Making sense of the markets this week: January 1, 2023

Before looking ahead to 2023, I just want to give a big “Thank you” to writer Dale Roberts and our editorial team, including Jon Chevreau, Lisa Hannam and Jaclyn Law, for filling in while I was on vacation. Dale wrote an excellent recap of 2022 last week, so I thought the natural follow-up would be to look ahead at the big picture for 2023.

First off, making predictions about investment outcomes and macroeconomic events is notoriously difficult. If you want to feel less badly about your job performance, look back at the predictions for 2022 most folks made this time a year ago. A general summary of “expert opinions” at the end of 2021 would likely go something along the lines of: 

“Coming out of COVID, the economy is ready to run wild. Never have consumers had more money in their pockets and the country with more jobs than people to fill them. The labour market hasn’t looked this strong in a long time. We’re predicting a solid year of 6%-plus gains in the stock market, with the potential for above-average returns.”

Then, the war in Ukraine with Russia happened.

And, inflation happened.

Then, everything changed. And all the assumptions about the year went out the window. 

The weird truth is that this complete upending of expectations is much more common than one might think. 

With that in mind, rather than make hard predictions—which could later be pointed to as evidence that I don’t know what I’m talking about—I felt it would be more intellectually honest to preview the probable major stories of the year, and to throw a few curveballs your way.

Inflation will continue to dominate the news

People who are unemployed feel the unemployment rate: but everyone feels the inflation rate.

Nothing gets people’s attention faster than paying higher prices for housing, gas and groceries. That’s what makes it such a tempting news story to keep reporting on. It also makes it almost impossible for politicians and policy makers to ignore.

Until the inflation rate comes down, to at least 4% (it’s currently 6.8%), I don’t see most investment commentators talking about much else.

It’s not that inflation itself is all that dangerous to long-term investors; it’s the accompanying response of central banks around the world that is the catalyst for concern. There’s a reason why “Don’t fight the Fed” has become a mantra for so many successful investors—to some degree, interest rates determine the value of all asset classes. 

Higher interest rates ultimately mean less borrowing and less spending. This often results in lower earnings per share and, consequently, reduces the value of most companies (whether publicly traded or privately owned).

For many years, when stock-market advocates were presented with evidence that company valuations were getting overstretched, they liked to say, TINA, which stands for “There is no alternative.” If you didn’t want to throw your money into pixie-dust-like assets, such as cryptocurrency or NFTs, then one of the few alternatives to stocks was 1% to 2% fixed-income returns. Most stocks looked pretty good in that environment.

However, when you can go online and grab a 5% GIC (guaranteed investment certificate), suddenly there is most definitely an alternative! When the mental stress of a bad year in the stock market comes at the same time as a very low-risk alternative emerges, that’s a recipe for the mood to sour on equities in a hurry. 

Moving forward, I’d argue real estate returns may fall into the category of TIASA: “There is a safer alternative.” Why take the risk in buying a rental property when mortgage costs are dramatically rising and housing prices are still elevated from where they were pre-pandemic? That 5% GIC investment option is just sitting there. That’s 5% without any landlord headaches, a simple five-minute time commitment, and no risk of a market crash to keep you awake at night. Canadian real estate investment trusts (REITs) are down nearly 26% this year. And that risk-free rate no doubt has something to do with that.

All this is to say: The effects of inflation are keenly felt by both consumers and investors. Those will feel all the more pertinent in 2023 due to their absence for the past two decades. I’ve written about Canadian investments for inflation hedging at MillionDollarJourney.com.

The Russian invasion remains predictably unpredictable

None of the experts I read about a year ago predicted Russia would invade its neighbours and send geopolitical shockwaves reaching every corner of the planet.

None of the experts I read about 10 months ago predicted the Ukrainian military response would be able to stand up to the Russian war machine for more than a few days.

At some point maybe it would be best to admit that the experts really have no idea where this conflict is headed. Despite the tragic loss of life and catastrophic disruption of society, it seems to me that there is little evidence that either side will back down as we enter 2023. 

From a purely economic standpoint, the costs of the war have been well documented:

• Russia’s economy has contracted by more than 5%, and will likely continue to shrink in 2023. Foreign direct investment is also down massively.
• Long-term spin-off effects of losing so many young men, crippling sanctions and a hastened demographic demise are impossible to quantify, but it will be painfully felt for generations in Russia.
• Ukraine lost a third of its gross domestic product (GDP) in 2022, and that market destruction will continue in 2023. The extent of its population loss and infrastructure deficit is almost unimaginable. 
• With Ukrainian and Russian exports in key areas like energy and food so compromised by the conflict, Europe and many emerging markets around the world have seen their economic growth forecasts evaporate.

