Soft landing or no soft landing, that is the question, with all due respect to William Shakespeare. But while this may be the most commonly asked question these days, it may not be the most important or the toughest. That honor goes to what’s priced in. Good market forecasts are not just about the economy and earnings—they are about what the market is pricing in. Below we share our thoughts on the potential for a soft landing, the possible role China might play in that, and whether markets are pricing in too much good news.

Strong Job Market Supports Case for Soft Landing

Recent economic and market data have reignited conversations about a potential soft landing. As we wrote in Midyear Outlook 2022: Navigating Turbulence, the ongoing economic recovery from the global pandemic required businesses and consumers to pilot the economy into a soft landing but that path would go through turbulence. As we subsequently developed Outlook 2023: Finding Balance, we thought the markets would be choppy as the world found its balance, while we waited for inflation to decelerate and central banks to ease up on their rate hiking campaigns.

So where are we in the business cycle? If you focus on jobs, the U.S. economy is headed toward a soft landing. Excluding the blowout report for January, average job gains were on a smooth downward trajectory (Figure 1). Minimal turbulence in the trend line is consistent with a pathway to a smooth landing. In fact, the blowout jobs report did not alter the Federal Reserve’s (Fed) playbook.

The unemployment rate was 3.4% as the labor market is still very tight—too tight for central bankers. But more importantly, wage pressures are abating. Growth in average hourly earnings continues to slow, easing down to 4.4% year-over-year in January.

Low participation rates continue to weigh on the minds of economists and investors, but it’s important to remember that business formation stats are consistently growing above pre-pandemic levels, revealing many workers’ interests in alternative employment and one reason why some of the workers remain out of the official labor force.

So bottom line here is the labor market is still solid, offsetting some risk of slower consumer spending. Additionally, the slowdown in average hourly earnings should ease inflationary pressures in the near term as wage growth comes back in line. No doubt the Fed will continue to increase rates at the next meeting to slow the demand side of the economy.

Consumers’ Debt Load Remains Manageable

As Figure 2 illustrates, consumers hold much less debt now relative to previous cycles. After the Great Financial Crisis, consumers started aggressively deleveraging. Overall debt payments as a percent of disposable income declined and remained steady until the emergence of COVID-19 and most recently, the debt service burden on the American household moved back up to pre-pandemic levels but still relatively low. The job market is tight, which means personal income growth is supporting consumer spending along with the accumulated excess savings. To further pad personal spending, consumers will likely tap into consumer credit. We expect revolving credit demand to increase in the first part of this year, but we don’t expect debt service payments to approach rates last seen in 2007 and 2008. This manageable debt load is a key component of the case for a possible soft landing.

China Reopening May Help

As the world’s second largest economy, China’s economy reopening could help prospects for the U.S. in 2023. The International Monetary Fund (IMF), which recently upgraded its global growth forecast for 2023 to 2.9%, listed China and India as economic “bright spots” contributing to nearly half of global growth for 2023. China is expected to expand by 5.2% as the stringent Zero-COVID-19 measures that hampered its economy during the pandemic have been lifted.

Similarly, global ratings agency Fitch recently revised its 2023 forecast for China’s economic growth to 5.0% from 4.1%, noting that “consumption and activity” are recovering at a faster pace than initially expected. The Purchasing Managers Index (PMI), an important indicator for growth, has already begun to reflect a sharp rebound in activity, with a jump from 41.6 in December 2022 to 54.4 in January 2023.

According to official government announcements and reports, consumer spending and support for private businesses are a top priority to help stabilize the sputtering Chinese economy. China’s debt-laden real estate sector is also a major area of the economy that is scheduled to be helped by government support, including lower interest rates to help property developers.

Chinese officials have embarked on a campaign to revive its longstanding trading relationships, with high level visits and talks with Europe and Australia. Despite difficult bilateral relations with the U.S., there are indications both countries seek to continue trade ties, as China remains an integral part of the global supply chain. In addition, U.S. companies have continued operations in China and expect their earnings to increase as the economy gains momentum.

