2022 was a great year—at least if you were a perma-bear like Nouriel Roubini.

When the year began, the Turkish-American economist correctly predicted conditions would be more difficult than in 2021 because of incipient inflation and rising geopolitical tensions. In July he called forecasts of a shallow recession “delusional.” By September, he said a “long, ugly” recession was likely and that stocks could tumble 40%. At least twice, in October 2022 and January 2023, he suggested the Fed was likely to “wimp out” in its efforts to fight inflation. You get the picture.

Roubini’s perspective might be almost comical, except that over the past 12 months it’s become pervasive. One sentiment indicator after another has revealed that everyone from CEOs to ordinary Americans expects a recession and for economic conditions to get worse, despite unemployment data at 50-year record lows and strong wage gains.

By last fall, some advisors were already telling clients to write off 2023 and focus on better times ahead in 2024. “After three years of substantial ups and downs in the financial markets, it’s no wonder that so many people are attempting to forecast what 2023 may bring,” Debra Brennan Tagg of BFS Advisory Group in Dallas told clients. “Based on current expectations, 2023 is still likely to be a rebuilding year, as opposed to a ‘normal’ year. Looking just a little further down the road to 2024, there are many things that could line up to create an environment that is healthy and prepared for long-term growth.”

Part of the current malaise can be traced to inflation, which is eating into real wages, as well as to other lingering effects of the pandemic like the hybrid work situation, which has yet to be resolved.

But there’s another factor at play.

For the first time since the Great Recession, bonds and cash represent viable alternatives to equities. Investors took notice in late 2022 and began buying bonds of a variety of stripes. That pushed up their prices, which lent stocks some support.

But if there is any consensus, it’s that financial markets are entering a brand new world that looks very different from the one in the rearview mirror. A change in leadership could already be underway. Rich Bernstein, CEO of the advisory firm named after him, noted in a January webcast that 70% of the world’s stock markets outperformed the U.S. in 2022. That’s after a decade that saw American stocks beat many foreign indexes by nearly three times.

Investors Look Abroad
Appearances can be deceptive, but global investors are starting to prioritize value over growth. For some, that means moving assets out of the U.S. While Americans understandably may view the U.K. as a nation beset by strikes, governments changing every few months and Brexit woes, the energy-heavy FTSE 100 index easily beat the S&P 500 and most other major markets last year.

In contrast, America’s equity market profile is skewed toward yesterday’s policies and deflationary tailwinds. “We’ve been uncharacteristically bearish,” notes Federated Hermes’s chief equity strategist, Phil Orlando, who acknowledges he sounded like a perma-bull for most of the quantitative easing era, when he was spot on. Now, however, “There’s very little to be optimistic about,” he says.

Simply put, the Federal Reserve allowed inflationary pressures to build even as fiscal authorities added more fuel to the stimulus fire. For much of 2021, Federal Reserve Chairman Jay Powell was a lame duck. Orlando believes Powell was very eager to be reconfirmed, and so was reticent when it came to reversing course and going on the offensive against inflation while his nomination hung in the balance. As soon as his confirmation occurred in November, the word “transitory” was expunged from the Fed’s lexicon, but the inflation genie was out of the bottle.

One year later, markets keep pinning their hopes on a soft landing. Despite favorable signals, that scenario could be trickier than investors hope. “The equation is: Inflation doesn’t come down until wages do. Wages don’t come down until unemployment rises,” said Bob Michele, chief investment officer of J.P. Morgan Asset Management, in an interview with Bloomberg on January 18. “Unemployment doesn’t rise unless we are in a recession.”

Such an inevitable recession appears embedded in the Fed’s pronouncements, even if the central bank isn’t calling for one outright. Orlando notes that the Fed expects unemployment to rise to 4.6% from its low of 3.5%.

“We’ve never had a situation in the last 100 years where the U-3 [the official unemployment rate] has gone up by 1% without a recession,” he notes. The team at Federated Hermes thinks unemployment could reach 5%, Orlando adds.

Recession talk has been rampant for almost a year, but the economy has been creating more than 200,000 jobs a month, a number noticeably better than those in the 2010-2020 period. Layoffs so far have been concentrated in Wall Street and Silicon Valley, America’s two leading wealth engines.

Orlando compares the pandemic’s effect on technology and software sales to the Y2K scare in the late 1990s, when businesses and individuals felt compelled to upgrade all their programs and systems. By the time both the pandemic and Y2K were over, there was “no one left to buy technology” products. “You need a rightsizing of the technology market,” he says.