If the war were to end tomorrow, the deflationary effects could be immediate and massive. By itself, that one event might bring inflation back down to acceptable levels and encourage renewed business investment around the world.

If—and this appears the more likely situation—the war drags on or escalates, it becomes difficult to quantify the damage inflicted on economies, like Germany’s, which are so dependent on Russia’s energy. 

Sure, demand destruction and the Green Revolution are coming… eventually… and at substantial cost. Even scarier is the unpredictable nature of the response to food shortages in desperate countries around the world. Generally speaking, food riots aren’t good for business (or humanity).

From a Canadian perspective, shortages in energy and commodities around the world may lead to a short-term boost for the resource-rich TSX. The iShares S&P/TSX Capped Energy Index ETF (XEG), iShares Global Agriculture Index ETF (COW) and iShares S&P/TSX Capped Materials Index ETF (XMA) might be worth a look if you want an active-management angle. 

That said, I think most Canadian economists would agree the war is a net negative, even for our natural resource-rich economy.

The much-talked-about recession will continue to be talked about

I’ve been writing about the definition of recessions and the psychology of recessions since I began writing the “Making sense of the markets this week” column in early 2022.

At this point, I feel like we might forecast a recession forever.

Whether a recession will ever actually arrive or not is another story. 

With inflation in the U.S. falling to an annualised rate of 3.7% over the last three months, I’d argue we’re not only past peak inflation, but are actually well on our way to some sort of “new normal.” With a substantial lag between when monetary policy is announced, and when its full effects are felt, we might not need a recession to lower inflation despite all of the headlines.

Of course, I continue to refer to the fact that whether we see two quarters of -0.1%, and -0.1% GDP shrinkage, or a quarter of -0.3% growth followed by a quarter of 0.2% growth, the distinction of “recession or not” is irrelevant. The first scenario is a technical recession by most definitions. The second scenario is just a bad quarter followed by a less bad quarter. Whether we have a recession or not really isn’t that important in the long term.

What questions most people should really be asking about current economic conditions are:

1. How bad will things get overall, when it comes to labour markets and economic growth?
2. Is this likely to affect my job or business?
3. Have the asset markets (such as stock or property markets) in which I’ve invested my money already anticipated the bad stuff coming by “pricing it in”?

For now, I think the answers from most of us would be:

1. Somewhat bad overall. Worse in some areas. Neutral in others.
2. Probably not.
3. Almost assuredly.

Remember that the stock market and the economy are not the same thing. Professional investors look past current events—they’re aware of the recency bias. They foresaw some rough waters ahead throughout 2022, but that doesn’t mean 2023 will also be so bleak.

6 white swans for 2023 

We didn’t accurately foresee much of 2022, so it’s quite possible that we simply have no idea what we’re in for with 2023. Essayist/mathematician Nassim Taleb popularized the term “Black Swan” within financial circles, and there is certainly potential for negative surprises this year. (A China-Taiwan conflict continues to be my biggest fear.) However, considering how well a positive bias has worked out for investors in the past, let’s take a quick look at some possible upside surprises.

1. Forward-looking stock markets see past any “hard” or “soft” landings and surprise on the back of earnings-per-share strength.
2. Capital continues to move from unproductive assets like cryptocurrencies (the downfall of which I correctly predicted in one of my first columns for “Making sense of the markets this week”), as well as speculative plus unprofitable tech stocks, and moves into more productive parts of the economy.
3. Supply chains adjust to a new normal with or without China, and disinflationary pressures continue their downward trend from the latter half of 2022.
4. Overall labour markets remain strong in the face of decreased activity in certain sectors, enabling most developed world economies to weather any short-term economic storms.
5. Increased rates of entrepreneurship, which will make people’s lives better in ways we cannot predict.
6. The combination of interest rate price pressures and increased political pressure to cut bureaucratic red tape leads to a better balancing of supply and demand in the Canadian housing market: making housing more affordable for first-time home buyers while not losing a massive amount of jobs.

Despite all the much-reported chaos in the world, if you bet on positive market outcomes, you’ll look smarter more often than not. So, I’ll break my own rule and make a—gulp!—prediction that a year from now the S&P/TSX Composite Index will be up 12% to 21,600. That said, a year from now, I may have a different perspective, especially if the market is down 12% instead of up by the end of 2023. I might forget to look back at this column when we wrap the year! But, it’s always safe to predict that markets will fluctuate!

Kyle Prevost is a financial educator, author and speaker. When he’s not on a basketball court or in a boxing ring trying to recapture his youth, you can find him helping Canadians with their finances over at MillionDollarJourney.com and the Canadian Financial Summit.

About Kyle Prevost

Kyle Prevost is a financial educator, author and speaker. He is also the creator of 4 Steps to a Worry-Free Retirement, Canada’s DIY retirement planning course.

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