For the global economy, China’s recovery and resilience should help underpin the broader worldwide recovery. The healing of remaining supply chain challenges will be an important factor in the normalization in global economic growth, as will the normalization of overall trade relations. If the U.S. is going to achieve a soft landing, China’s impact on global growth will likely be a meaningful part of it.

Is a Soft Landing Priced In?

The outlook for economic growth and corporate profits is always a good place to start when forming a view of the equity market, but that’s only the first step. Next we ask perhaps the tougher question—what’s priced in?

The simple way to answer this question is with a basic price-to-earnings ratio (P/E). On a trailing four quarter basis, the S&P 500 Index is trading at a P/E of 19, in line with the 30-year average. That suggests valuations are fair and that a soft landing, or short-lived, mild recession, is probably priced in. Earnings are a bit depressed, supporting higher valuations, but the challenging near-term economic outlook with still-high inflation and more Fed rate hikes forthcoming, perhaps argue against that. Upside risk to interest rates may also argue against that, though LPL Research sees manageable upside to yields this year from current levels at a 3.7% 10-year Treasury.

Interest rates are a powerful force in equity valuations as a lower risk alternative. Factoring in rates and calculating an equity risk premium (ERP, earnings / price vs. 10-Treasury yields) gives us a below-average valuation (Figure 3). The ERP of 1.6% is currently above (more attractive) the long-term average ERP of 0.9%, though it is one of the more expensive readings of the past decade, given the big jump in yields since summer 2020. 

So, do these higher valuations mean more downside risk for stocks? Not necessarily. The average bear market decline in a recession is about 29%. That includes all recessionary bear markets, including the really bad ones such as 2000–2002 and 2008–2009. Even if we get a recession this year, we simply do not expect it to be as deep as those two instances, suggesting the 25% peak-to-trough decline in the S&P 500 last year may have been sufficient to price in the risk of the current economic environment.

Another way to assess downside risk is to apply more of a typical recessionary haircut to valuations and earnings. Instead of 18–19 times $240 in 2024 (LPL Research base case assumptions), 16 times $230 in 2024 puts the S&P 500 at around 3,680 at year end (the index closed at 4,090 on Friday, February 10), seemingly a reasonable bear case scenario as laid out in our Outlook 2023: Finding Balance publication.

Evidence Investors Are Strongly Embracing Risk

Another way to assess what the market is pricing in is by looking at the strength in high-beta stocks year to date relative to their low beta (or low volatility) counterparts. Better returns for high-beta, or higher volatility, stocks indicate investor risk taking and, presumably, increasing odds of a soft landing. The strength of high beta stocks in January was the ninth best month out of the past 30 years (360 months), or higher than the third percentile. This suggests maybe the soft landing is priced in and any disappointment could result in some downside to stocks.

Bottom line, while we acknowledge downside risk to earnings in a recession scenario, the risk to valuations from further increases in interest rates, and the market’s increasing optimism based on where the biggest 2023 gains are so far, we expect the October lows to hold and see solid, double-digit gains for stocks in 2023.

Conclusion

The 14% move for the S&P 500 off the lows last October, despite the weakening earnings outlook, clearly tells us the market is pricing in a more optimistic outlook for the economy and corporate profits. But perhaps much of that move may be justified based on rising odds of a soft landing. Recent strength in the jobs market, while worrisome for the Fed, along with healthy consumer balance sheets and manageable debt loads, position the U.S. economy to potentially muddle through.

Valuations are fair by our assessment, not rich, and enable some upside potential as the market gains additional visibility into the potential resumption of earnings growth later this year and into 2024. LPL Research’s Strategic and Tactical Asset Allocation Committee (STAAC) maintains its overweight recommendation on equities and 2023 year-end fair value target of 4,400 to 4,500, based on 18.5 times 2024 earnings per share of $240.

Jeffrey Buchbinder, CFA, Chief Equity Strategist, LPL Financial

Quincy Krosby, PhD, Chief Global Strategist, LPL Financial

Jeffrey Roach, PhD, Chief Economist, LPL Financial

The script has been flipped in 2023. Last year’s underperformers have turned into outperformers this year, driving the S&P 500 Index up over 5% this month. The pace and composition of the rally have left many investors skeptical over its sustainability, especially amid a lackluster earnings season thus far. Of course, the market is also forward-looking, with expectations for falling inflation and a less hawkish Federal Reserve (Fed) as we progress into 2023. And although the trajectory of the rally will likely slow, seasonal indicators point to a path higher for U.S. equity markets by year-end.

