A recession in 2023?

The Fed has spoken by pivoting to a more hawkish trajectory for monetary policy. The FOMC announced that it is doubling the scale of its QE taper, which puts the program on track to end in March. The December median dot-plots show that Fed officials expect three quarter-point rate hikes in 2022 and three quarter-point rate hikes in 2023.


The 10-year Treasury yield is about 1.4% today. All else being equal, the Fed’s dot-plot puts monetary policy on track to invert the yield curve some time in 2023. Historically, inverted yield curves precede recessions and recessions are bull market killers.



Is the Fed on course to raise rates until the economy breaks?



The market reaction

Much depends on how the bond market interprets the Fed’s monetary policy pivot. Consider the following three scenarios for the 10-year Treasury yield, which currently stands at about 1.4%.
  1. Using the 2s10s as a benchmark for the yield curve and assuming that the 2-year yield moves in lockstep with the Fed Funds rate, the 2s10s would flatten and invert in late 2022 or early 2023.
  2. The 10-year yield has been falling in anticipation of the Fed’s hawkish pivot, which is a bond market signal that it expects a slowing economy. If the 10-year yield continues to fall, inversion would occur in H2 2022. 
  3. If the 10-year yield rises, which would be a signal that the market expects the Fed to get inflation under control and sparks a second wind in economic growth and earnings estimates continue to rise, it would be bullish for the equity outlook.
What happens next? Here is what I am watching.


What happens to the yield curve? Recent history shows that inverted yield curves have either slightly preceded or been coincidental with stock market tops. Arguably, the minor inversion in 2019 was a false positive as the 2020 recession was attributable to the pandemic, which is an exogenous event.



While the dynamics of the British economy is unique owing to the fallout from Brexit, the UK yield curve is inverted from 20 years onward. Is the UK the canary in the coalmine or a special case? Will the inversion spread across the developed markets?



Monitor the growth outlook. Accelerating growth translates to rising EPS estimates, which is equity bullish. So far, the Economic Surprise Index, which measures whether economic data is beating or missing expectations, is rising.



S&P 500 forward EPS estimates have also been strong, indicating positive fundamental momentum.



Rate increases are designed to cool off an overheated economy and control inflation. What happens to inflation expectations? 5×5 inflation expectations have been falling, which is positive for the Fed’s inflation-fighting credibility. Will it continue?



The latest release of global flash PMIs indicate that inflationary pressures look decidedly *ahem* transitory. Supplier delays are rolling over, which should alleviate some of the pandemic-related price pressures.



In addition, the newly listed Inflation Beneficiaries ETF (INFL) provides the equity market’s view of inflation. The absolute performance of INFL roughly tracks the relative performance of TIPs against their duration-equivalent Treasuries. The relative performance of INFL to the S&P 500 has been falling, which confirms the market signal from 5×5 inflation expectations. Will the trend continue?



If the Fed raises interest rates until something in the financial system to break, the most sensitive barometers of financial stress are high yield and emerging market bonds. Bloomberg reported that Ken Rogoff warned that EM countries are especially vulnerable to rising rates.


“Developing economies are just an accident waiting to happen,” the Harvard University economics professor said on Bloomberg TV on Wednesday, before the Fed’s policy decision. “There are already a lot of problems in what we call the frontier emerging markets.”


A full percentage-point of Fed rate increases next year could shut some countries out of markets, further straining already vulnerable fiscal situations. He pointed to Egypt, Pakistan and Ghana as nations already battling large debt obligations, narrower market access and, in some cases, double-digit inflation…


Emerging markets are “very sensitive to the hiking-more-quickly scenario,” Rogoff said. “Many, many countries that have access right now, suddenly wouldn’t. That would really be catastrophic.”
Keep an eye on HY and EM spreads. Widening spreads would be bad news for the growth outlook.




A question of credibility

Much depends on the market’s view of the Fed’s inflation-fighting credibility. Here is the FOMC’s Summary of Economic Projections (SEP). 



