Quarterly market outlook - first quarter 2023

Asset class performance

Looking back at the fourth quarter

In a turnabout from the previous quarter, all asset class returns in our framework were positive in Q4. Equity markets largely outperformed fixed income, and high-yield bonds outperformed investment-grade bonds. Within our equity asset classes, international markets led domestic returns, as the U.S. dollar softened slightly. International large-cap stocks, represented by the MSCI EAFE Index, had the highest returns in our asset class framework, while international bonds had the lowest.

Volatile quarter for bonds

Fixed-income and equity investors alike closely watched bond yields, which continued to be volatile. Yields on the 10-year Treasury bond peaked at over 4.2% in late October, when Federal Reserve rate fears peaked, before falling to around 3.4% in early December and finally settling around 3.85% toward the end of Q4.

Inflation indicators moved noticeably lower

Forward-looking indicators such as the Manheim Used Vehicle Value Index, mortgage demand, and the Freightos freight transport cost index are pointing toward a swift move lower in inflationary pressures. Most market forecasts put the Consumer Price Index (CPI) at 3% to 4% by the end of 2023. We think the Fed will start cutting rates toward year-end, even though the policy rate will remain restrictive until inflation moves closer to the Fed’s 2% long-term target.

Equity valuations resumed their slide

The outsized drop in equity valuations that was a common theme for much of 2022 continued in Q4, overwhelming any growth in company earnings. Investors and analysts have been downgrading the present value of future cash flows, a calculation largely driven by the rising Fed policy rate, which increases the cost of borrowing and acts like gravity to corporate valuations.

Action for investors

With 2022 in the rearview mirror, we think now is a good time to make any last-minute tax moves. Look at retirement contributions and charitable donations, and consider any taxable impacts from portfolio moves made last year. Additionally, we believe it’s a good time to re-evaluate your income, expenses and expected savings along with your broader financial picture and goals. Inflation can impact your financial plan — so can changes in your career and lifestyle. Work with your financial advisor to keep your financial picture up-to-date and ensure your investment strategy still matches your long-term goals.

Unemployment rate (%)

Economic outlook

We think a mild recession will materialize in 2023 as the full impact of the Federal Reserve’s restrictive rate hikes filters through the economy. The housing market and business investment are likely to slow alongside household consumption, but we think the healthy starting point for the labor market will help consumer spending, paving the way for a renewed economic expansion as the year progresses.

Labor market will soften, but not prevent, a slowdown

We think any recession this year will be mild compared to history, especially the downturns in 2008, 1981 and 1974. Looking at the past 50 years, the average unemployment rate at the beginning of each recession was 5.2%. With unemployment starting this year below 4%, labor market strength should foster a shallow economic slowdown. In the past eight recessions since 1953, the trough in the unemployment rate ranged from 2.5% to 5.7%, while the peaks ranged from 6.1% to 10.8% (averaging a high of 7.9%). Although we expect unemployment to rise in 2023, job growth remains fairly healthy and job openings remain elevated, which should provide some cushion for household income and consumer spending.

Inflation on a downward trend

We expect price pressures to ease meaningfully in 2023, providing relief to consumers and central banks. Though the path could be bumpy at first, we see core inflation (excluding the volatile categories of food and energy) falling toward 3% by year-end. Easing supply shortages, lower consumer demand and excess retailer inventories should all contribute to a sharp slowdown in goods inflation. Price increases for services tend to be more persistent and slow-moving, but will also likely shift in the right direction as the year progresses. Housing inflation is poised to slow as home prices cool under the weight of higher borrowing costs. And a gradual easing of tight labor market conditions should slow the pace of wage growth, helping further ease inflation pressures.

Action for investors

We recommend proactive portfolio rebalancing and dollar cost averaging as strategies for navigating ongoing volatility driven by early-year recession fears. This may also help position your portfolio for a more sustainable stock and bond market recovery as the year progresses.

S&P sector performance, 2022

Equity outlook

After a challenging 2022, equity markets may continue to face headwinds in Q1. The Federal Reserve and global central banks are likely to enact a final leg of rate hikes, and the U.S. economy may enter a mild recession in the first half of 2023. In addition, S&P 500 earnings growth may be further revised downward in the months ahead. While markets have priced in some of these challenges — with the S&P 500 down nearly 20% in 2022 — there still may be further equity volatility ahead.

