Market Watch: Outlook for 2023 - when will share markets bottom out?

The economy is expected to be tougher next year with a high risk of recession, but that doesn’t necessarily mean it is all doom and gloom for investors.

In fact, history suggests it is likely to be a better year for share markets, which tend to bottom out around six months ahead of the wider economy, says Pie Funds founder and chief investment officer Mike Taylor.

“So, 2022 has not been a good year. It’s not been the worst year on record. But it’s up there,” he said.

At the time of filming, markets were down somewhere between 15 and 20 per cent for the S&P 500 and close to 30 per cent for the Nasdaq, Taylor said.

Relatively speaking, the NZX50 is in better shape - down around 10 per cent for the year to date.

For 2023, the interest rate tightening cycle and a mild recession were already priced into equities at this point, he said.

“What’s not priced into equities is a financial accident caused by tightening or a severe recession, so one of those two scenarios could play out,” he said.

But while there might well be more downside for investors in the next few months, an end was in sight.

“What seems to be the likely course is that the Fed’s still going to talk tough for a couple of months. They will want to see more slack appearing in the labour market before they ease off and I think that will put more pressure on equities rolling into the start of the year.”

On top of that, we were starting to see an economic slowdown, he said.

“That’s going to come, going to be reflected in corporate earnings, which will probably be a little underwhelming for the first three to six months of next year,” he said.

That scenario meant a good chance that equity markets would bottom out in the first half of 2023, he said.

“Let’s not forget that this has been an inflation-led cycle. Once that’s under control, the Fed will be able to relax rates a little bit more, which will be beneficial for stocks.”

While they might seem a more complex and specialist area of financial markets, bond investments represent a sizable proportion of many KiwiSaver accounts.

Bonds had a terrible year in 2022 as interest rates accelerated beyond market expectations, Taylor said.

In fact, it was the worst year in history for US treasuries, in data that dates back to the 19th century.

Typically, after a slump like that, the following year, or the year after, ends up being a very strong year, Taylor said.

That would bode well for underlying returns in balanced portfolios.

Mike Taylor, founder and chief investment officer at Pie Funds. Photo / NZME

Meanwhile, a sharp recession would likely prompt the US Federal Reserve to cut rates aggressively, he said.

“Inflation becomes deflation. Then you would see a fall in bond rates, both in the short end of the curve and the long end of the curve, which will be very beneficial for treasuries. And who knows, if the interest rates went back to 1 per cent then it could be a bonanza year for bonds.”

A lot depends on when a recession hits and how hard.

The Reserve Bank has forecast recession in the second half of 2023, but Taylor believes it could hit sooner than that.

“Things are definitely slowing, but there are still more jobs available than there are people who are unemployed. So it won’t be, until that balance tips a little bit that we start to feel the bite of a recession,“ he said.

But mortgage rates had risen a lot. More people were rolling off low 2-3 per cent interest rates onto rates above 6 per cent.

“That will curtail household spending. So I would say there’s a high probability that New Zealand will be in recession by the second quarter of next year - between March and June.”

The good news for investors was that historically, in almost every recession the stock market bottomed out about six months before the real economy did.

“So if you think that the real economy’s going be bottoming out in the second half of the year next year, then it would imply the stock markets bottoming out in the first half,” Taylor said.

“I know that seems odd, and in some ways counterintuitive, but that’s what markets tend to do. They’re always looking for a light, and everyone wants to try and pick the bottom so that’s what seems to happen.”

- The Market Watch video show is produced in partnership with Pie Funds.