While the initial reaction to the publication of the SEP is to focus on its Fed Funds projections or the dot plot, two other forecasts are equally important. The Fed forecasts that core PCE, which is its preferred inflation indicator, falls from 4.4% in 2021 to 2.7% in 2023. While Jerome Powell has abandoned the term “transitory”, the SEP is projecting an outlook consistent with the now-banned term. Moreover, the December FOMC statement contained a nearly identical sentence as the previous month’s and attributing inflationary pressures to the pandemic and reopening factors is another way of saying “transitory” without using the word.


Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation.
As well, the SEP forecast calls for the unemployment rate to fall from 4.3% in 2021 to 3.5% in 2022 and remain at that level until 2024. The long-term unemployment rate, however, is 4.0%. In other words, the Fed is signaling that it is willing to run the economy a little “hot” and tolerate some inflation pressure to achieve full employment.


Both of these forecasts are growth-friendly and equity bullish. For equity investors, I sketch out two possible paths. A hawkish reaction, which would be signaled by a flattening yield curve, translates into slowing growth. Under those conditions, investors flock to quality large-cap growth stocks when growth is scarce. Moreover, the forward P/E spreads of FANG+ stocks against the S&P 500 have fallen since September and valuation premiums are not overly demanding.



However, investors are best served by avoiding speculative growth stocks as psychology has turned and their bubble seems to have burst. Speculative growth-related ETFs such as ARKK and BUZZ are lagging both the S&P 500 and the high-quality large-cap NASDAQ 100.



A dovish reaction, or a steepening yield curve, is friendly to value and cyclical stocks. In the current environment, however, a bifurcated market has appeared between large, mid and small-cap value and growth return patterns. The recent dominance of large-cap FANG+ names has meant that growth has been outperforming value among large caps. However, value stocks, which are also concentrated in cyclical sectors, are beating their growth counterparts among mid and small-caps. The bottom panel shows the relative performance of small-cap value against large-cap growth. Based on a head-to-head comparison, large-cap growth remains dominant.



How should investors position themselves? My Trend Asset Allocation Model remains bullishly positioned in equities. However, I have made the case in the past that the economy and market are transitioning from an early cycle recovery to a mid-cycle expansion. During such periods, rising rates put downward pressure on P/E ratios, which is offset by rising EPS estimates. If history is any guide, stock prices tend to move sideways as the Fed starts to raise rates, but we are still several months from liftoff and the market could continue to advance until then. Remain bullish on equities until the market signals a downside trend break, which hasn’t happened yet.



Owing to the uncertainty of the market’s reaction to the Fed’s policy pivot, equity investors should adopt a barbell position of large-cap quality growth and small-cap cyclical value. A scenario of slowing growth should see large-cap growth stocks outperform, while signs of accelerating growth should benefit high-beta small-cap stocks.


19 thoughts on “A recession in 2023?

  1. Hello Cam, and Merry Christmas to you and all of the members of your site! Based on your above conclusion, I would assume QUAL qualifies as a large cap quality growth ETF. Could you give me a few ETFs that fit the other side of the barbell, small cap cyclical value ETFs? Thanks


    1. Vanguard, Fidelity, I shares, all have their own Large caps and small caps. Just google. MGK/VUG are Vanguard large/mega cap growth and VBR is Vanguard small caps. Vanguard has small cap growth and value in different ETFs as well.
      Van Eck has MOAT which is a wide moat portfolio that tracks the Morningstar wide moat portfolio.

    2. Mike, I use QUAL and SCHD as my core holdings, not SPY, tilting between the two as necessary though not particularly successfully. In small caps Cam has pointed out that IJR’s index has balance sheet and profitability screens that IWM’s index, the Russell 2000, lacks, so I use some IJR. I’m eager to learn what funds other readers use for small cap value!

      1. I use VTI as an anchor and add small amounts of small caps, VXUS, commodities etc. For now, portfolio is skewed to cyclicals and value, based on Cam and Ken’s insights.

  2. “*ahem* transitory.” LOL!

    Regarding the UK yield curve inversion between the 20 and 30 year tenors, I believe the UK did a pension law change a few years ago that required tighter duration matching. This essentially forced pension funds to buy more long dated gilts (UK Treasury bonds). This drives down the thirty year yield. You see something similar with US swap spreads. This is why the 2s-10s is a better indicator for recession spotting purposes.