For background, market seasonality is premised on the adage of ‘history doesn’t repeat, but it often rhymes.’ The embedded assumption is the market exhibits seasonal patterns or cycles that ‘rhyme’ throughout history, or more specifically when prices move in a recognizable pattern that occurs with some degree of consistency over a specific timeframe. These patterns can last anywhere from several days to several years, each having its own tendencies unique to that period. For example, we are now in year three of the presidential cycle, historically the best-performing year for stocks across the four-year cycle. By no means is seasonality flawless, as pricing patterns are historical tendencies and not a guarantee of future results. Within LPL Research, we view seasonal data as one input, among many, into our decision-making process.

When various seasonal indicators tell the same story, the message becomes more powerful. The market is now on the cusp of receiving one of these ‘messages’ by potentially hitting a trifecta of seasonal indicators this month.

What are the components of the trifecta?

1. Santa Claus Rally: This seasonal pattern was first discovered by Yale Hirsch in 1972. Hirsch, the creator of the popular Stock Trader’s Almanac, defined the period as the last five trading days of the year plus the first two trading days of the new year. A positive Santa Claus rally signal occurs when the S&P 500 posts a positive return during this timeframe. For 2023, the S&P 500 was up 0.8% during this period, checking the box for a positive signal.
2. First Five Days: Hirsch also created the First Five Days indicator. This indicator is considered a warning system for the year ahead when the first five days of the year are negative. The S&P 500 finished the first five days of 2023 up 1.4%, checking the box for a positive First Five Days signal.  
3. January Barometer: Last but not least, Hirsch also created the January Barometer indicator and its popular tagline of ‘As goes January, so goes this year’ (positive January returns are historically associated with positive annual returns). A positive January Barometer indicator occurs when the S&P 500 posts a positive return in January. With the S&P 500 up over 5% this month as of Friday, January 27, a positive signal is expected.

When all three of these indicators are positive, such as this year, the January Trifecta has been hit (credit for the Trifecta indicator goes to Jeff Hirsch, Yale’s son who has continued his Stock Trader’s Almanac work).

Figure 1 highlights various return metrics for years when the trifecta indicator was hit for the S&P 500. For additional context, we also included year-over-year earnings growth for the index, along with whether or not the year included a recession.

Key Takeaways:

As you can see in the chart, the trifecta accomplished this month has historically led to some very strong returns. The S&P 500 has on average added 12.3% to a 4.6% January gain between February and December, bringing the average gain for these years to over 17%. This sounds like a big gain, and it is, but keep in mind the average gain in the third year of the four-year presidential cycle is 16.8%, and the average year following a down year is up 15%.

It also worth noting that with the broad market slipping nearly 20% last year, this gain still would not get the market back to the 2022 high set on January 3, 2022. Stocks enter 2023 much more attractively valued than a year ago—roughly 18 times forward (2023) earnings as compared to over 21 times forward (2022) earnings a year ago, based on FactSet estimates.

Steady Path to Gains

Finally, we also compared the monthly seasonality for trifecta years and non-trifecta years. Figure 2 highlights the returns across each scenario. While the strong January average returns during trifecta years decelerate in February, they do not historically turn negative. In fact, of the 31 trifecta years observed, all 12 months produced positive average monthly returns.

Conclusion

Stocks continue to climb the wall of worry despite mixed messages between technicals and fundamentals. Seasonality indicators, including the trifecta indicator, suggest the path of least resistance for the broader market is likely higher for the year ahead. And while the seasonality message is clear, the market still needs catalysts to climb higher. LPL Research believes the end of the Fed’s monetary policy tightening will be a key driver for stocks this year. Cooling inflation data will not only underpin a policy change, but also reduce headwinds for companies battling ongoing pricing pressures. The end of a rate hike cycle could also mean interest rate stabilization or even lower interest rates, another potential driver of equity market gains. Finally, while we believe recession risk remains high, there is the chance the U.S. economy is only facing a growth scare and muddles through on the back of a resilient consumer who is flush with cash. 

