By Grant Bowers
As we look ahead to 2023, we see an evolving economic backdrop. In 2022, the strong equity market performance of the last few years gave way to fear of the unknown about inflation, interest rates, global growth and geopolitical strife.
In the new year, we expect inflation to moderate rapidly in the first half of the year, but remain elevated relative to recent history. The US Federal Reserve (Fed) will likely slow the pace of rate increases and the direction of monetary policy will become more data dependent as recent rate increases work their way through the economy.
We believe the probability of a severe recession in 2023 is low, but growth will be pressured. If the labor market remains healthy and unemploy-ment remains around 3%–4%, it is difficult to imagine a case where we enter a recession that is anything but shallow.
That said, earnings growth could slow, and we are likely to see gross domestic product growth to continue to moderate from pre-pandemic peaks.
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Ultimately, we see Fed actions taking a backseat to company fundamentals. Our focus for US equities in 2023 will be on profit margins and earnings as the lagging effects of Fed rate increases take hold on economic growth, while inflation slows consumer demand and pricing power.
We anticipate earnings headwinds in the short-term as consumers and corporations adjust to the changing economic environment, particularly in highly cyclical
segments of the market.
As such, we believe 2023 will be a year where active management will shine, and idiosyncratic factors will drive returns—as opposed to macro factors which may lead to high correlations. In this environment, we believe investors should focus on quality and earnings visibility and areas of secular growth in the economy.
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We are finding opportunities in high-quality businesses levered to durable secular growth themes, with market leading competitive positions, strong financials and balance sheets that give them the ability to invest and grow through a range of economic conditions. Digital transformation is an important secular growth trend that we believe can drive productivity growth, lower costs and increase profitability amongst US companies.
In our analysis, it is not just a tech-nology-driven theme, but one that is broadly permeating other sectors of the market. In the technology sector, we are focusing on software over hardware. We continue to like software and see it as the largest beneficiary of the digital transformation sweeping through every industry.
In our analysis, valuations have compressed significantly in the sector, but fundamentals remain strong, creating an opportunity for investors with a long-term term view. We continue to find the health care area interesting, during a time when demographic tailwinds of a rising middle class and an aging global population can drive increased health care consumption.
Against this backdrop, we believe the health care sector offers a great combination of growth and stability in myriad market environments. In the financials sector, the fintech theme continues to grow, and we favor payments and financial services companies. We see a long-term path for the financials sector that is much more data driven and personalized, creating opportunities for new entrants to grow rapidly.
We seek a good balance of consistent, high-quality, name brand, best-in-class, established businesses along with exposure to next-generation leaders. To do this, we rely a great deal on our bottom-up, fundamental research capabilities and leverage our in-house team of analysts to uncover promising companies that we believe have the potential to become market leaders.
(Author is Portfolio Manager, Franklin Equity Group)