Faced with soaring inflation and rising interest rates, Kelly Bogdanova, vice president, US portfolio analyst, portfolio advisory group and Thomas Garretson, senior portfolio strategist of fixed income strategies, US portfolio advisory group at RBC Wealth Management discuss the outlook for US equities and fixed income in 2023.

US markets could change course more quickly, and in different ways, than investors might assume, RBC Wealth Management said last week. 

Even if the economy succumbs to recession in 2023, if history is a guide, the equity market would likely begin a new bull market cycle before the recession ends, the firm said in a statement. 

In fixed income, the window to put money to work is now open, but could close sooner than expected. RBC believes it’s time to bring portfolio asset allocations in line with long-term strategic recommendations.

US equities  
According to Kelly Bogdanova, equity market sentiment could benefit from declining inflation in 2023. Price trends for commodities and goods are already pointing in this direction, although there are still reasons to remain vigilant. 

The economy is still at risk of succumbing to a recession, she said. “And while we anticipate inflation will decline, there is an open question as to how fast and to what degree. This can impact the market’s valuation. Generally, elevated inflation and interest rates over the medium term, resulting in lower equity market valuations, and vice versa,” she continued.
 
She believes that the most important objective for investors is to review portfolios and bring them in line with long-term strategic allocation recommendations. 

“Allocations naturally get out of whack during corrections, and there is industry evidence that large cash positions have piled up in portfolios,” she said. “We think attempting to time the market is a precarious exercise. There is no bell that rings when a new bull market cycle begins. Missing the biggest rally days can have detrimental long-term performance consequences, and such rallies often occur unpredictably before all of the obstacles are out of the road,” she continued.
 
“Once allocations are brought back into balance, we would keep an eye out for opportunities as the economic, interest rate, and earnings' pictures start to become clearer,” she said.
 
“Currently, we favor the small-capitalization and midcap segments of the US equity market. Their valuations are relatively inexpensive compared to large caps and their own historical averages,” she continued. 

“This should provide a cushion as earnings' estimates adjust further. When the US economy works through challenging periods, these more economically-sensitive segments often lead the early stages of the next bull market phase,” she said.
 
“Within the large-cap S&P 500, we continue to favor the energy sector,” she continued. “Consensus earnings' revisions are holding up better than most sectors. Tight energy commodity supplies are unlikely to be fully resolved in the near or medium term due to many years of capital underinvestment. This should help support commodity prices and energy company earnings to a greater degree than in typical periods of economic weakness,” she said. 

US fixed income   
According to Thomas Garretson, the Fed’s sole focus in 2021 was returning US labor markets to “full employment,” the first side of its congressionally-given dual mandate, and long judged by the Fed to be around 4 per cent. Unemployment fell to 3.9 per cent in December 2021 and has remained at and even below the target level since. 

In 2022, the Fed became hyper-focused on returning the economy to “price stability,” the second side of its mandate and defined as prices rising 2 per cent annually on average through any given business cycle. While it will take time for the inflation to get there, the aggressive action from the Fed in 2022 has laid the foundation for it to return to target in due course, in his view.
 
“That now sets the stage for the Fed to turn its focus in 2023 to its unofficial third mandate – financial stability. The historically aggressive tightening campaigns by the Fed and many other global central banks will likely necessitate a far more cautious approach from policymakers, and a heightened focus on â€“ and consideration of – domestic and global financial vulnerabilities that may come as a result of higher interest rates, particularly from the strength of the dollar,” he said. 

“This could mean the Fed soon places the blunt tool of rate hikes back in the toolbox and employs more surgical, macroprudential measures that help to ensure the soundness of, and liquidity within, the financial system,” he continued.
 
“We anticipate the Fed’s likely 50 basis point rate hike at the December 13 to 14 meeting will bring short-term rates to a 4.25 per cent to 4.50 per cent range and will mark the last of the jumbo-sized moves. Any further rate hikes in 2023 should continue at 25 basis point increments, and only if justified by the incoming data, while attaining a level no higher than 5 per cent by Q1 2023, in our view,” he said. 

“Then, as the generally assumed 12- to 18-month lagged impact of rate hikes that began in March 2022 begin to significantly weigh on economic activity by the middle of 2023, we foresee the Fed delivering a series of modest rate cuts over the course of the back half of the year as it works to engineer some semblance of an economic soft landing,” he continued.
 
“Markets, forward looking as they are, may already be in the process of pricing in such a scenario as recent soft consumer and producer price data have driven Treasury yields sharply lower from this year’s highs,” he added. 

He believes that the sharp rise in yields across the fixed income landscape that played out over the course of 2022 will give way to the opposite in 2023. For example, the benchmark 10-year Treasury yield could fall below 3.5 per cent by the end of the year, from levels close to 4 per cent currently, based on RBC Capital Markets’ forecast.
 
“The net result for fixed income investors is that the window to put money to work is open, and it could close sooner than expected. Based on Bloomberg bond indexes, Treasuries yielded 4.2 per cent, investment-grade corporate bonds 5.4 per cent, and tax-exempt municipals 3.7 per cent as of November 22,” he said. 

“Should yields on offer fade over the course of 2023, as we broadly expect, that could introduce heightened reinvestment risk for short-maturity securities. We continue to favor a strategy of locking in historically-high yields in intermediate and longer-dated bonds to maintain income, and to benefit from capital appreciation should bond prices move higher, and yields lower, due to recession risks in 2023 and the potential for Fed rate cuts as a result,” he continued.