Adam Turnquist, CMT, Chief Technical Strategist, LPL Financial

Jeffrey Buchbinder, CFA, Chief Equity Strategist, LPL Financial

Fourth quarter earnings season is underway and probably won’t bring much good news. Lackluster global growth, ongoing profit margin pressures from inflation, and negative currency impacts are likely to translate into a year-over-year decline in S&P 500 Index earnings for the quarter. As always, guidance matters more as market participants look forward. The key question coming into this earnings season is whether the pessimism surrounding 2023 earnings has gone too far.

A number of headwinds

As was the case last quarter, corporate America faces several stiff headwinds this earnings season. These headwinds—clearly not new news—include slower global economic growth, cost pressures from still-elevated inflation, ongoing supply chain issues, currency drag from a stronger U.S. dollar last quarter compared with the year-ago quarter, and geopolitical instability, particularly in Eastern Europe and China. These headwinds will likely translate into a slight year-over-year (YOY) earnings decline for the S&P 500 in the fourth quarter, with an outside shot at getting above the flat line (Figure 1).Consensus currently stands at -3.6% YOY in the quarter (source: FactSet).

The good news is some of these pressures have started to abate, particularly currency pressures, after a 9% drop in the U.S. dollar since the fourth quarter began on October 1 (though it was up about 6% YOY in Q4). Even the economic pressures have eased some, with fourth quarter U.S. gross domestic product (GDP) likely to exceed the 1.2% consensus forecast of economists surveyed by Bloomberg based on the latest data. And don’t forget the U.S. economy grew at a solid 3.2% pace in the third quarter of 2022, while Europe has held up better than we anticipated, thanks in large part to falling natural gas prices.

Bottom line, if we’re going to get enough upside for the S&P 500 to grow earnings at all in Q4, it will likely come from the resilience of the U.S. and European economies, currency effects, and some mitigation of profit margin pressures from cost controls and lower inflation.

Guidance is key

The key question to answer this earnings season is whether the pessimism surrounding 2023 earnings has gone too far. LPL Research believes that it probably has. Admittedly, analysts have been too slow to bring S&P 500 earnings estimates for 2023 down from the current $230 per share level to a more reasonable $215 to $220 range (our estimate is currently $220, flat or down slightly from 2022 levels). A mild recession would likely take us down to $210 or lower, depending on how fast and how much inflation comes down later this year.

As shown in Figure 2, estimates have come down substantially over the past two quarters, but the pace of cuts has slowed heading into fourth quarter earnings season. That may indicate estimates may not have to come down 10%-plus in the near term as some market strategists expect.

Here are some reasons why estimate cuts may not be as drastic as some fear:

• China’s reopening—uneven or not—is well underway and may be a catalyst for supply chain fixes and more global demand.
• Companies have had plenty of time to prepare. If a recession occurs this year, it may be the most anticipated recession in history.
• Cost pressures have started to ease, taking some of the pressure off margins. Examples include lower energy prices and slowing wage increases.
• Recession may be a more than 50/50 proposition, but it isn’t inevitable. The U.S. economy may “muddle through” and skirt recession.
• Revenue growth is solid, bolstered by the higher revenue that comes with inflation. Consensus is calling for a 3.8% YOY increase in fourth quarter S&P 500 revenue, but recent quarterly trends suggest a 5% increase is possible.

Pushing in the other direction is the 1–2% hit to S&P 500 earnings expected this year as a result of the tax increases in the Inflation Reduction Act (which, as we’ve shared in the past, won’t do much to lower inflation this year). Soft manufacturing activity and ongoing inventory adjustments in certain segments of the economy, such as semiconductors, will also be a drag on earnings in the near term.

Bottom line, we would look for 2023 earnings estimates to come down, but not collapse, this reporting season. The path to a sub-$220 number for S&P 500 EPS estimates this year, if we get there, will be gradual. Modest cuts in the coming weeks may actually be a positive catalyst for stock prices.