      1. Not that I’m aware of, though I suppose there could be an effect as I read somewhere that European managers with fixed income mandates buy US Treasuries and swap the returns back to Pounds and Euros and that depresses US long yields by about 80 bp. Perhaps another reader knows that source.

        1. Yes, it is possible there may be some effect on the US market. i would like to think the pension market in the UK could have a small effect in the US, as the US market is very big.

        2. One reporter asked Powell at the presser about the flattening of the yield curves and the threat of inversion due to the coming three rate hikes. Powell said that foreign buying of the long bonds distorted the curves. So there is room for hikes without slowing the economy, and then immediately resorted to the data-dependent mantra about the speed of hikes.

          So Powell obviously learned from the Dec 2018 fiasco. But a quick browse of the results of my own search engine/headline aggregator shows that no one believes there is going to be three hikes in 2022. These people are from sell side, think tanks, money mangers. Petty much everyone in the game.

          But I prefer watching big money positioning over any prediction. At this moment it is total chaos (maximum randomness). So just hunker down when math does not show favorable odds in any direction. But there is one thing, short covering, to consider in light of deep pessimism, horrible market internals, and lopsided hedging.

  3. Taking a a view from 30,000 feet, I see Omicron like the Katrina hurricane satellite shots building in the ocean as it heads towards New Orleans. Some residents back then ignored the warning, some fortified their homes/businesses and others left town. We know who did best. With the Omicron hurricane, I see most investors ignoring the warnings, some are fortifying their portfolios with Low Volatility Factors and Defensive indexes now outperforming but few are leaving town.

    This virus has an R factor of 4 or 5. The simple mathematics of that are awesomely and awfully exponential. When this health hurricane hits, I expect the roadways out of town will be gridlocked with investors trying to leave town.

    What I’m trying to say as I am shifting out of any sense of investment market normalcy until the eye of this hurricane is past and heading out of town.

    1. But this isn’t 2020. We have vaccines, we have pills, we still have mitigation techniques. We also have fatigue and a desire to move on. Omicron is also not looking as impactful. I think we will have to shift our thinking toward hospitalizations versus number of cases.

      I just don’t see a March 2020 event in the offing. Of course, I could be wrong, I just don’t think the odds are high enough to change my risk assessment of the market, which is has been on the conservative side for some time (due to where I am in my career and investment life).

      1. March 2020 is very unlikely, but valuations are coming from a higher level and monetary policy reaction will be very different. The “lockdowns” are coming in a completely different form compared to what happened in Italy and then in many other parts of the world last year. According to this survey however, there is a significant part of american households facing serious financial problems already:
        • Thirty-eight percent (38%) of households across the nation report facing serious financial
        problems in the past few months.
        • There is a sharp income divide in serious financial problems, as 59% of those with annual
        incomes below $50,000 report facing serious financial problems in the past few months,
        compared with 18% of households with annual incomes of $50,000 or more.
        • These serious financial problems are cited despite 67% of households reporting that in the
        past few months, they have received financial assistance from the government.
        • Another significant problem for many U.S. households is losing their savings during the
        COVID-19 outbreak. Nineteen percent (19%) of U.S. households report losing all of their
        savings during the COVID-19 outbreak and not currently having any savings to fall back on.
        • At the time the Centers for Disease Control and Prevention’s (CDC) eviction ban expired,
        27% of renters nationally reported serious problems paying their rent in the past few months

        1. The gridlock in Congress will not allow any more cash help for the bottom 50% of the population. There are no more bullets in that gun.

          The inflation is a huge boom for you and I with homes and portfolios that the Fed’s has pumped up with cheap money. Home owners of a $500,000 home just got a gift of 20% or $100,000 inflation boost and likely as much on their portfolios. That dwarfs the $5,000 or $10,000 in extra food and gas costs to us folks. But renters and non-stock holders, inflation is a cost and it must be bringing folks to the brink as Jan outlines.

          The Fed report on Wealth shows a 27 Trillion jump in wealth almost all by the top 50% with stocks up 30% and homes up 20% from end of 2019 to June 2021 or during a depression/recession. Did all those Americans become Warren Buffetts? Did everyone on the block renovate their homes and landscape? No, the Fed gave a government gift.