Is a recovery on the horizon?

Despite these headwinds, we believe equity markets may look forward to a recovery well ahead of the end of a potential recession. Historically, markets start to bottom and recover about six months ahead of the end of a recessionary period. In our view, the pending economic downturn is well-anticipated, and equity markets have started to discount some of this outcome already. We see an opportunity for markets to recover more meaningfully in the back half of 2023, as inflation continues to moderate, the Fed pauses its interest rate-hiking campaign, and the economy potentially stabilizes.

Sector diversification still a key portfolio strategy

From a sector perspective, the value and defensive parts of the market have outperformed, with energy, consumer staples, health care and utilities all holding up better than the overall market. As we head into a potential mild recession in early 2023, we would expect defensive sectors to continue to hold up relatively better than the broader market. But as we progress through the year, we believe cyclical sectors may rebound, and we would favor sectors that are levered to economic growth and moderating inflation, such as consumer discretionary and industrials.

Action for investors

We continue to favor defensive positioning near term but believe maintaining a balance of offense and defense in portfolios will be an important diversification strategy in 2023. For now, we recommend a neutral allocation to U.S. large-cap stocks, with an underweight to small-cap equities. As the year progresses, we would expect cyclical parts of the markets, including quality growth, to rebound.

Economic activity indicators suggest long-term yields might have peaked

Fixed income outlook

Historic inflation and aggressive Federal Reserve rate hikes pushed short- and long-term bond yields sharply higher in 2022. As inflation moderates and the Fed’s tightening campaign ends, interest rate volatility is likely to settle down, with upward pressure on yields starting to ease.

The end of the Fed’s tightening campaign is in sight

Last year’s interest rate journey dragged on as expectations for the federal funds rate kept adjusting higher, but these expectations have now stabilized at around 5%. With economic growth weakening and inflation falling, we think the Fed can end its rate hikes as early as the end of the first quarter. Historically, the peak in the 10-year Treasury yield has occurred about two months ahead of the last Fed rate hike.

Focus shifts from inflation to growth

We see early but convincing signs that the inflation tide will turn as we move through 2023. But the lagging impact of the Fed’s aggressive interest rate hikes and the sharp rise in borrowing costs could trigger a mild recession. The yield curve, which is one of the most reliable predictors of an economic slowdown, is deeply inverted, with short-term rates higher than long-term rates. As the focus shifts from inflation to growth, this can be a catalyst for improved bond performance. Yields undershot leading indicators of economic activity in 2021 but are now overshooting them. As this divergence starts to close, we believe the 10-year yield could fall toward 3%.

Bonds could be ready to rebound

In 2022, long-term bonds experienced their largest sell-off since records began in 1926. But bonds are now much better positioned to add both income and diversification benefits to portfolios, in our view. We believe investors can look for opportunities to complement their shorter-duration bond positions with longer-duration investment-grade bonds.

Action for investors

We recommend a neutral allocation to fixed income but see attractive opportunities across bond maturities as higher yields enhance return potential. Higher-quality bonds can offer stability, and longer-duration investments may benefit if yields begin to move lower.

International investments should see a boost from a softer U.S. dollar

International outlook

International equities have lagged amid a rising U.S. dollar and economic and geopolitical headwinds. We think global challenges (the war in Ukraine in particular) will persist, but possibly become less acute as inflation pressures recede, China’s economy stabilizes and the U.S. dollar softens, supporting the case for global investment exposure.

Diverging central bank policies reflect evolving cycles

While much of the globe is dealing with elevated inflation, we anticipate economic cycles will be less synchronized in the year ahead. The energy crisis and Russia-Ukraine War may temper the decline in Europe’s inflation, slightly delaying the European Central Bank’s ability to slow its rate hikes this year. That said, labor markets in Europe have shown improvement, policy rates are not as restrictive as in the U.S., and international valuations are at a sizable discount to historical averages and U.S. stocks.

A weaker dollar could boost international returns

We think the dollar could soften as improving inflation trends allow the Fed to pause its aggressive rate hikes in 2023. Also, global growth could start to recover in the back half of the year. Historically, international equities tend to perform well during periods of a weakening dollar, while U.S.-based investments typically outperform during periods of a strengthening dollar. Even a modest shift lower in the dollar could be a catalyst for international equity performance to improve.