Pay attention to earnings season, revisions matter

With so much disagreement about the 2023 earnings outlook, maybe it’s not a tough sell to convince investors that earnings matter. We often hear analysts projecting the seemingly obvious “earnings matter” refrain; of course earnings and fundamentals matter, but at times of irrational exuberance—though not as much in 2022 and 2021—and meme stocks (see here), we feel the need to yell it even louder. Beyond the obvious reasons to pay attention during earnings season, there are quantitative trading trends that support paying attention to earnings, and more importantly, forward estimate revisions.

LPL Research’s quantitative research team created a revisions composite factor, which combines four estimate revisions metrics (current and following fiscal year EPS and sales estimate revisions over last three months) into one standardized score.

Using the S&P 500 as the investible universe, a hypothetical long-only portfolio is constructed of the top quintile (top 20 percent) of stocks’ estimate revisions composite score. This portfolio is equally weighted and rebalanced monthly. Looking at 2022 in isolation, this strategy would have outperformed by about 6.5% to 7%, depending on whether you neutralize sector effects or not.

Figure 3 shows the hypothetical performance of the sector-neutralized portfolio vs. the S&P 500 on a total return basis. We analyzed this phenomenon by sector, and while most sectors showed positive performance vs. their cap-weighted sector index, there were sectors that underperformed. This estimate revision phenomenon provides a compelling backdrop for fundamental stock picking and provides another tool for investors to use in equity and sector selection. 

Conclusion

This earnings season likely won’t offer much in the way of good news. We saw that in the challenges the banks faced in their reports on Friday, January 13 (an inauspicious date to start earnings season). But pessimism may be overdone, and investors may be surprised at how well stocks hold up on the news. Look for earnings throughout the next year to exceed those pessimistic forecasts and—along with falling inflation and the end of Federal Reserve rate hikes—serve as positive catalysts for solid gains for stocks in 2023. 

Jeffrey Buchbinder, CFA, Chief Equity Strategist, LPL Financial

Thomas Shipp, CFA, Quantitative Equity Analyst

2022 was a dizzying year as markets and the global economy continued to find itself out of balance due to the still present aftereffects of the COVID-19 pandemic and the policy response to it. If 2022 was about recognizing imbalances that had built in the economy and starting to address them, we believe 2023 will be about setting ourselves up for what comes next as the economy and markets find their way back to steadier ground. The process of finding balance may continue to be challenging and we may even see a recession, but underlying fundamentals could create opportunities in stock and bond markets that were difficult to find in 2022.

This commentary contains excerpts from LPL Research’s Outlook 2023: Finding Balance.

Outlook – Economy

The global economy will likely slow from the upper-2% range in 2022 down to the mid-1% range in 2023 [Figure 1]. Much depends on China’s growth path now that it has largely abandoned its overzealous zero-COVID-19 policy. An important aspect for investors is that the U.S. appears to have fewer headwinds to growth compared with Europe and other developed economies. The divergence between the domestic and international economies is most obvious in the inflation regime. Germany, for example, is still experiencing accelerating rates of inflation, whereas the U.S. has likely moved past the peak. The longer inflation is uncontained, the riskier the growth prospects.

If the U.S. falls into recession, the chances are it would occur during the first half of 2023 and will not likely be as deep as the 2008 recession, which was initiated by a fundamentally flawed financial market.

More Clarity on Potential for U.S. Recession

One reason we’re currently seeing a healthy debate on the likelihood of a recession is that for most of 2022, not all of the metrics that typically precede recessions were flashing warning signs. However, recent data may give us more clarity. The Conference Board’s Leading Economic Index (LEI), an aggregate of indicators that tend to lead economic activity, is now in an extended decline, showing the economy could enter a period of significant and broad-based contraction. The decline is predictable as many sectors, such as housing, started slowing months ago. Since the inception of the LEI, a decline of the current magnitude over a six-month period has always foreshadowed a recession in subsequent quarters. As such, we think recession risks appear more probable by the beginning of 2023. If the economy does fall into a recession, the cause will likely be from the consumer sector retrenching after years of inflationary pressures, high housing costs, and slow real wage growth.

