Market Outlook 2023

“For the times they are a-changin’.”

– Bob Dylan

“Trying to predict the future is like trying to drive down a country road at night with no lights while looking out the back window.”

 – Peter Drucker

Introduction

Our 2023 Market Outlook represents our best thinking on what will unfold in the markets over the short and medium term. While we have a lot to share, I would preface it with one simple personal belief: trying to successfully predict what will happen in the markets over a short period of time is a fool’s game. With that in mind as you read this, I would ask you to place a greater significance on the big picture macro trends we raise and remember that our opinions may change at any time and often do.

With that said…

The world we have come to know over the last 40 years built on globalization, peace, and free trade is in our opinion over for the foreseeable future. We have entered a new period of greater macro, geopolitical, and market volatility resulting in a shift toward localization and protectionism. 

The effectiveness of long-held commonly accepted investment strategies and concepts such as the “60/40 portfolio”, “buy and hold”, and “bonds are a conservative investment” should be reassessed for a rising interest rate and inflationary environment, as many investors learned in 2022. While there will be peaks and valleys in inflation and interest rates on the way up, just like there were on the way down, a reset in the investor mindset and approach is necessary in our view as we navigate this new landscape. 

Throughout 2022 our proprietary risk management approach had us reducing exposure to risk assets and increasing our Dynamic Cash Allocation^© in client portfolios. Our Growth and Balanced Asset Allocation Models ended the year in defensive positions (exhibit 1). While this may change during 2023 if it does, we don’t think it will be the beginning of a sustained long-term equity or fixed income bull market, but instead more of a trading opportunity in a prolonged bear market.

We continue to believe that the Fed reacted too slowly in addressing inflation and, as a result, is now tightening too aggressively in the face of a weakening economy and a ballooning federal deficit. We believe the Fed will take too long to recognize this and change course. This playbook is being implemented, to varying degrees, in much of the developed world. Central bankers are playing a dangerous game that makes a 2023 recession in the US and globally a high probability in our opinion. 

Historically, one of the most reliable indicators of a recession is the spread between the 10-Year and 2-Year Treasury yields. When the 10-Year yield is lower than the 2-Year yield, as it is today, the probability of a recession is high (Exhibit 2). We think a recession is looming and will be more severe than the markets are currently pricing in. As a result, we believe central banks will eventually have to back off from rate hikes and return to a more accommodating monetary policy.

Geopolitical uncertainty is a major wild card today and, in our opinion, the market isn’t giving enough consideration to this. Geopolitical risk is creating a new and uncertain world order. We see geopolitical cooperation and globalization turning into a splintered world with competing interests. This comes at the cost of economic efficiencies and creates a heightened possibility of significant market volatility that we don’t believe the markets are currently reflecting.

One bright spot we see entering 2023 and beyond is the continued exponential growth in innovation. You wouldn’t know it based on how growth assets performed in 2022 and 2023 may be another difficult year. However, the world is facing many complicated challenges: global warming, food and energy insecurity, income and wealth disparity, providing healthcare for the masses, global monetary and financial market stability, and manufacturing fragmentation to name a few. Technology helps solve problems and should not, in our view, be underestimated in the long term. As market sentiment and the economic cycle changes over time, so will the long-term outperformance of growth assets in our opinion.

While we may be pessimistic about the current macro and market environment, we are optimistic about the future. Secular bear markets and economic recessions, no matter how severe and long, create the foundation for future secular bull markets and economic expansions in our opinion. If we are correct and markets continue their current secular downtrend, we want to be able to opportunistically take advantage when they bottom out as this may become a generational investment opportunity.

In 2023 we believe that volatility will pick up and trading ranges may emerge requiring a more strategic investment environment. While uncertainty is everywhere, I believe you can take comfort in our risk management approach and the knowledge that we will use it to adjust risk and the Dynamic Cash Allocation in your portfolio no matter what the new year brings.

Jay Bluestine, Managing Principal and Chief Investment Officer

Market Outlook

2022 was a year of repeated inflation surprises that sent bond yields soaring, causing significant pressure on asset prices with the exception of Commodities (Exhibit 3). Production constraints, misallocation of resources, geopolitical events, and a tight labor market have been the main drivers as pandemic bottlenecks and a shift in consumer spending from services to goods caused shortages. Moving forward we see several issues keeping production capacity constrained and impacting global growth for some time. This new reality stands in sharp contrast to the last 40 years of steady growth and lowering inflation.

As we enter 2023, the current wave of inflation seems to have peaked and we see it continuing to come down. To what level we will have to wait and see. Beyond covid-related supply disruptions and central bank miscues we see several medium-term drivers keeping inflation elevated such as: a shift towards localization in manufacturing, protectionism by countries disincentivizing cheaper imports, underinvestment in commodity infrastructure, an aging populating reducing the workforce, and geopolitical risks. 

However, there may be another wave of inflation in the second half of the decade due to the likelihood of any number of events causing central banks to start easing again, leading to an increase in liquidity and rise in asset prices, particularly in scarce commodities. This could result in a second more severe period of inflation in most industrialized countries.

If this does occur, it wouldn’t be the first time. In the 1970s, there was a second wave of inflation that was more severe than the first. At the time, the first wave was thought to be manageable, as it is perceived to be by many today. But it was during the second wave that the bond market demanded higher premiums and bond yields rose significantly. 

It is worth noting that since 2000 there have been three times the Fed was forced to aggressively lower rates. In each of these instances the equity markets eventually traded significantly lower: Dot Com Bubble -47%, Financial Crisis -55%, and the Covid Crisis -24% (Exhibit 4). While history may not repeat itself, we believe investors should be cautious at this time as a Fed pivot may not provide the immediate relief many are anticipating.  

