Capital Markets Outlook: 1Q 2023

20 January 2023
7 min read

What You Need to Know

While 2022 was one of the toughest years ever for markets, the final quarter provided some relief. With markets reshaped and valuations lower, the opportunity set has grown. But 2023 won’t be an easy road; investors will need to be focused in their research and selective—because the devil’s in the details.

Key Takeaways

  • 2023 will be a transition year, as central banks induce economic pain in their battle to cool off inflation. That means slower growth and perhaps recession in some economies. Policymakers and investors will eventually shift more focus to growth struggles—and more volatility is in store. 

  • Valuation contraction was the story of 2022 for equity markets; now, as fears pivot to economic recession, earnings move into the spotlight. Fortunately, the market seems to offer a broader opportunity set and a number of strategies to capitalize. Quality is the key.

  • While the rising rates of 2022 were painful for bonds, higher yields have put the income back in fixed income. Despite looming concerns of recession, corporate and municipal finances are generally healthy, creating potential opportunities for selective investors. 

A Year of Transition for Policy and Economies

Major central banks, including the Fed, European Central Bank and Bank of England, continue to wrestle with stubbornly high inflation rates. Tighter monetary policy, including a series of policy-rate hikes, have somewhat tempered rising prices, with goods prices declining accompanied by the healing of global supply chains.

But inflation is still too high, and it takes time for rate hikes to take full effect. That means policymakers will likely continue raising rates, though at a slower pace, as they watch for more signs of progress. Housing-related inflation will likely peak in the next few quarters, but inflation in other services components shows little or no signs of slowing down—with tight labor markets and rising wages stoking the fire (Display). 

Wage and Services Inflation Have Been Tightly Linked
Wage and Services Inflation Year-over-Year Percent Change

Past performance does not guarantee future results.
Wage inflation is represented by the Federal Reserve Bank of Atlanta Wage Growth Tracker. Services inflation is represented by Services Consumer Price Index
Through November 30, 2022
Source: Refinitiv Datastream and AllianceBernstein (AB)

Tackling inflation requires weakening the labor market and inducing economic pain in the form of reduced activity and a drag on earnings. Markets and the Fed don’t see eye-to-eye on the path of inflation, with markets expecting a temporary earnings hit. But services inflation is sticky, and it may take longer to cool down, which leaves this question: How long will we be battling inflation in 2023?

Our 2023 forecast is for core US inflation to decline to 3.5% and official rates near today’s. We’ll likely see near-zero growth in US gross domestic product (GDP), with global growth (excluding Russia) of 1.7% and core inflation of 4.6%. Ultimately, we think inflation will ease enough for monetary policy to become less hawkish, but 2023 will be very much a year of transition—from high inflation and slowing growth to lower inflation and low growth.

Equities: In a Market Seeking Its Footing, Quality Matters

This is the backdrop investors face as 2023 gets under way, with the disruptions of last year having dramatically reshaped the market landscape. Stocks suffered their worst year since 2008, with the S&P 500 Index falling 18%, a tumble that pulled valuations down with it. The S&P 500 Index forward price/earnings ratios fell sharply—from nearly 23x at the start of 2022 to roughly 17.5x by year-end.

A performance rebound in the fourth quarter provided investors with some welcome relief, but inflation is still elevated and policy easing a ways off. As fears pivot to recession, earnings are moving squarely into the spotlight. It’s true that markets are likely to be fitful in 2023, but in a world of higher inflation and lower growth, stocks remain vital for generating real returns.

A Broader Opportunity Set…but Research Matters

One bright spot is a broader set of potential opportunities in equity markets (Display). More than 60% of all US publicly-traded stocks outperformed the S&P 500 last year —that’s well above the long-term average of roughly 48%. 

A Broadening of the Market Creates Opportunities for Stock Selection
Percent of Stocks Outperforming S&P 500

Past performance does not guarantee future results. Reprinted by permission. Copyright © 2022 Bank of America Corporation (“BAC”). The use of the above in no way implies that BAC or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of the use of such information. The information is provided “as is” and none of BAC or any of its affiliates warrants the accuracy or completeness of the information.
As of November 30, 2022
Source: Bank of America US Equity and Quant Strategy, and Lipper

But we think it makes sense to steer away from “bargain hunting” among the most shunned stocks, which we believe are generally cheaper for a reason. The most-shorted stocks in the S&P 500 were down more than 50% in 2022 versus a much less painful 18% for the index.