Inflation Should Become Convincingly Softer

Investors and central bankers will likely enter 2023 with a slightly different trajectory for inflation, particularly services inflation. In recent months, durable goods prices have clearly decelerated—and in some cases, outright declined—but services prices have been stubbornly accelerating as rent prices and health services rose. We could potentially be entering a new regime as rents across the country are showing signs of abating. During this transition period for services prices, the coming year could be the time when inflation is convincingly decelerating closer to the Federal Reserve’s (Fed) long-run target of 2%.

If inflation in 2022 was about supply constraints, then inflation in 2023 could center on demand constraints. For the past year, supply-related problems contributed more to inflation than demand-related imbalances. China’s zero-COVID-19 policy was one of the biggest glitches in supply chains, as metro areas and ports were shuttered by the Chinese government. However, things may be on the verge of changing as supply and demand get into balance throughout 2023, and as inflation likely becomes more demand driven and less supply driven. This is positive for policymakers because monetary policy tools do not work on supply shocks but rather, only on demand; thus, these tools are now more relevant than they were when inflation was primarily from supply bottlenecks. So as supply constraints ease and as Fed tools become more impactful, we could see the rate of inflation decelerating further in 2023.

Outlook – Stocks

Equity markets lacked balance in 2022 as the challenging macro environment overwhelmed business fundamentals. Stubbornly high inflation and sharply higher interest rates were the dominant market drivers, pressuring valuations and inciting fears of recession and falling corporate profits. In 2023, we look to equity markets to find a better balance between key macroeconomic factors—inflation, interest rates, and Fed policy—and business fundamentals.

Reaching the Peak of the Rate Climb

If stocks are going to go higher in 2023, a prompt end to the Fed’s rate hiking campaign will likely be a key component. Our base case is the Fed will pause in early spring of 2023 amid an improving inflation outlook and loosening job market. Should that occur, stocks would likely move higher, consistent with history. Stocks have tended to produce solid gains after hiking cycles end, including a 10% average gain one year later.

What Goes Down Tends to Go Up

They say what goes up must come down. For the stock market, it also works the other way. Through many economic downturns, recessions, and geopolitical crises over many decades, the stock market has always recovered. Those patient and courageous investors who were able to take advantage of those declines have usually been rewarded nicely. Following down years, the S&P 500 Index (S&P 500) has risen an average of 15%, with positive returns in 15 out of 18 years. Since 1950, a down year was only followed by another down year three times: in 1973, 2000, and 2001.

Looking at this another way, after losing 20% or more at any point in time, the S&P 500  has gained an average of 17.6% over the subsequent 12 months (monthly data). The positive post-midterm election year pattern provides another historical analog that should be supportive of higher stock prices in 2023.

Wide Range of Possible Earnings Outcomes

Corporate America faces significant headwinds as 2023 gets underway. Cost pressures amid high inflation and still-snarled global supply chains are the biggest factors, but slowing economic growth and the strong U.S. dollar may make any earnings growth in 2023 difficult to achieve. Many companies over-earned during the pandemic, so some reversion back to normal still needs to occur. Inventories also need to be brought down. Even though some of these pressures have started to ease, lower commodity prices and slightly looser labor markets have, thus far, had limited impact on inflation overall.

Our base case for S&P 500 earnings per share in 2023 is $220, similar to where 2022 is tracking and well below consensus ($230.66 as of December 29, 2022). Revenue will continue to get a boost from inflation, as many blue chip companies during third quarter earnings season demonstrated an ability to pass along higher prices due to their pricing power. But margins will likely compress further over the next several quarters before support from lower costs potentially arrives.

An upside scenario could materialize if inflation falls faster than we anticipate, propping up margins and potentially putting S&P 500 earnings per share as high as $235 in 2023 and over $250 in 2024. On the other hand, stubbornly high inflation and a more prolonged economic downturn could introduce downside risk, possibly down to $200 per share in earnings in 2023 before a potential rebound to $230 in 2024.

Tilting the Scales Back in Favor

In 2022, the bear market decline in stocks was all about the macro picture—high inflation, surging interest rates, and rising recession risks. Strong consumer and corporate balance sheets and growth in corporate profits were not rewarded by investors, who were focused on rising recession risk and concerns of higher interest rate levels affecting future earnings. Add to that a tense geopolitical landscape and a strong U.S. dollar, and stocks struggled to make any headway throughout the year.

