Brace For Economic Downturn
Jan 20, 2023
PGIM Quantitative Solutions’ 2023 Outlook discusses possible outcomes and areas of opportunities as the global economic forecast remains uncertain.
Expect Another Turbulent Year
Financial markets were hit by multiple shocks during 2022, leaving investors few places to hide as both stocks and bonds posted significant declines. Russia’s invasion of Ukraine propelled already-concerning inflation to new heights, prompting aggressive central bank tightening and contributing to significantly higher sovereign bond yields and a surging U.S. dollar. While most asset segments posted negative returns, commodities were the exception, advancing by double digits and further burnishing their credentials as effective inflation hedges. 2022 saw the worst annual performance for a 60/40 portfolio since the Global Financial Crisis and the lowest returns for the Barclays U.S. Aggregate Bond Index on record.
In the U.S., growth stocks fell sharply during 2022, while the pullback in value stocks was more modest. EAFE and emerging market stocks also experienced double-digit declines. U.S. REITs struggled as higher rates took the wind out of the sails of the commercial real estate sector. Global bonds declined as well, as yields rose sharply higher in 2022. Commodities were the lone bright spot, benefiting from supply scarcity along with continued solid demand. Major asset classes staged a rally in the fourth quarter, tempering year-to-date declines after better-than-expected U.S. inflation reports for October and November, which led to expectations that the Fed might adopt a less hawkish stance.
With considerable risk of a global economic downturn and increased prospects that central banks could make policy mistakes in their attempts to tame inflation, the earnings landscape looks poised to change in 2023. U.S. corporate earnings are likely to come under pressure as input costs remain sticky, while demand slows due to fading tailwinds from COVID reopening as well as tighter financial conditions. While net revisions to earnings turned negative in the second half of 2022, expectations for 2023 still remain around +5%. However, earnings expectations are likely to see more downgrades from current levels. In a moderate recession, earnings growth would likely fall 10%-15% for calendar year 2023.
U.S. Stocks May Bottom in 2023
While U.S. equity valuations have improved over the course of 2022, they remain elevated relative to history. If 2022 was the year of downward valuation multiple adjustment, 2023 will likely be about economic recession and earnings downturn. The forward P/E ratio on the S&P 500 Index has fallen to 17 from 24 at the end of 2021. Despite this sharp decline, multiples are still elevated relative to their long-term average of 16. Therefore, we see room for U.S. stocks to correct further and reestablish new lows before reaching a durable bear market bottom, probably in the first half of 2023. Stocks will likely recover sharply after this trough as investors look forward and begin discounting eventual economic and earnings recovery. However, the strength of any recovery in stocks will depend on the depth and length of the recession and the nature of the Fed’s policy response. Overall, we think U.S. stock returns will be positive but weak for calendar year 2023—though we can’t rule out another year of negative returns.
Long-term Prospects for Commodities Remain Positive
The outlook for commodities is challenged in the short term, but still very positive structurally. While commodities (Bloomberg Commodity Index) gained strongly since the bottom of the 2020 crash, the index is still 49% below its previous peak in 2008. The pandemic likely marked the bottom of the secular bear market for commodities, and we believe a new structural bull market is in place. In the near term, there are some positives for commodities, including the reopening of China and the imposition of Russian oil price caps by the G7 (which could further reduce Russian oil exports). Recession risk, however, is likely to keep prices volatile and at risk of a near-term drawdown.
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The Barclays U.S. Aggregate Bond Index is a broad measure of the U.S. investment-grade fixed income securities market. The MSCI EAFE Index is an equity index which captures large- and mid-cap representation across 21 Developed Markets countries around the world, excluding the U.S. and Canada. The Bloomberg Commodity Index (BCOM Index) is calculated on an excess return basis and reflects commodity futures price movements. Indices are unmanaged and are provided for informational purposes only. Investors cannot directly invest in an index. Past performance does not guarantee future results.
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