Unfortunately, many investors accustomed to ever-rising tech shares can’t grasp a new reality dawning. Orlando’s baseline scenario for 2023 calls for a 10% correction sometime in this year’s first half followed by a rebound near year’s end. But a 20% correction would hardly surprise him. Were that to happen, he thinks value stocks would fall a modest 10%, while the tech-heavy growth sector could drop as much as 40%. That’s after a 33% decline in the Nasdaq-100 in 2022. It is simply going to take that long a time to “unwind” all the fiscal and monetary excesses of the pandemic, in his view.

Disrupting The Disruptors
Late last year, John Linehan, a portfolio manager and chief investment officer in charge of large-cap U.S. value strategies at T. Rowe Price Associates, outlined how “accepted market truths” might backfire. Investors are confronting a confluence of factors “that have few precedents,” he said.

Value stocks are still cheap, and their fundamentals are improving. At the same time, Linehan postulated that the disruptors might find themselves getting disrupted. During the financial crisis, digital advertising was in its infancy, so Alphabet and Facebook benefited from the industry’s secular growth. Today, digital advertising dominates the entire business and advertising ultimately is a cyclical business.

Moreover, growth for these companies is bound to slow thanks to the law of large numbers. A decade ago, software companies were able to grow their businesses with limited competition; now, many companies are introducing new products directly into rivals’ primary markets. “We think growth expectations [for growth stocks] may disappoint,” Linehan said.

The last two years also witnessed a housing bubble of sorts, thanks to zero interest rates and housebound Americans’ desire for more expansive living quarters. Housing prices across the nation are falling thanks to soaring mortgage rates, but few analysts see a replay of the 2008 housing crisis.

Tight inventories, resulting from limited home building for most of the last decade, are keeping home prices from collapsing, according to Matt Doherty, a housing analyst at MFS Investments. Affordability is a problem for many first-time home buyers, and there is something of “a buyer’s strike,” he says.

The good news is that more than 90% of Americans have fixed-rate mortgages. That’s drastically different from conditions during the housing crisis 15 years ago.

Doherty thinks that prices will adjust. But he also believes there is a whole “wave of buyers waiting out there.” After all, the number of millennials in their 30s today greatly exceeds that population 15 years ago.

Where the adjustment to housing prices settles remains to be seen. Most homeowners fixed the rates on their mortgages before the Fed started hiking interest costs, so a surge in delinquencies is unlikely. But if price declines continue, the negative wealth effect, when added to lower stock values, should further dampen consumer sentiment.

Markets appear convinced that the Fed will be able to vanquish the current round of inflation over the next few years, although it’s by no means certain annual price increases will reach the central bank’s 2% target. By early 2024, Federated Hermes’s Orlando thinks the Fed may be talking about a “2% to 3% rate.” After all, inflation averaged 2.75% from 1990 to 2008.

Loomis Sayles’s Vice Chairman Dan Fuss thinks conventional wisdom may be overly optimistic. While he doesn’t anticipate a return of 1970s-style hyperinflation, Fuss thinks price pressures will prove stickier than most mainstream institutional investors believe.

Several factors are influencing his outlook. First, the global economy appears to be moving from a world of insufficient demand to one of insufficient supply. Second, the era of central bank liquidity looks like it’s over. Third, financial markets are exhibiting increasing fragility. Finally, a growing shortage in the global supply of workers is squeezing labor markets in developed nations and China.

Fuss also expects certain policy initiatives of the Biden administration to fuel inflation. Moving high-paying, semiconductor manufacturing jobs from Asia to North America, particularly the U.S., is one of those policies. The workers in China’s chipmaking facilities are already well-paid, but North American labor will be far more expensive.

Inflationary cycles have a tendency to develop a momentum of their own. It is tempting to think the Fed is past the “toughest part” of the inflation-fighting cycle, but Fuss notes that many wage and price hikes are already built into the system. He sees a “25% chance” of a soft landing.

A more likely scenario is that the U.S. economy could be witnessing the first of several bouts of inflation that ends late in the decade. He sees the first round bottoming out at around 3% or 4% in 2024, followed by two more cycles in the middle and end of the decade.

As interest rates have normalized over the last 12 months, some advisors have looked at the option of locking in yields on 30-year Treasurys and investment-grade corporate bonds at 4% to 6%. The prospect of going long looks tempting after the income drought of the last cycle. But Fuss says it is “way too early.” He advises focusing on short- and intermediate-term bonds with improving credit profiles and on the equities of companies gaining market share.

Just because bonds present a viable alternative for income investors doesn’t mean they won’t sport better yields in a few years.