We continue to favor assets with the most predictable source of returns, US investment grade coupon payments (especially US Treasuries) and dividends from the most consistent growers.

Global markets surged in January as inflation eased and a short covering rally boosted the value of unprofitable firms and weak borrowers in credit markets (CCC-rated issues). Subsequently, strong January economic data reignited interest rate fears on legitimate concerns that inflation will only decelerate slowly.

We believe January economic data for the US are highly misleading, reflecting difficult adjustments for seasonal variation during the most extreme seasonal swings of the year. Nonetheless, we don’t believe the economic environment justifies “all clear views” for the economy. Reduced inflation will likely come at the price of stalled economic growth.

US jobs and retail sales data showed dramatic strength in January – likely signaling less weakness than reported during the prior two months. However, the sharp rise in inventories in 2022 – across retail, wholesale business and housing – points to reduced labor demand in the year ahead.

Corporate profits have fallen below our estimates in the final quarter of 2022, suggesting that our estimate for a roughly 10% EPS decline for the S&P 500 in 2023 is not excessively pessimistic. While continuing to cut estimates, industry analysts forecast an implausibly large EPS rebound during the second quarter of 2023. Their estimates also show a new record high for US EPS by 4Q 2023. This appears far too premature. As we expect declines in cyclical activity in the spring quarter as firms slash production, EPS estimates seem likely to be rationalized lower by midyear.

If economically sensitive equities correct lower in coming months, we would consider raising our allocation. For now, however, we favor strong and stable income opportunities in US fixed income and high quality dividend-oriented equities. Non-US markets in particular are more cheaply valued and should provide stronger returns as currencies appreciate against the US dollar. However, this could be realized in a period longer than our 12-18 month tactical return window.

In fixed income markets, we expect 10-year US Treasury yields to reach 3.0% at year-end 2023. However, longer-duration bonds are volatile and forecasts for bond price appreciation are not nearly as certain a source of return as coupon payments. Two-year US Treasury yields of 4.7% are higher and far less volatile.

With shorter-term yields rising most sharply in recent months as the Fed tightened rapidly, we have added larger overweight positions in short-term bonds within portfolios. However, these high short-term rates are likely unsustainable. The Fed expects its long-term policy rate to average 2.5%, with the rate likely reaching 5.0% later this month. Avoiding ultra-low yields such as Japan government bonds and very low quality credit has given us the capacity to hold large overweights in high-yielding, high-quality fixed income across maturities.

Overall, our long-term strategic return estimates in both equities and fixed income have increased following the double-digit losses in both bonds and stocks in 2022. Even as markets still suffer from the after-effects of excessive macroeconomic stimulus and restraint, we urge investors to avoid abandoning a diversified portfolio approach. Innovation drives economic growth, and over time far exceeds the value of even prescient market timing (see our Outlook for 2023 for discussion).