Looking ahead to 2023, stock drivers are likely to be more balanced. Rather than the scales tilting toward rising interest rates and runaway inflation, we may see falling interest rates and lower inflation supporting higher stock valuations. Should the outlooks for economic growth and inflation improve as 2023 progresses, stocks may also get a lift from prospects for stronger earnings growth in 2024.

LPL Research’s Strategic and Tactical Asset Allocation Committee (STAAC) sees fair value for the S&P 500 at 4,400–4,500 at year-end 2023, based on a price-to-earnings ratio of 18–19 and $240 per share in S&P 500 earnings in 2024. That target is also derived from probability-weighted scenarios and based on various paths for the economy, inflation, interest rates, and earnings [Figure 2].

We look for stocks to find better balance between the macro environment and business fundamentals in 2023, tilting the scales toward the bulls.

Outlook – Bonds

The path of interest rates in 2023 will largely be influenced by the Fed’s behavior, which will be guided by economic growth and inflation data. Equally important is the level of non-U.S. developed government bond yields, as foreign investors are an important buyer of U.S. Treasuries. Higher foreign market yields, all else equal, generally dissuade foreign investment into our markets. There are a range of scenarios we think could play out over the year. However, given our view that the U.S. economy could eke out slightly positive economic growth in 2023, we think 10-year Treasury yields could end the year around 3.5% [Figure 3].

The Road to Recovery for Core Bonds

The core bond index (as defined by the Bloomberg Aggregate Bond Index) has seen losses in 2022 unlike any year since its inception. But because bonds are both financial instruments and financial obligations, which pay coupons and principal repayments at par when they mature, the potential for recovery is a bit more certain than in the equity markets that rely primarily on price appreciation. So, how long will it take to recover this year’s losses?

If interest rates don’t change at all, the best expectation for performance over the next year would be the index’s starting yield, which sat at approximately 4.7% on December 28. But if interest rates decline by 0.5%, the Bloomberg Aggregate Bond Index could return more than 8% over the next 12 months. Moreover, if interest rates move back into the low 3% range, the core bond index could return around 11% over the next year. Also, and importantly, given where starting yields are, if interest rates increase by another 1% from current levels, fixed income markets broadly could still generate positive returns over the next 12 months. Given the move higher in yields we have experienced this year, we think the risk/reward for owning core bonds has improved.

However, for investors that don’t want to take on a lot of interest rate risk, the opportunity set in shorter maturity fixed income securities has improved as well. With 1- and 2-year Treasury securities both yielding above 4%, cash and cash-like instruments finally offer an attractive yield. Moreover, shorter maturity investment grade corporate securities are offering yields in line with longer maturity corporate credit securities—without the same level of interest rate or credit risk.

One thing to consider is that because starting yields are the best predictor of future returns over the maturity of a fixed income instrument, by taking on that additional interest rate risk and owning a full market core bond portfolio, investors would be “locking in” investments at higher yields for a longer period of time. If interest rates do fall from current levels, investors that are in shorter maturity securities would then have to reinvest proceeds at lower rate levels.

So for investors with an investment time horizon greater than five years, a full market core bond portfolio may make sense. Otherwise, shorter maturity securities offer attractive yields as well. Bottom line, after the back-up in yields in 2022, there are a number of attractive fixed income opportunities again.

What’s Next for Corporate Credit?

Since Treasury yields are generally used as the base rate for consumer and corporate borrowers, this year’s increase in Treasury yields pushed many borrower’s borrowing costs to levels not seen in years. For corporate borrowers, after years of borrowing at ultra-low rates, the backup in yields we’ve seen this year has pushed corporate borrowing rates back above 5%, which is meaningfully higher than the 2% levels many borrowers enjoyed in 2020 and 2021. Could higher borrowing costs for corporates reduce profitability and potential growth opportunities?

