Outlook 2023: Why this could be a pivotal year for investors

“2023 COULD BE A FOUNDATIONAL YEAR FOR INVESTORS,” says Chris Hyzy, Chief Investment Officer for Merrill and Bank of America Private Bank. After a period that most investors would like to forget — with surging inflation, rising interest rates, geopolitical conflict and the worst performance for financial markets in decades — Hyzy characterizes the year ahead as “back to the new future.”

By that, he means a likely return to pre-pandemic economic conditions — and the opportunities that were emerging before the pandemic turned everything upside down. “The next business cycle could be characterized by new investing themes and new drivers of growth,” Hyzy says. Innovation will address many needs, from bringing supply chains closer to home to expanding and refining how big data is used to preparing for a more sustainable future.

And although the recession that may arrive later this year could feel like more bad news, it is likely to be mild and relatively brief, helping reset an economy that ran too hot for too long. This might provide an opportunity for investors to reexamine their strategies and portfolios and put themselves on firmer ground as they prepare for better days ahead.

Below, Hyzy and other top strategists from the Chief Investment Office (CIO), Merrill and Bank of America Private Bank, discuss what they believe will be the key drivers of — and risks to — growth in 2023 and share ideas for how you can prepare for both.

For more on the CIO’s outlook, read 2023 Year Ahead: Back to the New Future and also watch our webcast.

Headwinds vs. tailwinds

The transition to the new future may not be smooth, with conflicting economic forces likely to compete through much of the year, Hyzy says. That could create continuing uncertainty and disrupt investment markets. “The headwinds are still the geopolitical landscape, including the war in Ukraine; concerns about the timing of a recession in the United States, the UK and/or Europe; lockdowns in China that have limited its contribution to global growth; and the deep inversion of the yield curve, with interest rates on short-term bonds higher than those on long-term bonds,” he says.

The tailwinds are an expected sharp decline in inflation, stabilizing energy prices and corporate earnings, better equity valuations and, as a contrarian indicator, poor investor sentiment that could provide opportunities to purchase equities at low valuations as earnings recover. “This foundational year should be the base year or a jump off point of a renewed bull market cycle,” Hyzy adds.

What this could mean for your portfolio: “At a time when there’s so much uncertainty — including slowing growth and the lingering global impacts of the pandemic — it makes sense for your portfolio to be as diversified as possible,” notes Marci McGregor, head of CIO portfolio strategy. “On a scale of one to 10 for diversification, you want to be at a 10 right now, and that means using all of the tools in your toolkit, which could include investments in commodities, real assets and, where appropriate, alternative investments.” This would include exposure to global equities as well, McGregor says.

Tempering demand to control inflation

Particularly crucial to the outlook for 2023 is what happens to consumer spending, which accounts for more than two-thirds of U.S. gross domestic product (GDP). In addition, the labor market has been very strong, and wages have been rising. Those factors help explain why spending, especially on services, has remained buoyant. 

Unfortunately, for the Federal Reserve (the Fed) to succeed in tamping down inflation for good, it will take a rise in unemployment, which should lead to a moderation in consumer spending, Hyzy adds. This is why we’ve seen the Fed raise interest rates by more than 400 basis points in 2022 and into the beginning of this year, and the impact on the economy is likely to be a mild recession. But inflation, as a result, should continue to come down to more normal levels in 2023,  Hyzy says. “The Fed is showing a lot of resolve and is very likely to win this battle.”

What this could mean for your portfolio: Those conditions could benefit defensive stocks such as utilities and healthcare, as well as cyclical stocks that may recover as the economy begins to rebound. “We have a slight preference for value stocks over growth stocks, and we suggest broad exposure to the market,” says Hyzy. Looking further ahead, Hyzy sees another possible market shift, with small-cap stocks and select emerging markets, both of which have performed well recently, gaining momentum.

A tale of two halves

If a recession comes, the Fed will need to shift its attention from fighting inflation to encouraging growth. That could mean a pause in interest rate hikes in May, Hyzy says, and by the end of the year, rate cuts might begin. Against that backdrop, investing conditions are likely to shift mid-year. During the first half, high-quality bonds may outperform other parts of the market, while in the second half, conditions for stocks are likely to improve. Hyzy notes that stocks are a leading indicator. “With the potential for a mild recession, equity markets should start to anticipate a much better environment, with corporate earnings stability and ultimately a new profit cycle beginning in 2024,” he says.

What this could mean for your portfolio: Investors shouldn’t try to time that expected bond-to-equity shift, Hyzy emphasizes. Rather, you might take McGregor’s suggestion about greater diversification to heart. “Making sure you have a very broadly diversified portfolio at the start of the year can help you take advantage of potentially better risk-adjusted returns throughout the year regardless of when sentiment moves from bonds to stocks,” Hyzy says.

Finally: Real income from bonds

The historically low bond yields of recent years have frustrated investors looking for income, says Matthew Diczok, head of fixed income strategy for the CIO. And because bond yields were already at such low levels, they had little room to fall further. That meant that bond prices, which rise when yields move down, had scarce potential for appreciation. “Now we’re in a much better place,” he says. “Because yields are currently much higher, you not only get the income you need, but you also get more portfolio diversification — because if yields move lower, bond values will rise.”

At the same time, Diczok notes, investors who hold bonds to maturity don’t have to worry about volatility in yields and prices. “You get the income you need now, and as long as you match the maturity to your investing time frame, you get the return of your principal when it’s needed — to pay for a child’s or grandchild’s education, for example, or for other large, planned expenses,” he says.

What this could mean for your portfolio: Diczok suggests a mix of fixed-income holdings that includes four kinds of high-quality securities: U.S. Treasurys, agency mortgage-backed securities and investment-grade corporate and municipal bonds. “Historically, all of these have shown very little in the way of credit losses, regardless of what’s happening in the economy,” he says.

With volatility comes opportunity

After the stock and bond market declines of 2022, investors are understandably hoping for a calmer 2023. Still, McGregor expects ups and downs to continue, especially during the first half of the year. “Volatility is an integral part of investing,” she says, “and in a dynamic economy, slowdowns in growth are essential for removing excesses from the markets. Then capital can flow to the most productive areas of the economy, creating new drivers for the next business cycle.” McGregor notes that potential returns for many asset classes are better than they have been in years, especially for bonds.

What this could mean for your portfolio: Ongoing volatility will present chances for rebalancing your portfolio, McGregor says, giving you opportunities to increase allocations to global equities, for example. Stocks in energy and healthcare, among other sectors, are now paying attractive dividends. And long-term, growth-oriented investors could look for opportunities based on themes such as digitization, clean energy and healthcare infrastructure.

Know what you can control

Looking ahead, McGregor also sees a time of accelerating innovation. “Money is going to flow into all kinds of areas — artificial intelligence, big data, cybersecurity, cloud computing,” she says. “There will likely be a lot of investment in energy and commodities and a build-out of high-tech manufacturing coming back to the U.S.”

Yet the path ahead will inevitably be bumpy, with many factors remaining outside of an investor’s control. “You can’t control volatility any more than you can control what the Fed is doing, or what Congress does, or what the next geopolitical crisis may be,” Hyzy says. “But, with the help of your advisor, you can control your emotions and your investment approach, and you can stay the course on a plan built around your financial goals.”

Now, after such a difficult year and amid considerable uncertainty about how 2023 will unfold, having a conversation with your advisor may be more important than ever.