This is the time of year where everybody starts making their predictions for what’s going to happen in the new year. I’m no exception, suggests David Dierking, exchange-traded fund specialist and editor of TheStreet's ETF Focus.
Some of these predictions will be ETF-specific. Some will focus on the markets or the economy. All will be relevant to the path of returns in 2023.
No Interest Rate Cuts From The Fed In 2023
This really depends on whose narrative you want to believe. The Fed says it’s targeting a rate of around 500-525 basis points when all is said and done sometime in the first half of the year. The futures market is calling BS right now and is pricing in quarter-point cuts at both the September and December meetings. Which one is right?
I’m leaning towards the Fed here because they’ve given no indication at all that they’re going to soften their stance any time soon. The two times this year that we saw bear market rallies based on the belief that the Fed would soon pivot, Powell shot down the idea both times (and did so without any ambiguity).
At last week’s meeting, he said clearly that the Fed will need “substantially more evidence” and that the labor market will be the metric used to assess whether pricing pressures will ease indefinitely. The economy is still adding 200,000 jobs a month and the unemployment rate hasn’t even budged. It’ll take months, if not longer, for the labor market to break. I don’t think the Fed even considers cutting until after that happens.
Treasuries Will Be The Best Trade Of The Year
I’ve suggested this more than once already this year and I have no reason to change my opinion now. After the worst bear market in history, bonds are showing strong signs of recovery. Treasuries have largely priced in the top of the interest rate hiking cycle and the long end of the curve has clearly turned its attention towards recession risk.
Long duration investment-grade credit (both government and corporate) have rallied strongly off of their bottoms, but junk credit has been steadily lagging. That’s the type of behavior you’d expect to see as investors position themselves more defensively.
We’ve seen it as well in ETF flows. Long-dated Treasuries have attracted a lot of new money over the past month after seeing ultra-short bonds take the lead prior to that. I had thought that investors might be hesitant to dip their toes back into the Treasury bond trade after what happened in 2022, but that seems like it’s not the case.
I believe that once recession draws closer, investors will continue to migrate to Treasuries for safety. As I write this, the 10-year Treasury yield is around 3.6%. I wouldn’t be at all surprised to finish the year in the 2.0% to 2.5% range.
A Stock Market Rally In The 1st Half Followed By Losses In The 2nd Half
Even though general market sentiment is bearish at the moment, it won’t be a straight line down. We’ve seen multiple bear market rallies in 2022 and we’ll probably see some more in 2023.
In my opinion, the biggest rally probably occurs sometime around the end of Q1 when the Fed officially finishes its work in raising interest rates. The market has been waiting for this for nearly a year and will be ready to go on a buying spree when it actually happens.
It’s impossible to ignore the macro backdrop though. The retail sector is weakening. The manufacturing sector might already be in recession. A housing market bust looms. Earnings expectations haven’t even really been revised lower in any major way yet. All of these factors likely contribute to the first half rally fizzling out again and leading to fresh lows for the S&P 500 during the second half.
Inflation Finishes Around 3%
It seems like not so long ago that economists were talking about how slow progress will be on the inflation front and how long it could be until we return to the Fed’s 2% target. I’ve heard forecasts of anywhere from 2 years to around 8 years! While the path from getting from a 7-8% inflation rate all the way down to 2% certainly won’t happen overnight, I also don’t think it will take nearly as long as everyone thinks.
If you look at the month-over-month headline inflation rates in the United States, the last five months have looked like this - 0%, 0.1%, 0.4%, 0.4%, 0.1%. That’s an annualized rate of around 2%. This could be a quick decline from November’s 7.1% rate once those high base effect numbers start rolling off, even if we don’t get all the way down to 2% at the end.
The core CPI rate is stickier and still has more work to do, but we know that shelter costs are the biggest component of this number. Remove rent of shelter from the equation and the core rate has actually DECLINED two months in a row. If the housing market continues to contract, shelter costs come down, core CPI comes down and, by extension, the headline inflation rate.
Annual ETF Flows Make A Run At $1 Trillion
This might be a bit of a long shot, but it’s also not out of the question. U.S. ETFs will probably end up with net inflows of between $600 and $700 billion when all is said and done. That probably makes the leap from $600 billion to $1 trillion seem unlikely, but ETFs took in more than $930 billion in 2021. The ETF industry came close to the $1 trillion mark just one year ago and I think they’ll do it again.
ETFs have shown the ability to draw in money regardless of the environment. It took a step back this year with bear markets in both stocks and bonds having a big impact, but 2022 was still the 2nd best year on record despite it. Economic conditions should be at least a little more balanced for a while in 2023 and I think that could give ETF flows a big push.
Lots Of ETFs Closing
2022 was a big year for new ETF launches as well. We’ll probably end up with a little more than 300 net new launches this year, which would also be 2nd place all time just behind 2021. That year came within a stone’s throw of 400 net new launches.
In other words, a lot of new issuers and a lot of new product has hit the market over the past two years. A lot of it will struggle to gain traction and not all of it is going to survive.
I think issuers are going to start to cut bait on some of these tiny, more niche strategy type of ETFs and we’re going to see that net new ETF number much closer to zero than 300-400. The record for number of ETF closures in a calendar was 2020 with close to 300. We could hit that number again.
Raging COVID Pandemic In China
This one doesn’t have anything to do with the financial markets specifically, but it will have a lot of spillover effect. The government’s zero COVID policy was incredibly draconian in nature, but it did have the desired effect of limiting the number of coronavirus infections (if you want to believe the official numbers, of course).
