What to expect from global markets

Compared with the turmoil global markets experienced in the past year, 2023 should be less threatening and more opportunistic, says Michael Hartnett, Chief Investment Strategist for BofA Global Research. A recession during the first half of 2023 may favor bonds, with stocks and corporate bonds rising later as economic conditions improve.

 

Here, Hartnett discusses his market outlook for 2023, what history may tell us and why asset classes battered by recent market conditions could rebound in the year ahead.

 

This interview took place on: December 1, 2022

 

Generally, what’s your global market outlook for 2023?

 

In 2022, financial markets sustained a number of shocks, particularly from inflation and interest rates, which were very destructive for bond and equity prices. But we’re a lot of the way through those challenges now, and for 2023, we’re bullish on bonds in the first half of the year and on stocks in the second half.

 

We forecast a recession in the first half, which is why we favor bonds over equities. But the most important factors in determining asset prices are interest rates and corporate earnings—and by the middle of 2023 it should be clear that we’re past the peak in interest rates and the trough in corporate profits. Then, markets should be on a much more solid footing.

 

In 2022, even a balanced portfolio of 60% stocks and 40% bonds had its worst performance in a century. Do you expect that to change in 2023?

 

It’s rare for lightning to strike twice. Going into 2022, markets clearly weren’t prepared for inflation or for a very aggressive response from the Federal Reserve. That’s why bond markets fell so far and then took equity markets with them.

           

Even if inflation continues in 2023, it will be expected, and much less likely to have the negative impact it had in 2022. That just leaves questions about the size and length of the recession. The expectation is that it will last through the first six to nine months but won’t be deep or scarring. If that’s the case, bonds certainly should do better than in 2022, and eventually the stock market will follow. If you look at the overall expected returns for those asset classes, a 60/40 portfolio should generate a positive return in 2023.

 

Does history offer any perspectives on what might be ahead for markets in 2023?

 

It always does, but it’s never perfect. The bull case would be that 2023 is going to be much like 1975. Then, after a period of soaring inflation and interest rates, the labor market finally cracked and inflation fell sharply. In early 1975, the Fed was able to pivot aggressively toward lower rates, and that was a glorious year of massive returns for both bonds and equities.

 

The bears would point to 2001 and 2002. They would note that although markets were brutal in 2022, there wasn’t much damage in the real economy—much like in 2000, when a bubble burst but the real economy was fine. The ramifications came in 2001 and 2002, when recession ultimately overwhelmed good news about interest rates and equities struggled.

 

As they say, history rhymes but never repeats. What’s always important are interest rates and corporate earnings. If interest rates come down sharply without a collapse in profits, the markets and economy should rebound. If corporate profits collapse and you don’t get much help from interest rates, things could go in the other direction.

 

What geopolitical events could affect financial markets in the coming year?

 

The Russia-Ukraine situation may continue to cause higher-than-desired energy prices—and energy is a huge driver of corporate profits and inflation. With the U.S. and China, a trade war and tech war are bubbling away. Sometimes it feels as if that may calm down. But the recent U.S. move to limit Chinese access to semiconductors could rear its head as a negative event in 2023. Less expected is the social unrest in Iran, which could be significant if it mutates into political change or regime change. And social unrest in China bears watching. 

What’s the outlook now for some of the asset classes that have underperformed recently, such as emerging markets and small-cap stocks?

 

For small-cap stocks, the outlook is really quite good. They’re generally a smart way to approach economic recovery, and at some stage in 2023, the market will anticipate recovery rather than recession. Small caps are also relatively cheap compared with large caps, and they’re a good hedge against inflation.

 

Small-cap stocks may also benefit in a world of less globalization as well as reshoring and capital spending now concentrated in domestic areas. We’re not going back to a world of 0% rates or quantitative easing in which all you had to do was own big tech stocks. People are looking for new leadership in the markets, and small-cap stocks will be part of that.

 

Emerging markets are clearly dominated by China, so the primary reason to be overweight in emerging markets is if you believe the Chinese reopening story is going to be as bullish as what happened in Europe and the U.S. in 2020 and 2021. If that happens in China, which has a lot of excess savings that people are going to want to spend as the economy reopens, that’s a simple and very powerful story.