Inflation is finally cooling down and interest rates may soon peak. That means now may be the right time to jump back into the market, even with a possible recession on the horizon, some strategists say.
Forty years of high inflation and the most aggressive rate hikes by the Federal Reserve since the 1980s ravaged people’s wallets last year. Stocks and bonds, which normally move in opposite directions, plummeted at the same time, making the classic diversified portfolio of 60% stocks/40% bonds, or 60/40, a mess with nowhere for investors to hide. Morningstar’s US Moderate Target Allocation Index – designed as the benchmark for a 60/40 allocation portfolio – lost 15.3%, its biggest annual decline since 2008.
But 2023 is on a different trajectory, giving investors hope they can start building their retirement balance, some say.
“Overall, the inflation pendulum is now swinging back,” said David Russell, vice president of market information at online securities and futures brokerage firm TradeStation. “The bond market sees it, and so does the stock market. That whole 60/40 strategy can go back to work, and I think we’re seeing that happen today. We see money flowing into bonds and particularly into the S&P and Nasdaq.”
What happened last year?
As inflation hit a 40-year high, last year the Fed raised its short-term benchmark Fed Funds rate by a whopping 4.25% overall, including three consecutive supersized 0.75%, to cool inflation. Higher rates increase the cost of borrowing for people who spend and for businesses to invest in future earnings growth, slowing demand, the economy and inflation.
When interest rates rise, bond prices fall because older bonds lose value. Their coupon payments are now lower than those of new bonds that are offered to the market at higher rates.
The combination of high inflation and aggressive rate hikes set the stage for a rare event: the value of stocks and bonds plummeted simultaneously.
“Going back to 1929, there have been only 3 years where bonds didn’t rise when stocks fell,” investment firm BlackRock wrote in a report last year. The last time it happened was in 1969, he said.
What if a recession comes?
Maybe it doesn’t matter.
“There is so much negative sentiment that it almost feels and looks like the recession is already priced in,” said Peter Essele, head of portfolio management at Commonwealth Financial Network. “This has been the most over-anticipated recession. I think people are a little numb.”
Three-quarters of Americans thought the economy was already in recession last fall, according to a CNN poll. The AICPA Business and Industry Economic Outlook Survey for the fourth quarter found that 51% of business leaders said the U.S. economy was already in recession or would be in recession by the new year.
Because people are already preparing for the worst, Essele says, “Usually stocks fall about 60% during a recession, but I think in this recession we will – or have already bottomed out – much earlier. According to some economists, recent data also points to a slower economy, but possibly no or a shallow recession.”
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What could this mean for investors in 2023?
If inflation continues to fall, the Fed pauses rate hikes as expected and all the bad news is priced in, some strategists say it’s time to get back in the market.
“We have more clarity on where the endgame is for rates and inflation,” Essele said, and that’s the most important thing. Unpredictability is what troubles markets, not so much the level at which the Fed stops raising rates, he said.
If the economy slides into recession, the Fed could start cutting rates in the latter part of 2023, which would give the economy new impetus, some strategists say. The CME’s Fed Watch tool, which shows where investors think the Fed Funds rate will be at every policy meeting of the year, reflects this view, with most expecting a quarter-point rate cut in November.
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What could be good investments?
With signs that 10-year yields have peaked or are close to peaking, “we will see strength in the housing stock,” Russell said. “Homebuilders will be very strong. There is a very strong structural demand in the country for housing.”
He also likes steelmakers and metals companies that have underperformed but could benefit from infrastructure projects.
In addition, “the combination of high home prices and high rates deterred buyers last year, but as we see home prices fall, people will be more willing to buy in the hope that they can refinance in the future when rates are lower,” said Jon Klaff, general manager of investment platform Magnifi. A recession, he said, could be the start of a fall in house prices.
Bonds are another good bet for retirement portfolios. “Now that yields are a lot higher, I think bonds have become a lot more attractive,” said Jason Kephart, director of multi-asset ratings for Morningstar Research.
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Don’t forget about diversification
Whatever you invest in, diversification is key to weather volatility in the event that markets rise in fits and starts or, as other strategists believe, the stock market has not yet priced in all the bad news and has room to fall.
Michael Wilson, chief strategist for US equities at Morgan Stanley, says companies’ earnings forecasts are still too low, suggesting a drop in stock prices “for which most are not prepared…profitability.”
But this is where the traditional 60/40 portfolio comes in handy, say bullish strategists.
Although the 60/40 portfolio did not work well last year, you say it was an anomaly. With higher bond yields this year, bonds can generate income for investors that will help protect against any price declines this year.
“The risk is slowly returning to normal,” Russell said. “After three years of intense turbulence, we are returning to equilibrium. It is not a straight line, but the economy is returning to normal.”
If you’re still concerned, strategists recommend dollar cost averaging. “By investing in the same securities regularly over time, you calculate the average price you pay for the securities,” Klaff said. That ensures that you benefit from market downturns and don’t have to worry about buying at top prices.
Medora Lee is a money, markets and personal finance reporter for USA TODAY. You can reach her at [email protected] and subscribe to our free Daily Money newsletter for personal financial tips and business news every Monday through Friday morning.