2023 – The Horizon Ahead
The Horizon is a quarterly report from our Chief Investment Office, exclusive to Merrill Private Wealth Management, intended to help high net-worth clients pursue their personal goals by addressing timely topics in areas such as macroeconomic trends, long-term investment themes, market dynamics, asset allocation and portfolio strategy as well as wealth structuring, planning and transfer.
In this edition, we highlight various factors that could signal a new equity bull cycle, and the potential value of incorporating a total return mindset and recognition of diversity, equity and inclusion into portfolio strategies.
With an aggressive tightening campaign by central banks, the slow emergence from a global pandemic, the onset of war in Europe, and significant levels of inflation, 2022 will go down as one of the most challenging years for investors. An unfolding global slowdown and still hawkish central banks have the potential to create additional volatility for them.
“As we head into 2023, conditions may come together for forward returns to improve and, at the same time, opportunities may arise to derive income from financial assets.”
We believe investors should maintain a disciplined approach during periods of heightened uncertainty. To assist in the process of rebalancing portfolios and putting cash to work in the upcoming quarters, they should be aware of certain triggers that could signal a new equity bull cycle,1 such as a shift lower in core inflation, a peak in labor market weakness, stabilization of corporate earnings downgrades, a weaker U.S. dollar and a spike in volatility. In Q4 2022, we saw inflation cool off slightly from the mid-year high of 9.1%, but remain far above the Federal Reserve’s target of 2%. A Fed pivot to a balanced focus on both inflation and growth sometime in 2023 is likely to be a major catalyst for stocks. Additionally, as the economy weakens, unemployment is likely to rise and a peak in jobless claims could coincide with an acceptable level of inflation from the Fed’s perspective. Expectations for corporate earnings in 2023 are declining, and moderating revenues and lower margins will remain headwinds, but a stabilization in the rate of downgrades should ultimately support equity prices. Further, the dollar, which is currently showing signs of peaking, could trend lower in a sustainable fashion sometime in 2023 and 2024, to the benefit of international investments. Lastly, volatility indicators, such as the Chicago Board Options Exchange Volatility Index (VIX), remain at levels that are not yet considered a turning point for Equities. However, if the Fed continues to keep policy tighter for longer, this could cause an increase in volatility, leading to a potential trough in major indexes.
Where the period from 2019 to 2021 was characterized by capital appreciation propelled by abundant liquidity and lower rates, 2022 brought a re-evaluation of liquidity conditions and asset valuations. As we head into 2023, conditions may come together for forward returns to improve and, at the same time, opportunities may arise to derive income from financial assets. Therefore, we believe investors could consider applying a total return mindset to portfolios.2 Valuation metrics, such as current forward price-to-earnings (P/E) levels, indicate that the S&P 500 could see average annual returns in the mid- to high-single-digit range over the coming 10 years. Additionally, the S&P 500’s dividend payout ratio is below its long-term average, which signifies that dividends have room to grow in the coming years to meet the needs of the expanding ranks of retirees looking for additional income-producing investments. This demographic shift supports the potential for companies to increase their shareholder payouts and for dividend-producing Equities to outperform in the years ahead. With a slowing economy and moderating inflation, Fixed Income is currently providing attractive levels of income given higher levels of real and nominal yields as of the date of this report and also could potentially provide capital appreciation in the years ahead. In this next era of investing, it is our opinion that total return investments like income-producing Equities, Fixed Income and certain alternatives can present attractive prospects for long-term investors.
“With economic volatility projected to remain for the immediate future and economic distortions from the pandemic still filtering through, we recommend investors continue to maintain a balanced, long-term approach within their portfolio strategy.”
The global pandemic and multidecade-high inflation levels have disproportionally impacted minority groups, underlining the urgency of promoting a diverse, equitable and inclusive world. In Diversity Equity & Inclusion: A Lens for Investing,3 we highlight that a growing body of evidence suggest that inclusion of these factors, both in society and one’s portfolio, could potentially lead to increased economic growth and sustained long-term outperformance. The Bank of America Institute found that including individuals from different backgrounds with unique perspectives leads to a more innovative workforce, which can drive productivity. If this ‘innovation mindset’ was increased by 10% across countries, global GDP could rise by up to $8 trillion by 2028. Investors can consider taking part by either using actively managed funds that invest in companies with robust support for gender inclusivity, or passive strategies that track companies with diversity within management teams. In addition, many municipal bond strategies recognize the social value of some revenue bonds and the potential to directly address systematic inequalities in local communities.
With economic volatility projected to remain for the immediate future and economic distortions from the pandemic still filtering through, we believe investors should continue to maintain a balanced, long-term approach within their portfolio strategy. As we move towards a more foundational state in the markets and economy, the next few quarters could be characterized by moderating inflation levels, less hawkish (to dovish) central bank actions and an ultimate recovery in the business cycle.