Inflation has finally subsided, and interest rates may soon peak. That means now might be a good time to get back into the market — even with a potential recession looming, some strategists say.
Forty years of high inflation and the sharpest interest rate increases by the Federal Reserve since the 1980s weakened people’s wallets last year. Stocks and bonds, which usually move in opposite directions, fell simultaneously, leaving the diversified classic 60%/40% bond portfolio, or 60/40, in disarray and investors with nowhere to hide. Morningstar’s US Target Average Allocation Index — designed as a benchmark for a 60/40 allocation portfolio — lost 15.3%, the largest annual decline since 2008.
But some say 2023 is on a different path, giving investors hope that they can begin to rebuild their retirement balances.
“In general, the inflation pendulum is swinging again now,” said David Russell, vice president of market intelligence at online stock and futures brokerage TradeStation. The bond market sees that, and so does the stock market. That 60/40 strategy can come back into action, and I think we’re seeing that happen today. We are seeing money flowing into bonds and the S&P and Nasdaq in particular.”
What happened last year?
When inflation soared to a 40-year high, the Fed last year raised its benchmark short-term rate on fed funds by a whopping 4.25%, including three consecutive 0.75% triples, to quell inflation. Higher rates increase the cost of borrowing for individual and corporate spending to invest in future earnings growth, slowing demand, the economy and inflation.
When interest rates jump, bond prices fall because old bonds become less valuable. Their coupon payments are now lower than those of new bonds offered on the market at higher rates.
The combination of high inflation and skyrocketing interest rates set the stage for a rare event: stock and bond values fell simultaneously.
“Back in 1929, there were only 3 years that bonds didn’t go up when stocks went down,” investment firm BlackRock wrote in a report last year. She added that the last time this happened was in 1969.
What if there is a recession?
Maybe it doesn’t matter.
“There’s so much negative sentiment, it feels like the recession has already been calculated,” said Peter Iseley, head of portfolio management at Commonwealth Financial Network. This was the most overhyped recession. I think people are kind of numb.”
Three-quarters of Americans already believe the economy was already in a recession last fall, according to a CNN poll. The AICPA Business and Industry Prospects Survey for the fourth quarter showed that 51% of businesspeople said the US economy is either already in recession or will be in the new year.
Since people are already preparing for the worst, Essele says “Normally, stocks drop 60% or so during a recession, but I think we are — or may have already hit bottom — a lot, much sooner in this recession.” Some economists say that Recent data also indicates a slowdown in the economy but perhaps no recession or shallow recession.”
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What could this mean for investors in 2023?
If inflation continues to trend downward as it has, the Fed pauses rate hikes as expected and all bad news is priced in, then it’s time to get back into the market, some strategists say.
“We have better clarity about where the end game is in terms of rates and inflation,” said Iseli, which is most important. He said it’s the unpredictability that’s bothering markets, not the level at which the Fed stops raising interest rates.
Also, if the economy falls into recession, the Fed could start cutting interest rates in the latter part of 2023, which could stimulate the economy, some strategists say. CME’s Fed Watch tool, which shows where investors think the fed funds rate will be at each policy meeting of the year, reflects this view as most expect a quarter-point rate cut in November.
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What are good investments?
“We’re going to see strength in housing stocks,” Russell said with signs that 10-year yields have peaked or are close to peaking. “Home builders are going to be very strong. There is a very strong structural demand in the country for housing.”
He also likes steelmakers and metals companies that have underperformed but can catch tailwinds from infrastructure projects.
In addition, “the combination of high home prices and rising rates put off buyers last year, but because home prices are lower, people will be more willing to buy in the hope that they can refinance in the future when prices are lower.” John Clough, managing director of investment platform Magnifi. He said a recession could lead to lower housing prices.
Bonds are also a good bet, again, for retirement portfolios. “Now that yields are much higher, I think bonds are much more attractive,” said Jason Capehart, director of multi-asset ratings at Morningstar Research.
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Don’t forget to diversify
Whatever you invest in, diversification is the key to weather swings in case markets move higher in fits and starts or as other strategists believe the stock market has yet to spot all the bad news and has room to fall.
Corporate earnings expectations remain very low, says Michael Wilson, senior US equity strategist at Morgan Stanley, pointing to a decline in stock prices “for which most were not prepared… The main reason is the high and volatile inflationary environment that is likely to hurt profitability.”
But this is where the traditional 60/40 portfolio comes in handy, optimistic strategists say.
Although the 60/40 portfolio didn’t do well last year, it was an aberration, she says. With bond yields rising this year, bonds can generate income for investors which will help protect against any downturn in stocks this year.
“The risks are slowly returning to normal,” Russell said. “After three years of severe turbulence, we are returning to balance. It is not a straight line, but the economy is returning to normal.”
If you’re still concerned, the strategists recommend dollar cost averaging. “By making regular investments in the same securities over time, you calculate the average price you pay for the security,” Claff said. This ensures that you take advantage of market dips and not have to worry about buying at the highest prices.
Medora Lee is USA TODAY’s money, markets and personal finance correspondent. Reach out to her at mjlee@usatoday.com and sign up for her free Daily Money newsletter for personal financial advice and business news every Monday through Friday morning.