After 2022’s bumpy ride, which included historic inflation and a plunging stock market, what does the road ahead look like for investors in 2023? Vanguard’s Joseph Davis, global chief economist, sees a number of developments advisors may want to note.
For starters, Vanguard sees a 90% chance of a recession in the United States by the end of next year.
“Longer term, however, our global equity outlook is improving because of lower valuations and higher interest rates,” said Davis, who also noted that he expects the recession to be milder than those in recent history.
“Households, businesses and financial institutions are in a much better position to handle the eventual downturn, such that drawing parallels with the 1970s, 1980s, 2008 or 2020 seems misplaced,” he said.
While he said he can’t foretell where the stock market’s bottom is, Vanguard’s expectations for returns are 2.25% higher than last year. From a U.S. dollar investor’s perspective, the Vanguard Capital Markets Model is projecting higher 10-year annualized returns for non-U.S. developed markets (at 7.2% to 9.2%) and emerging markets (at 7% to 9%) than for U.S. markets (at 4.7% to 6.7%).
The selloff in equity markets this year has been “indiscriminate,” the economist noted. The equity indexes for the U.S. markets, for the developed markets outside the U.S. and for the emerging markets all posted losses greater than 20% in the last nine months.
The valuation declines were more pronounced in the U.S., but a strengthening dollar meant U.S.-based investors realized larger losses on their unhedged international equity exposures than on their local ones, Davis said.
“Even though this is negative from a short-term, realized-return perspective, it means that the global opportunity set is now more attractive than it was a year ago,” Davis said.
The firm’s 10-year forecast for U.S. and international equities (from September 30, 2012, to September 30, 2022) was 7.6% per year, and the same portfolio returned 8% over the same period.
Valuations are more favorable going into 2023, but opportunities are still limited, Davis said.
“Equity markets have yet to drop materially below their fair-value range, which they have historically done during recessions,” he noted.
Longer term, however, the global equity outlook is improving because of lower valuations and higher interest rates.
In the U.S. market, Davis said “the return of value investing has been a notable narrative that has continued in 2022. Unlike in the first quarter of 2021, value’s outperformance over the last 12 months has had more to do with growth’s relative weakness than value’s relative strength.”
Davis believed that, by the end of 2020, even if the macroeconomic conditions that supported growth persisted, value was likely to outperform in the coming years.
He still expects value to outperform over the next decade, “but this outperformance has less to do with relative valuations and more to do with the ‘value premium’ that our research, along with that of academic and other practitioners, finds,” he noted.
The one part of the U.S. market where Davis sees greater opportunity is in small caps, “albeit to a much smaller degree than we saw in value last year. We find that similar drivers—interest rates, inflation, volatility and corporate profits—explain 72% of the variations in small-cap versus large-cap price-to-book ratios,” he said.
On the international equities front, the chief economist now sees growing opportunity after global stocks lagged by a wide margin over the past decade. In fact, a portfolio of U.S. stocks bought in 2012 is worth twice as much as a portfolio of international stocks bought in the same period, Davis said.
But he said the performance dynamic is shifting. “We believe that the valuation-based expansion in U.S. equities is sowing the seeds for lower returns in the decade ahead. We expect more favorable international valuations, higher dividend payout ratios and a weaker dollar to drive international outperformance,” he said.
In particular, emerging markets are poised to outperform U.S. equities. Davis predicts emerging market stocks should return between 7% and 9% (2.3% higher than U.S. equities) over the next decade.
Emerging market equities have a lower correlation with U.S. equities than other international developed markets and a higher inflation beta to U.S. inflation.
“For these reasons, we believe that a balanced allocation to emerging market equities plays an important role in investors’ portfolios,” Davis said.