By Bill SchmickiBerkshires columnist
4:45 p.m. / Thursday, December 08, 2022
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Historically, midterm election years are notoriously periods of underperformance in stock markets. The year after the election is a completely different story. Will 2023 be one of those years?
The average return for the stock market in the 12 months following the election was 16.3 percent.
2022 will go down in history as one of the underperforming midterm election years. To date, the benchmark S&P 500 index is down around 20 percent and could end the year even lower.
Historically, going back to 1932, the S&P 500’s returns have averaged 14 percent in a divided Congress and 13 percent in a Republican-held Congress under a Democratic president. The fact is, stock markets do well when Congress comes to a standstill. Neither new spending initiatives nor tax increases are likely to pass a divided Congress. If, after this election, the House and/or Senate move to the GOP, the best that can be said is that additional business regulation will be limited and possibly even rolled back somewhat in sectors such as energy, pharmaceuticals, biotechnology, and other financial sectors.
However, given the global economic backdrop, a market recovery next year is anything but certain. We grapple with the highest inflation rate in a generation, skyrocketing interest rates, the war in Ukraine and a global economic slowdown. The International Monetary Fund has lowered its forecast for global growth from 3.2 percent in 2022 to 2.7 percent next year. That’s the weakest growth rate since 2001.
As the global economic pie shrinks, I expect global trade blocs to increase as the world scrambles for a larger slice of the shrinking pie. A north-south economic and political axis has been emerging for more than a decade, with China leading the way in expanding trade and investment in Asia, Latin America and Africa.
Russia joined the bloc in response to Western economic sanctions, while nations like India, Brazil, some in Eastern Europe, and certain Middle Eastern energy producers are strengthening economic ties with both Russia and China. Together, these countries represent more than a third of global economic output and two thirds of the population. As global growth slows, trade wars between this bloc and a US-led trading bloc are expected to accelerate. This trading group includes most of Western Europe, Japan, South Korea and a host of other pro-democracy nations.
A recession looks all but guaranteed here in the US in 2023. In a recent CNBC CFO Council survey, more than 68 percent of chief financial officers (CFOs) believe a recession will develop in the first half of 2023. No CFO surveyed believed the country would avoid a recession. The only question is how severe the recession will be. I think that will depend on how much the Fed has to hike rates to bring inflation down.
Inflation has been identified by the Federal Reserve Bank as the greatest risk to the economy and businesses. Most Americans would agree with this position. Unfortunately, inflation, now at over 8 percent, has been much tougher than most pundits expected. As a result, the tightening of monetary policy by central banks that started this year will continue into 2023.
The longer inflation stays elevated, the longer and higher interest rates must rise. The main debt instrument that the Fed uses to raise interest rates is the fed funds rate. All other debt instruments sample this rate. Bond investors expect the Fed to eventually target interest rates above 5 percent. The Fed’s announced target interest rate is now between 3.75 percent and 4 percent. Bond investors expect the Fed to eventually target interest rates above 5 percent before all is said and done. That means we still have a significant amount of tightening ahead of us.
The Fed expects higher interest rates to curb demand by reducing economic growth while raising the unemployment rate. That would hopefully lower the inflation rate. Some economists might expect inflation to fall to 5-6 percent in this scenario.
I expect rising interest rates will cause the economy to slow down in the first half of 2023, leading to a mild recession and a fall in the headline inflation rate. I assume that the financial markets will remain volatile in the course of these economic developments. Traders who are witnessing a gradual fall in inflation will react quickly, markets will bid higher and expect the Fed to ease only to be disappointed.
The Fed will stand firm for months, I think, until they are confident their policies are working. This deviant behavior will upset investors. It will likely set off a series of vicious bear market rallies, only to see pursuers fall into nasty bull traps. I expect to see lower highs and lower lows throughout January and February.
Sometime in the first quarter, fears that the Fed will “over-tighten” and force the economy into an even deeper recession will circulate on both Wall Street and Washington. That will continue to fuel the fires of uncertainty and likely make life difficult for Fed officials, especially if the job market weakens. We may also see heightened stress in financial markets both domestically and internationally as credit markets tighten.
US corporate earnings for the benchmark S&P 500 index, currently at $225, are likely to turn it on its head. At best, I expect earnings to be flat from 2022 and worst-case scenario, could drop to around $200. Hitting a 15x win ratio on this number gives you a price level of 3,000 in the index, compared to today’s level of 3,900.
So I see a pretty nasty fall in stock markets in the first quarter to new lows that could take the S&P 500 index another 10-20 percent down from here. I forecast a final capitulation in the stock market towards the end of March 2023 with a temporary bottom of 3,200.
When do I see the Fed pivot or at least a pause in tightening? That depends on inflation, but I think it will be several months before the Fed is ready to ease policy once inflation starts to fall. That hasn’t happened yet. Let’s say it happens in the next six to nine months, sometime in the second quarter of 2023.
If so, I expect markets will anticipate this change. The US dollar will start falling, interest rates will start falling, and we should see stocks and bonds rise in the spring and throughout the summer. For the year, my estimate, which will certainly change as the year progresses, is a target of 4,500 for the S&P 500 Index.
I would expect assets that are negatively correlated to a falling dollar like materials, commodities, energy and maybe cryptocurrencies to do well. Emerging markets would also benefit, as would US and foreign stocks in general. If interest rates fall, bond prices across the board would rise, as would bond funds. High-yield dividend stocks and value stocks would also do well.
Bill Schmick is a founding partner of Onota Partners, Inc. in the Berkshires. His projections and opinions are solely his own and do not necessarily reflect the views of Onota Partners Inc. (OPI). None of his comments are or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at [email protected]
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