Investment Outlook: Strategies for a Volatile Market

The year 2022 was a testing ground for investors, marked by a grueling bear market. Inflation soared to heights not seen in decades, prompting an aggressive response from the Federal Reserve. This made it one of the most challenging years for investment returns in the last fifty years. But what can investors anticipate in 2023?

2. Managing Your Wealth

Finding a Financial Advisor and Private Wealth Advisor Near You

As we step into 2023, it's not the time to hold your breath for a swift recovery in U.S. equities. Instead, Morgan Stanley’s Global Investment Committee advises adopting a more patient approach, allowing the market to reward you in the long run. Furthermore, considering international opportunities for potential returns might be a prudent move.

Here's our 2023 forecast and three key strategies for investors to navigate the year effectively:

3. Temper Your Expectations for U.S. Stocks

The numerous bear-market rallies witnessed in U.S. stocks during 2022 seem to indicate that many investors haven't fully grasped the reality of prolonged higher interest rates and a slowing economy. Despite economic data and Treasury yields sounding warning bells, optimism prevails.

We believe there are two significant causes for concern as we enter 2023:

Unattractive Valuations

Equity risk premiums, which represent the potential excess returns from investing in stocks over risk-free bonds, remain relatively low. They currently range between 180 and 250 basis points, compared to a long-term average of over 350. This suggests that investors are not being adequately compensated for the risks they are taking.

Lofty Earnings Expectations

The consensus 2023 earnings projections for the S&P 500 Index hover around $230, assuming an earnings growth of about 5%. However, this estimate fails to account for the challenges companies are likely to face, especially as they begin to feel the impact of tighter monetary conditions. These challenges may include reduced sales volumes and decreased pricing power. We propose a more realistic forecast of $195, foreseeing a potential 15% to 20% retreat in the index before it stabilizes by the end of 2023.

4. Exercise Patience and Focus on Income Generation

With the trajectory of inflation and the overall economic outlook still shrouded in uncertainty, it's prudent for investors to emphasize fixed income within their portfolios. Currently, there are high-quality opportunities offering yields ranging from 4% to 6%. The potential for higher returns arises if the economy slows further or enters a recession.

Consider the following:

Two-Year Treasuries

Yielding over 4%, these offer a relatively secure option for income.

Investment-Grade Corporate Bonds

Providing returns of more than 5%, these bonds are an attractive choice for investors willing to accept a moderate level of credit risk while prioritizing quality.

Additionally, fixed income presents the possibility of capital appreciation. In the event of a slowing economy, investors may flock to "safe haven" assets, including U.S. Treasuries and higher-rated bonds, potentially driving their prices upward.

5. Exploring Emerging Markets

Historically, U.S. stocks have dominated investor allocations, but the time might be ripe for selective investment in emerging markets (EM) equities. Several factors support this move:

Attractive Valuations

EM stocks currently trade at historically low levels compared to their past performance and developed market equities. Their cyclically adjusted price-to-earnings ratios are notably lower.

Abating Headwinds

Challenges that previously hindered EM regions are expected to ease. The U.S. dollar has weakened from recent highs and could continue to do so in 2023, benefiting EM economies.

Positive Prospects for China

China, accounting for a significant portion of the MSCI Emerging Markets Index, is poised for economic improvement as it gradually relaxes its zero-COVID controls. The absence of high inflation or rising interest rates in China provides room for economic stimulus in 2023, particularly in the residential housing market. Moreover, China's growth potential could have positive ripple effects on other economies in Asia and Latin America in 2023, particularly in areas such as exports and tourism.

In conclusion, we urge investors to remain patient. The economic and market landscape is riddled with uncertainty, and investors should demand a premium for assuming risk. Be open to portfolio rebalancing as inflation and interest rates return to normalcy. For personalized insights and guidance on how the 2023 economic outlook and market forces may influence your investment decisions, connect with your Morgan Stanley Financial Advisor.