Perhaps, but over the last two years in particular, corporate borrowers have increased the amount of new debt issued seemingly to prepare for the rising rate environment we’re currently facing. In fact, new corporate debt issuance for investment grade companies hit record highs in 2020 and 2021, when over $3 trillion of new debt was issued. As such, corporate entities were able to term out debt by issuing a lot of debt at longer maturities and lower rates. Also, and notably, because companies were able to refinance existing debts over the last few years and push out maturities, only about 1% of existing debt needs to be refinanced in 2023, and less than 10% needs to be refinanced before 2025. So the need for companies to refinance existing debt at these higher levels seems to be currently muted. 

That said, if the Fed is able to keep rates at these elevated levels, and as the need for corporate borrowers to access the capital markets increases, there’s no doubt corporate profitability will be negatively impacted by higher interest expenses. However, we don’t think it will happen in the near term.

LPL Financial Strategic and Tactical Asset Allocation Committee

Despite the S&P 500 Index starting December with five consecutive days of losses, we think December is down but not out. December often starts slow but historically has been a strong month. There are also some potentially supportive seasonal patterns ahead, such as the Santa Claus Rally, the outlook for January following down years, and the third year of the presidential cycle. ‘Tis the season, and this week LPL Research looks at some important seasonal patterns as the year winds down.

Slow Start to December Not Yet Bucking the Positive Seasonal Pattern

December is off to a rough start, and so far it’s not living up to its seasonal reputation of being one of the best months for equity market returns. Since 1950, the S&P 500 has historically produced average returns of just over 1.5% and has finished the month in positive territory 75% of the time. While the index is down as of Friday, December 9, seasonality trends point to a potential second-half recovery during the month.

As seen in Figure 1, despite the positive seasonal pattern, it’s not unusual for December to get off to a slow start. In fact, we’re near the low point for the historical pattern, and most gains have typically taken place in the second half of the month, although there’s a lot of variation from year to year.

Figure 1 also highlights some added factors that apply specifically to this year, such as how December looks when we’re down year to date as we enter the month and what December looks like after a positive November. Both factors temper our enthusiasm for December strength, but December remains above average even when taking these factors into account.

Santa’s Helper

Part of the strong second-half December story is attributable to the market’s tendency to advance during the final trading days of the year and early into the next. This unique seasonal pattern was first discovered by Yale Hirsch in 1972. Hirsch, creator of the Stock Trader’s Almanac, termed the period the “Santa Claus Rally”, which he specifically defined as the last five trading days of the year plus the first two trading days of the new year. The period of just seven trading days is very short, but has historically provided a return comparable to a strong month [Figure 2]. It’s not unusual for stocks to move up (or down) more than one percent even in a single day, but having solid numbers over such a long time period may be meaningful. In any given year, it’s going to be more important factors, such as the economy and the policy environment, that drive returns. However, behind the scenes this period of relatively light volume does seem to provide added support.

Retail Stocks Not as Resilient as Consumers

If the consumer has remained resilient, as evidenced by economic data and corporate sales, public retailer equities have been anything but. The retailers are down 29% to date, compared to the broad S&P 1500 and S&P 500—both down 14% year to date. Retailing is typically a competitive, lower margin business, and stocks typically trade on earnings expectations. Rolling forward (next 12 months) EPS estimates for the industry group have declined about 11% from the start of the year [Figure 3], and current year quarterly earnings have been a mixed bag of positive surprises and newsworthy stumbles. “Big Box” stores (aka multiline retail) have seen some of the larger earnings misses, as changing consumer behaviors coming out of the pandemic left stores with bloated inventories of pandemic favorites such as exercise bikes and patio furniture.

An Early Happy New Year

We’re now in the homestretch of 2022. It’s been a challenging year for both stocks and bonds as inflation soared, interest rates climbed, and the Federal Reserve executed one of its most aggressive rate hike campaigns on record.  Ultimately, the economy, earnings, and the policy environment drive stock returns, not seasonal factors, but seasonals provide an important backdrop. And right now, the outlook based solely on seasonals is about as supportive as it gets (For our broader market view of 2023, see our Outlook 2023: Finding Balance).  But even if only a potential small tailwind, we hope the seasonal outlook helps us put a rough year behind us and gives us reason to say an early Happy New Year.

Adam Turnquist, CMT, Chief Technical Strategist, LPL Financial

Barry Gilbert, PhD, CFA, Asset Allocation Strategist, LPL Financial