Until late summer this year we thought that corporate and consumer resilience will be able to withstand the significant increase of interest rates, wealth destruction, and global geopolitical uncertainty. As such, we thought that buying the pullbacks in risky assets, such as the one in June, was the right strategy. As the expected peak in short-term interest rates moved from 3% to 5% (terminal Fed Funds) and prospects for geopolitical de-escalation faded in early fall, we abandoned our positive view in the near term. We believe that further market and economic weakness may occur as a result of central bank overtightening. There is good and bad news for equity markets, and more broadly risky asset classes, in 2023. The good news is that central banks will likely be forced to pivot and cut interest rates sometime next year, which will result in a sustained recovery of asset prices, and subsequently the economy, by the end of 2023. At that time, markets likely will focus on better economic and corporate fundamentals in 2024 and trade at levels higher than now. The bad news is that this will require central banks (primarily the Fed) to cut interest rates, and in order for that pivot we will need to see some combination of more economic weakness, an increase in unemployment, market volatility, decline in levels of risky assets, and decline in inflation. All of these are likely to cause or coincide with downside risk in the near term.

Our view on risk markets in 2023 consists of 2 periods: market turmoil and economic decline that will force interest rate cuts, and subsequent economic and asset recovery. However, the critical parameters of this market path are the depth of the correction that prompts the Fed pivot, and the point in time next year that this pivot happens. It is hard to give a precise answer on those two questions, but we believe that 1) previous lows in equity markets are likely to be re-tested as there may be a significant decline in corporate earnings, at a time of higher interest rates (implying lower P/Es and lower prices relative to the 2022 lows); and 2) we are inclined to think that this market decline could happen between now and the end of the first quarter of 2023. Indeed, one can imagine market turmoil as soon as at the end of this year similar to the 2018 episode (QT and manufacturing recession), or a selloff post the potentially weak Q4 earnings season in February next year. A mitigative factor for this near-term negative view is the continued low positioning in risk assets. Risks to our view include continued consumer and corporate resiliency pushing out the downside market scenario to late 2023, or a sharp near-term decline in inflation that could prompt a Fed pivot without significant economic damage.