2023 Capital Markets Forecast: Inflationary Vortex and Our Investment Roadmap

Inflation has been top of mind for consumers, business owners, and investors throughout 2022, and it remains central to our market and economic outlook for the coming year. Inflationary Vortex, the title of our 2023 Capital Markets Forecast, refers to the spiraling upward of several forces. But take heart: Inflation will not persist at these levels. In fact, we are seeing compelling signs of disinflation in the pipeline and expect the headline Consumer Price Index (CPI) to decelerate to 3% by mid-2023. In our forecast, we explore three pivotal trends—the tight U.S. labor market, China’s policy and demographic challenges, and the cost of the transformation to green energy—and how they are expected to impact global inflation. For more detail, read the full report here, as these trends inform the positioning of our client portfolios.

Before we delve into the investment opportunities ahead, we first look at our inflation projection, as its risk over the short to medium term is critical for identifying those opportunities. Our expectation is for a deceleration in inflation from about 7% at the end of 2022 to about 3% by mid-2023. While this drop is critical in the short term, what is as important for medium-term asset class returns is where inflation settles. How might inflation and other factors impact whether we will cross into recession territory in 2023? Here are three possible scenarios:

• A mild recession, our expectation, is unlikely to be avoided, despite our projected rapid drop in inflation. Slow inflation movements, plus the Federal Reserve’s (Fed) desire to keep interest rates elevated until inflation has been erased, will likely result in a 5.0% or slightly higher fed funds rate. We expect this to curb consumer and business spending, leading to two quarters of contraction of 1.0%–1.5% annualized, and S&P 500 earnings to decline by at least 5%–10%.
• A soft landing, where economic growth slows but does not contract, is our second most likely scenario. The Fed could limit rate hikes to a peak of 5.0% or below before pausing to assess the economic impact, likely bringing on rate cuts in the second half of 2023.
• A severe recession assumes wages, housing, and the broader services sector continue to exert upward pressure on the CPI. The Fed takes its policy rate up to 6.0% or higher, unemployment rises above 5.5%, and the economy contracts at a rate of 2.5%–3.0% for over two quarters.

What does this mean for portfolios?

While the stock market response to a mild or soft landing recession scenario is not clear-cut, the degree of Fed communication throughout 2022, potential brevity of the recession, and likelihood of rate cuts in 2023 could mean further stock weakness is limited and we expect the next bull market to begin in 2023, if it hasn’t already done so. We are prepared to deploy cash opportunistically and expect reasonably priced growth stocks to outperform. Still, the tight labor market means labor costs weigh more heavily on the industrials, tech, communication services, and financials sectors. According to Macrobond, energy remains an attractive sector, despite its stunning 91% outperformance over the broader S&P 500 in 2022.

One positive to higher interest rates is that it could return the advantage to the diversified investor. After years of low rates punished savers and fixed income investors, we believe pain for bond investors is largely in the rearview mirror. Current yields finally give fixed income investors decent interest payments and justify a full allocation to fixed income in portfolios.

For developing, or emerging markets (EM), we think investors should hesitate to divest from this space, and call for a nuanced approach to investing in Chinese equities, which comprise roughly one-third of EM stocks. Heightened policy risks will require greater selectivity and reap potential reward from active managers with a knowledge of and presence in the country. Look for EM strategies with the flexibility to increase or reduce China exposure, looking at EM markets more broadly. Our outlook for international developed economies is grim, and Germany is likely to lead the broader European Union into a recession that could last through the majority of 2023. High inflation, Ukraine war, weakening currencies, and other risks weigh on this asset class.

Economic abnormalities can be challenging, but our experience shows that they eventually normalize, even as “normal” evolves. With diversification as the linchpin of our investment philosophy, we move forward with confidence that overall portfolio returns will soon be positive once again. Again, we encourage you to read our full 2023 forecast and speak with Curt Edwards, president of the Naples, Florida office or connect with an investment advisor if you're concerned about how these influences may impact your portfolio.

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Wilmington Trust Investment Advisors, Inc's Capital Markets Forecast is provided for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a recommendation or determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the investor's objectives, financial situation, and particular needs. The investments or investment strategies discussed herein may not be suitable for every investor. The material is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional should be sought.

The forecasts presented herein constitute the informed judgments and opinions of Wilmington Trust about likely future capital market performance and are subject to change without notice. Forecasts are subject to a number of assumptions regarding future returns, volatility, and the interrelationship (correlation) of asset classes. Assumptions may vary by asset class. Actual events or results may differ from underlying estimates or assumptions, which are subject to various risks and uncertainties. No assurance can be given as to actual future market results or the results of Wilmington Trust's investment products and strategies.

The estimates contained in this presentation constitute Wilmington Trust's judgment as of the date of these materials and are subject to change without notice. The information in this presentation has been obtained or derived from sources believed to be reliable, but no representation is made as to its accuracy or completeness.

Securities listed or mentioned are provided for illustrative purposes only and are not intended to be representative of current recommendations or holdings. It should not be assumed that these securities were or will be profitable.

Investing involves risk and you may incur a profit or a loss. Past performance cannot guarantee future results. Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment strategy will be successful.

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