Instead, we believe the key is to focus research on company fundamentals and earnings prospects, always critical elements, especially as the economy slows. Identify quality businesses well-positioned for an inflationary world, delivering cash flows that support positive real returns over time. Growth stocks offer a more appealing entry point than they had before, now that valuations have fallen back closer to their long-term average.

Investors might also consider lower-volatility strategies, which have historically provided better performance than the general US market in times of modest or low returns (Display). Within value stocks, we think opportunities are present in industries with strong expected growth—financial exchanges and data, regional banks, and electronic equipment and instruments.

Consider Lower-Volatility Strategies in an Uncertain Time
Low-Volatility Performance in Different Market-Return Regimes (Percent)

Historical analysis and current estimates do not guarantee future results.
Annual data from 1988 through 2022
US Market is represented by MSCI USA; US Minimum Volatility by MSCI USA Minimum Volatility
As of December 31, 2022
Source: MSCI, Thomson Reuters Datastream and AB 

Income Is Back in the Fixed-Income World

For bond investors, central banks’ aggressive policy actions have been painful, but the silver lining is that there’s income back in fixed income after an era of near-zero yields. Yields are up across the bond universe, with many sectors at multiyear highs. For example, yields on US and global high-yield bonds have nearly doubled since the start of 2022. Historically, the yield-to-worst measure has generally been a reliable indicator of returns to come over longer time horizons (Display).

Higher Yields Suggest Attractive High-Yield Returns

Past performance and historical analysis do not guarantee future results.
GFC: global financial crisis; HY: high-yield
Left display: yield to worst (YTW) and returns represent Bloomberg US Corporate High Yield Index; right display: YTW and returns represent Bloomberg Global Corporate High Yield Index (USD Hedged).
As of December 31, 2022
Source: Bloomberg and AB

With an economic recession more likely, it’s understandable if some investors are hesitant to add corporate bonds. After all, credit fundamentals have typically weakened heading into economic slowdowns, leading to rating downgrades and possible defaults. However, today’s issuers, broadly speaking, sport much healthier profiles than they have historically.

A big reason is the weatherproofing from the post-pandemic default cycle. The strong survived—those that have been conservative in managing their balance sheets and liquidity. Within US high yield in particular, fundamentals are very strong. Net leverage is near 15-year lows, and so are default rates. Net-income margins are at 15-year highs. These metrics will naturally weaken in an economic slowdown, but they’re coming from a strong starting point, and we don’t expect significant downgrades or defaults.

Municipal Bonds: Fundamentals Still Strong After a Tough Year

On the tax-exempt side of the bond world, 2022 was the worst year for municipal bonds in four decades. Along with headwinds from inflation and Fed rate hikes, munis suffered historic capital outflows. All told, the broad municipal benchmark yield rose from just over 1% to over 3.5% during the year. Municipal credit underperformed, with BBB-rated and high-yield issues struggling.

Like other market segments, municipals started to regain footing in the fourth quarter, and we expect better performance in 2023. Yields are higher, and state and local governments are well-positioned to weather an economic slowdown. Tax-revenue collections are strong, state rainy-day fund balances are at all-time highs on average, and rating upgrades have outpaced downgrades for seven consecutive quarters (Display). 

Municipal Credit Fundamentals Are Historically Strong

Past performance does not guarantee future results.
*Compares year-to-date revenue through September 2021 to the same time period in 2022
Through December 31, 2022
Source: Bloomberg, Moody’s, National Association of State Budget Officers, US Census Bureau and AB

As 2023 gets under way, munis are slightly more expensive than comparable US Treasuries on an after-tax basis. For example, two-year AAA municipal yields ended 2022 at 2.4%; the after-tax yield on two-year US Treasuries was 2.6%. In an environment where returns are harder to come by, that premium can make a big difference. Active investors with flexibility should consider shifting some municipal exposure into Treasuries.

What’s the bottom line? There's much disagreement about what 2023 holds for inflation and Fed policy, but views for 2024 are much more aligned around normalization, with falling rates, better bond returns, multiple expansion and modest earnings growth that would bolster equity markets. The devil is in the details, but we believe investors have an opportunity to invest thoughtfully today, building portfolios with meaningful return expectations over a two-year horizon.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.