China’s reopening helps the global growth outlook

We think emerging-market equities have the potential to outperform as the easing of China’s zero-COVID policies offer a boost to growth. The accompanying increase in the spread of COVID-19 in the region will complicate the reopening process, but we think China’s policymakers will be committed to an economic rebound, offering the prospects of a monetary and fiscal tailwind at a time when much of the world is experiencing restrictive policy conditions.

Action for investors

We recommend a neutral allocation to international developed-market equities, and a slight overweight to emerging-market equity allocations.

MSCI World vs. MSCI World ESG leaders (cumulative index performance)

Sustainable investing: Key questions for 2023

With sustainable investing, investors may align investments with their personal values or support companies that are focused on improving ESG (environmental, social and governance) practices. There are two broad approaches to sustainable investing: ESG investing and values-based investing.¹ ESG investments consider ESG factors as risks or opportunities in addition to traditional financial metrics and returns.These investments tend to perform in line with their asset classes, as the ESG focus should have a neutral impact on performance. Values-based investments, which include thematic and faith-based funds, place a higher priority on select ESG factors and may have potential risks and performance trade-offs.

How did sustainable investments perform in 2022?

ESG investment strategies generally performed in line with their relative asset classes in 2022, while certain thematic investing fared worse (see chart). ESG intentional funds prioritize both ESG considerations and investment fundamentals and may, for example, allow managers to own energy companies that are focused on policies around emissions and drilling. Climate-focused thematic funds, however, typically exclude traditional energy companies, which were among the best-performing sector last year.

How might increased scrutiny and regulation impact sustainable investing?

Last year was marked by increased concern from investors and regulators around potential ESG greenwashing practices, those that may mislead or overstate ESG principles. Some critics are pressing the asset management industry for more support of environmental initiatives, while others accuse it of boycotting traditional energy companies. Shareholders and regulators are now calling for more transparency, with the SEC proposing rule changes on ESG disclosures and other mandates.² We believe increased regulation and enhanced ESG disclosures could help investors make better-informed decisions.

Action for investors

Sustainable investing is an investor preference and may also help address your financial and nonfinancial goals. For those interested, we provide advice and offer investment choices to help you invest in a sustainable way.

Strategic asset allocation guidance

Our strategic asset allocation represents our view of balanced diversification for the fixed-income and equity portions of a well-diversified portfolio, based on our outlook for the economy and markets over the next 30 years. The exact weightings (neutral weights) to each asset class depend on the broad allocation to equity and fixed-income investments that most closely aligns with your comfort with risk and financial goals.

Opportunistic asset allocation guidance

Our opportunistic asset allocation represents our timely investment advice based on current market conditions and our outlook over the next one to three years. We believe incorporating this guidance into your portfolio may enhance your potential for greater returns without taking on unintentional risk.

Visit edwardjones.com for a discussion of portfolio performance.

Investment performance benchmarks

It’s natural to compare your portfolio’s performance to market performance benchmarks, but it’s important to put this information in the right context and understand the mix of investments you own. Talk with your financial advisor about any next steps for your portfolio to help you stay on track toward your long-term goals.

Asset class performance

U.S. equity sector performance

^{Source: Morningstar Direct, 12/31/2022. Cash represented by the Bloomberg US Treasury Bellwethers 3-Month index. U.S. investment-grade bonds represented by the Bloomberg US Aggregate index. U.S. high-yield bonds represented by the Bloomberg US HY 2% Issuer cap index. International bonds represented by the Bloomberg Global Aggregate Ex USD hedged index. International high-yield bonds represented by the Bloomberg Emerging Market USD Aggregate Index. U.S. large-cap stocks represented by the S&P 500 Index. Developed international large-cap stocks represented by the MSCI EAFE index. U.S. mid-cap stocks represented by the Russell Mid-cap index. U.S. small-cap stocks represented by the Russell 2000 Index. International small- and mid-cap stocks represented by the MSCI EAFE SMID index. Emerging markets represented by the MSCI EM index. All performance data reported as total return. An index is unmanaged and is not available for direct investment. Performance does not include payment of any expenses, fees, or sales charges, which would lower the performance results. The value of investments fluctuates, and investors can lose some or all of their principal. Past performance does not guarantee future results.}