Looking out a bit further, it is our opinion that the current economic mess is largely due to a significant amount of global government debt and a lack of political will by governments to restructure their economies. We are in a vicious cycle of growing deficits and debt that are being financed by each country’s or economic region’s central banks, which is not a sustainable long-term model in our opinion. While this will likely continue for as long as governments can get away with it, it can’t go on forever in our view, especially in the inflationary changing geopolitical and global economy we envision. 

In a worst case scenario, this could lead to hyperinflation in several developed countries and cause their governments to go bankrupt; this has occurred many times in emerging market countries in Latin America and elsewhere. As a result, there is a possibility the second half of this decade will be difficult and potentially lead to a severe recession.

Markets

Equities

From a fundamental standpoint, equity valuations currently don’t reflect the weakening economy, in our opinion. We think that current earnings expectations aren’t pricing in even a mild recession and will eventually come down 10-20% in 2023.

From a technical perspective, many of the broad equity indices continue to make lower highs and lower lows and are trading below their 200 Day Simple Moving Average (”SMA”) (Exhibit 5). Just as these moving averages can be strong areas of support in bull markets, they can become strong areas of resistance in bear markets. While these major indices continue trading below these moving averages, we will remain defensive as it is a sign of future weakness in our opinion.  We will turn more constructive on equities when they regain these moving averages, and our Dynamic Cash Allocation reacts to the change in market direction.

Fixed Income

The new landscape requires taking a different approach with bonds. Higher yields feel like a gift after years of low rates, but you don’t have to go far out on the curve to benefit from them, which is why we like short-term bonds. Based on our view on interest rates we don’t see long-term bonds as attractive at current levels.

However, if we go through periods of the Fed adding and removing liquidity, as we expect it will, long-term bonds may be a productive trading vehicle through different market cycles as they are the most sensitive to moves in interest rates.

Ultimately, we see bond investors demanding higher compensation for holding bonds as central banks revert to tighter monetary policy to fight, what in our opinion will be another wave of inflation during the second half of the decade, at a time of record debt levels. If this were to occur, investors holding intermediate to long duration bonds would experience significant losses.

This is clearly something investors should be aware of and monitor closely, as many retail investors still believe bonds are always a conservative investment. However, as they experienced this year, in an increasing interest rate environment bond prices can go down sometimes as much or more than stocks. This is something we don’t believe many retail investors have fully come to terms with.

Commodities

There are many intermediate-term drivers that can play a role in commodity prices moving higher in our view including localization, protectionism, recent underinvestment in commodity infrastructure, and geopolitical risk.

Consider the impact of western sanctions on Russia and how it has created the need for countries to pursue economic self-sufficiency in our view. As an example, China seems to be placing a priority on self-sufficiency in energy and food. Global central banks are now very aware of this risk and will significantly increase their exposure to neutral assets like physical and digital commodities (ie gold, oil, bitcoin, etc.) that can be stored in their country and/or are not able to be confiscated by other countries. As global cooperation breaks down, a focus on protectionism and possibly the weaponization of commodities may develop.

We also anticipate higher demand over the remainder of the decade as the global economy transitions to renewables. In the US alone we believe the Inflation Reduction Act is about to unleash an enormous amount of investment that will increase demand for copper, nickel, cobalt, and lithium.

Geopolitical risks can also have a significant impact on energy prices as we’ve witnessed in 2022. This uncertainty is a wildcard but can have a meaningful impact and should not be discounted.

The increased demand and drive towards local sourcing is occurring at a time when there has been an underinvestment in commodity infrastructure in general over the last decade. It will take time to address this as new mines can take years to develop. As a result, we place a high probability of demand and supply imbalances.

Final Thoughts

Investors should prepare themselves to deal with the longer-term reality of living with inflation and higher interest rates as well as a new period of greater macro, geopolitical, and market volatility.

This investment environment will highlight the importance of productive risk management strategies like our Dynamic Cash Allocation. We also believe it will involve more frequent portfolio allocation changes to balance the impact elevated macro and market volatility may have on asset prices.

It is our view that the broad markets will continue in a downward trading range for much of 2023. We believe sector, asset class, and investment theme exposures, rather than simply focusing on broad market exposures, will be necessary to productively navigate this market environment.

There were few, if any, in the financial industry that were predicting the number and swiftness with which the Fed raised rates in 2022. Almost every year there is one or a few unanticipated events that dominate the markets. We’d be shocked if 2023 is any different.

However, at Blue Square we are both realists and optimists. With that in mind, here’s hoping that we are wrong about 2023 and a major surprise is the markets have a positive year and client portfolios have outsized returns. Our days are more enjoyable when the markets are going up, but historically the probabiity for productive long-term returns increases after large drawdowns. If this were to happen this year, we will seek to be in a position to take advantage of it. There is always a silver lining in our view if you have a long-term investment perspective.

While uncertainty is everywhere, we believe you can take comfort in knowing that we will continue to invest based on our core principles. It is our strong opinion that you cannot predict the market’s short-term direction with any degree of success, but you can prepare for what actually happens and react accordingly. As such, we will continue to implement our rules-based risk management approach adjusting our clients’ portfolio exposure to risk assets based on what the market does. We believe this gives us the best opportunity to deliver better risk adjusted long-term returns for our clients than more traditional investment approaches. 

As always, please reach out if you have any questions or would like to discuss the material we’ve presented here in greater detail. We wish you and your family a healthy, prosperous, and meaningful 2023!

The Blue Square Investment Committee

Jay Bluestine, Managing Principal & CIO

Andy Ceisler, Principal & Director Asset Mgmt

This document contains forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “potential,” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory, and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties, and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of Blue Square Asset Management or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.