What’s ahead for investors in 2023?
The full impact of the Fed’s restrictive monetary stance will become more transparent in 2023. The unemployment rate is expected to tick up as the economy slows down and companies seek to reduce costs. This process has already begun, with a rash of head count reduction announcements in the once-hot tech sector. A negative wealth effect from declining asset prices will begin to filter through the economy and slow demand.
The inverted yield curve is an indicator of economic weakness in the future. The market is currently predicting that the terminal rate for Fed increases will be around 5%-0.75% above where observers expect rates to be after the December FOMC meeting. It’s always possible that inflation could prove to be more resilient than expected and rates could rise higher. The level of volatility in both equity and fixed income markets will remain elevated, regardless of the outcome, until it’s clearer that the Fed is winning its battle with inflation.
It can be painful for investors enduring this volatility—but there’s a silver lining to consider. The sell-off in financial assets has created an improved risk–return profile for many asset classes going forward. Consider municipal bonds as one example. At the beginning of 2022, a taxable investor based in California could purchase a laddered municipal portfolio with a tax-equivalent yield of slightly less than 3%. That portfolio now trades at a tax-equivalent yield of above 7%, or 4% higher than in January, thanks to the sell-off in rates. Yields in fixed income haven’t been this high since before the 2008 global financial crisis.
A similar situation exists in equity markets. When investors purchase equity shares in a company, they’re paying for that company’s future earnings. The key metric is the forward price/earnings (P/E) ratio, which is price the investor pays for a dollar of earnings in the future. Using an estimate of forward earnings, the sell-off in equities has made them cheaper with foreign developed-market and EM equities trading at a significant discount to domestic equities.
P/E ratio of global equity indexes
Source: FactSet, 11/20/2022. For illustrative purposes only. Not a recommendation to buy or sell any security. It is not possible to invest directly in an index.
Could stocks decline further in price? Of course. Earnings could underperform expectations, P/E ratios could decline further, or both could happen in a recession. Buying a broad basket of equities at a lower P/E ratio simply means that an investor pays less for those companies’ expected earnings. It reduces the likelihood that they overpaid for earnings, but it doesn't eliminate it.
The bottom line
The Fed took aggressive actions to reverse the course of inflation and created a headwind for investors. However, the pain of 2022 has led to opportunities for investors heading into 2023. Parametric stands ready to assist investors as they navigate what we expect will continue to be a volatile market environment.
Experts expect tax-loss harvesting to add 1% to 2% of additional after-tax performance per year to a diversified equity portfolio and 0.3% for a fixed income portfolio. For more information, see Shomesh E. Chaudhuri, Terence C. Burnham, and Andrew W. Lo, “An Empirical Evaluation of TaxLoss-Harvesting Alpha.” Financial Analysts Journal 76:3 (2020): 99–108; and Andrew Kalotay, “Tax-Efficient Trading of Municipal Bonds,” Financial Analysts Journal 72:1 (2016) 48–57. These studies did not involve Parametric or its clients. There is no guarantee that a tax-management strategy will result in increased after-tax returns. Results will differ based on an individual investor’s circumstances.