanksgiving; performance remains hyper-concentrated in the Magnificent 7, which accounts for over 70% of the year-to-date gains. The “40” leg of the portfolio disappointed for the third year in a row as it has struggled to maintain positive year-to-date gains. Perhaps the biggest letdown has been the lack of diversification, as the 52-week rolling correlation between traditional stocks and bonds revisited the high since 2000. The risk-reward profile of the 60/40 has not been attractive. As investors, we deserve better!
Score
A+
We were right to be pessimistic about the 60/40 heading into 2022. This traditional portfolio was crushed, with equities down -16% and bonds down -14% YTD. Amplifying the pain was the lack of diversification, as correlation between stocks and bonds was the highest in over a decade. The 60/40 portfolio experienced its worst year in U.S. history driven by inflation and rising rates. The outlook for inflation has improved somewhat in 2023, but remains highly uncertain, and investors should continue to rethink the role of alternatives in adding growth, income and diversification in a portfolio.