But now the country is entering a new era. Unfortunately, most of its citizens have no exposure to COVID, but the recent rollback of the zero COVID policy in response to mass protests recently is probably going to unleash a torrent on the nation’s population.
Eventually, the reopening may have the end effect of igniting a surge in consumer demand, which could help lift the entire global economy, but I think it’s going to take some time to get there. In the meantime, I’d expect a lot of struggles for China in the 1st half of the year, both economically and health-wise, and it’s likely to add to the pressures of an impending global recession.
The Best Performing Sector Will Be Consumer Staples
Let’s make a few more specific calls. As far as how the U.S. stock market will play out in 2023, I fall into the majority opinion that equities will finish in the red again. Given that we haven’t even entered a recession yet, but the Fed plans to keeping monetary conditions incredibly tight for the entire year, I think it’s very likely that the bottom on the S&P 500 isn’t in it and we’ll keep trending towards new lows.
That keeps defensive, value and low volatility stocks near the top of the performance charts. The natural pick might be utilities, but I’m not sure that’s the right pick. Utilities are debt-heavy businesses and yields have gone from 1% to 4-5%. I think there will be a lot more pressure on balance sheets and that opens the door for another traditionally defensive sector to jump into the lead.
The Worst Performing Sector Will Be Materials
The materials sector has been one of the market’s success stories this year (relatively speaking). It outperformed in the aftermath of the Russian invasion of Ukraine, fell back to earth as commodities prices began to moderate, but has had a solid run over the past 2-3 months.
As of now, materials have outperformed the S&P 500 by about 6-7% year-to-date.It’s tough to see it lasting though. Most commodity prices are back around their pre-invasion levels. Cyclicals have held up throughout 2022 on the belief that any potential recession might get pushed out another 12 months into the future.
The can can only be kicked down the road so far. Manufacturing is already contracting and likely to get worse as the year goes on. Factory demand will start drying up. The homebuilder market is collapsing too. The cyclical downturn is likely to continue and one of 2022’s biggest winners could turn into one of 2023’s biggest laggards.
No Bitcoin ETF In 2023
This isn’t a stretch by any means. We got bitcoin futures-based ETFs last year, but still no spot bitcoin ETF. The SEC keeps refusing to approve these products based on their deregulated nature. Gary Gensler has consistently said that he’s uncomfortable with the risks involved in crypto and is unlikely to change his mind until the regulatory environment changes.
It was already unlikely before, but given the FTX blowup and the issues with BlockFi, Binance and others, I think there’s no way the SEC touches this now. Should there be a spot bitcoin ETF? I think so. Will it happen eventually? Probably. Will it happen in 2023? I just don’t see a path.
Single Stock ETFs Will Be A Bust
Even a few months ago, this was supposed to be one of the breakout categories of ETFs. Funds that provide inverse or leveraged exposure to a single stock within an ETF wrapper would provide easy access to strategies they might not normally have if they don’t have the clearance or expertise. Some people thought it was possible we could see hundreds of new ETF launches based on single stocks.
As of today, we have about two dozen single stock ETFs in existence with a total of around $300 million in assets. Around 75% of those assets belong to just three ETFs - the Direxion Daily TSLA Bull 1.5x Shares ETF (TSLL), the AXS TSLA Bear Daily ETF (TSLQ) and the Direxion Daily TSLA Bear 1x Shares ETF (TSLS). Most of the other ones in this category still have less than $5 million in assets.
I think it’s safe to say at this point we won’t be seeing hundreds of single stock ETFs. We might not see many more than we see right now. Clearly, there’s some demand to trade Tesla shares, but that’s about the only one.
Even ETFs based on Microsoft, Alphabet, Amazon, Apple and Coinbase haven’t garnered much interest. Not only do I suspect we’ll only see a handful more of these products get launched in 2023, I think we’ll see some closing in 2023 as well despite their recent launch.
International Stocks Will Outperform The S&P 500 By At Least 10%, Ushering In A Decade Of Dominance For Foreign Stocks
If you look at history, U.S. stock and international stock leadership trades off in roughly 10-year cycles. The current U.S. stock leadership regime traces all the way back to the end of the financial crisis, so you could argue that it’s already overstayed its welcome. On top of that, the performance gap over this period has grown so huge and created such a disparity that the ratio between the two is nowhere near historical norms.
I believe the pendulum starts swinging back towards international stocks again and it starts now. It would be a bit counterintuitive to think that emerging markets would lead heading into a recession, but this is no normal environment.
The dollar continues to decline and I believe it won’t stop until the dollar index gets back to 100. Valuations are ridiculously cheap with some P/E’s in the 5-6 range. Dividend yields are high. Value has done well throughout 2022 and should continue to do so in a cyclical recovery.
I think a lot of investors have ignored international stocks for years, but 2023 will be the year where they start missing out on potential real gains.
The 10-Year/2-Year Treasury Yield Spread Will Break -100 Basis Points
Again, this would be a good example of something incredibly unusual happening in an incredibly unusual market environment. A triple digit 10Y/2Y spread hasn’t happened since the early 1980s. It’s at -69 basis points today. Even at this level, it’s an historical outlier, but I think there’s a pretty clear path to hitting -100. It’ll require the Fed to stay firm on their commitment to keep monetary conditions tight well into 2023.
If the Fed remains hawkish, the 2Y yield could continue to hover around the 4% level since it tends to correlate strongly with what the central bank does. The long end of the curve, however, would respond to recession risk.
As I noted above, I think long-term Treasury yields will fall significantly this year as investors seek safety. If the 2Y yield remains around its current level and the 10Y falls into the 2’s, you’ve got your spread of -100 basis points. It’s more likely than you might think.