          On the other side of the 27 trillion gift from government, the government asks for some back in taxes for programs to help the bottom 50% that didn’t get the big windfall. The social bill that just got killed/postponed was 175 billion a year for ten years. Put in understandable money terms rather than trillions/billions, if I gave someone a gift of $27,000 and then said, “Would you please give my brother $175 bucks?” and they said, “Screw him. Tell him to get a job.” I would be shocked by the insensitive greed of that.

          People don’t seem to realize the extent of the government gift given via the Fed to us wealthy folks. Bernanke came right out and said it, ‘The Wealth Effect” back in 2012 was going to happen via new monetary tools, QE and interest rate suppression.. It was more subtle for years until totally unleashed the last almost two years.

          The Wealth Effect calculates that higher wealth leads to about a 3% rise in spending. So folks with a million dollar home and a million dollar portfolio just got a $400,000 gift from the government Fed since 2019 (and a hell of a lot since 2012 when QE started). That means they will (we) spend an extra $12,000 more (3% of $400,000) than last year. No way should we pay more of the $386,000 left over for taxes for unnecessary stuff like child care of the poor, education, climate. That would be socialist stuff.

      2. I hear you Livewell but what if on Nov. 9, 2020 the vaccine announced was 22.5% effective like the current ones now with Omicron rather than the 95% that was the case with Alpha and later Delta back then. We would not have seen the huge liftoff in stocks. Sure, they say if you get a booster after your first two shots, you are up to good effectiveness but many people don’t have any shots and to get to the third dose, takes months of waiting between shots. The Omicron hurricane is not going to wait for those folks.

        In 2020 the vaccine gave us the thinking that human technology would conquer this virus. The fact that it has mutated around the vaccine makes me wonder who will conquer who?

        The R 5 rating of this virus likely means it will be much worse than March of 2020. The number of cases will be so much greater than the Alpha that its lesser hospitalizations will be a bigger number to deal with.

        Momentum has shifted to Low Volatility and Government Bonds. Momentum strategy follows the money rather than predicting the unpredictable.

        1. The world is in a different place than in March 2020. We have oral drugs, (new) monoclonal antibodies and vaccines that appear to be effective. We also are coming up with tweaked vaccines. Politicians, globally are proactive, more than last year. We are now proactive and are battening the hatches and not reactive. Testing has become more widely available. Lot of positives.
          We probably get a quick, short decline in global GDP in Q1, but a sharp recovery that follows in Q2. Sure, a 10-20% pull back would be good to correct some of the excesses in the market. We are already seeing that under the hood, regardless. Take a look.

        2. I think Ken may be right in that this is like a hurricane. This covid is going to infect fast and furious. With steep increase followed by a steep decline in infection rates. So omicron being temporary shock is almost a given. But the headlines are going to get scary and it’s worrying if China will strictly lock itself down and exacerbate inflation given that the population have low immunity to it (i.e. sinovac protection). Though that may be offset with the end of Christmas shopping season. I’m wondering just how much is priced in and how vulnerable is the market to these headlines coming into the new year.

  4. Yes, the world is in a different place today with respect to protocols in place/ vaccines + treatments available/ ongoing research and development.

    But so is the virus. And viruses are single-minded and far more relentless than human nature.

    (a) I’m hearing reports that symptoms are milder with Omicron only because more people are now vaccinated and/or have acquired natural immunity from previous infections. In other words, it’s not necessary less virulent.

    (b) What about the next variant?

    (c) With both the delta and omicron variants in circulation, it’s easy to imagine gene-swapping between the two – especially in immunocompromised patients harboring both simultaneously – thus creating the super variant.

    I have a great deal of faith in science – but I don’t want to be the guy who dies from Covid-19 due to reckless behavior or lax adherence to protocols while waiting for scientists to do their thing.

    1. Thing with Omicron is that everything is happening so fast and trading desks will have limited time to react – how many will want to stay fully invested over an uncertain low liquidity holiday period?

    2. ” I’m hearing reports that symptoms are milder with Omicron only because more people are now vaccinated and/or have acquired natural immunity from previous infections. In other words, it’s not necessary less virulent.”


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