Quarterly Market Update

First Quarter 2023

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Market outlook: Slowing inflation sparks optimism

Posted: 1/23/2023 by Fidelity's Asset Allocation Research Team

Key Takeaways

  • Markets: The chances for elevated market volatility remain relatively high. The good news is that some of the challenging dynamics are reflected in more attractive valuations, particularly in fixed income.
  • Economy: The US is in the late-cycle expansion phase, but a descent into a mild recession appears likely in 2023. Europe has likely tipped into a recession. China may be poised for an upturn.
  • Investments: Global earnings growth continued to slow in Q4 and expectations for the next 12 months are relatively muted across the entire world.
  • Valuations: The 2022 sell-off in stocks caused valuations for all categories of global equities to fall from their elevated 2021 levels.

After an abrupt rise in 2022, bond yields held steady during Q4 amid signs that rapid inflationary pressures were coming off the boil. The US Federal Reserve and many other central banks further tightened monetary policy, and the US and global economies faced rising recession risks.

We believe the evolution of these trends defines the 2023 outlook, and valuation opportunities may appear within a still-volatile backdrop.

Asset prices staged a broad-based recovery in the final 3 months of 2022, with non-US stocks leading the gains amid a weaker dollar. Stable US Treasury yields and tighter spreads boosted most fixed income sectors into positive territory. Nevertheless, almost all asset categories finished 2022 with double-digit percentage price declines. Commodities were one of the only bright spots during a year marked by the highest inflation in 4 decades.

At the start of 2023, the markets appear overly sanguine about how quickly and painlessly the Fed can pivot to easing monetary policy. Slower liquidity growth, persistent inflation risk, slowing growth momentum, and greater monetary policy uncertainty raise the odds that market volatility will remain elevated. Some of these challenging dynamics have been priced into markets in the form of much more attractive valuations, particularly in fixed income.

See our interactive chart presentation for an in-depth analysis.

Economy/macro backdrop: Elevated global recessionary pressures persist early in 2023

The US is in the late-cycle expansion phase, but a descent into a mild recession appears likely in 2023. Europe has likely tipped into a recession. China's lifting of COVID restrictions and policy stimulus offer hope for a 2023 upturn.

Leading economic indicators across the world's largest economies slowed in the second half of 2022, suggesting weak global economic momentum at the start of 2023. Global manufacturing activity decelerated further in Q4, ending the year in slightly negative territory. With new orders slumping and inventories rising, this negative "bullwhip" effect is a leading signal of more slowing ahead.

Our preferred yield curve—the 10-year less 3-month Treasury yield—inverted during Q4 as the Fed continued to hike short-term rates. Historically, the yield curve has been a reliable leading indicator of economic weakness and, on average, inverted during the late cycle one year before recession. However, the timing of recession after curve inversions is uncertain and variable, ranging between 4 and 21 months historically.

The rate of inflation is set to materially slow, but persistent pressures may keep it more elevated than expected. Many inflation pressures that tend to be less persistent, such as supply-chain disruptions, slowed significantly in recent months. However, categories where price increases tend to be more persistent and more reliant on demand-side factors account for the bulk of current inflation drivers. If tight labor markets continue to boost unit labor costs, inflation in services sectors may linger for longer than investors expect.

The Fed is closer to the end than the beginning of its hiking cycle, but global monetary tightening is dampening liquidity and adding to growth risks. Aggressive monetary tightening by the world's major central banks continued during Q4, bringing global short-term interest rates to their highest levels in more than a decade. Japan remained an outlier by keeping its policy rate negative, but it raised the target for 10-year bond yields in a move that appeared to solidify the global trend away from the zero-rate era. Most investors expect the pace of rate hikes to slow in 2023.

In its December forecast, the Fed signaled plans to end its hiking cycle in 2023 amid lower inflation and higher unemployment. Market expectations project a lower inflation rate and higher unemployment rate in 2023, with a Fed pivot toward easing policy in the second half of the year. We believe the Fed's policy rate may remain higher for longer than the market expects, with the degree of financial-condition tightening a key swing factor.

Global earnings growth continued to slow in Q4, coming back to earth after a decade-high spike during the 2021 profit recovery associated with economic reopening. Emerging markets suffered a profit decline in 2022 amid weaker results from China. Global earnings growth expectations for the next 12 months are relatively muted across the entire world.

Asset markets: In a tough year, almost everything ended on a high note

Early in 2023, the trailing, one-year price-to-earnings (PE) ratios for all major categories of global equities—US, non-US developed markets, and emerging markets—are below their long-term averages, with emerging markets and non-US developed markets appearing the most attractive. The broad 2022 equity sell-off caused valuations for all categories of global stocks to fall from their elevated 2021 levels.

At the end of 2022, 10-year Treasury yields moved closer to our secular forecast of 4.2%, a huge improvement from nearly a record low yield at the end of 2021. Equity valuations improved across all regions, with cyclically adjusted price-to-earnings ratios for non-US markets providing more attractive opportunities based on our secular expectations.

Both Treasury yields and credit spreads rose during 2022 across all major bond categories. During Q4, credit spreads tightened somewhat across all categories to end the year close to their respective historical averages. After many years of extremely low bond yields, fixed income assets now offer relatively better income with more attractive valuations.

Almost all asset categories posted gains in Q4 but negative returns for 2022. Commodities, energy and utility stocks, and Latin American equities, were the year's exceptions, finishing in positive territory and benefiting from the more inflationary environment. All fixed income categories ended down for the year with more interest-rate sensitive sectors—such as long-duration government bonds—suffering the biggest losses.

After hitting a multi-decade high in Q3 2022 against most major currencies, the US dollar fell back during Q4. Cyclical drivers of dollar strength—including stronger US relative growth and rising US real bond yields compared to other major countries—reversed course. On a longer-term basis, fundamentals and valuations appear favorable for non-US currencies, particularly the Japanese yen.

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