3 scenarios that could surprise markets in 2023

Our Top Market Takeaways for January 6, 2023

Market update: New Year, Same Vibe

It may be a new year, but U.S. financial markets still have the same vibe. This week, the S&P 500 oscillated within the same range that it has been in since the middle of December. It moved up on hints that inflation is receding, and down on data points that suggest a stubbornly strong labor market. Under the surface, sectors that do better when economic growth is strong (financials, industrials, and materials) have done well while mega-cap technology and energy stocks lag.

Outside the U.S., the vibes do seem to be shifting. In December, China rapidly removed many COVID-19 restrictions. Markets are excited. Chinese stocks have rallied 50% from the late October lows with the latest 10% coming in just the first few trading days of 2023. Post-COVID normalization should provide a boost to the Chinese (and global) economy through 2023.

European markets are likewise off to a relatively strong start, gaining over 3% in as many days. This continues a run of impressive performance. Over the last 6 months, Eurozone equities are up 15%. The S&P 500 is flat over the same period. Despite the cost of living crisis driven by the war in Ukraine and the resulting food and energy shortages, economic activity has been better than anticipated, and the warm winter has alleviated the natural gas shortages. In fact, natural gas prices are back down to where they started 2022.

Heading into this year, many feared that the three major economic blocks of the U.S., Europe, and China would all be dealing with stagnant to recessionary economic growth. While recession risk looms in the United States, reopening in China and a rapid improvement in European energy supplies has seemingly removed the worst case scenario for those two regions.

Spotlight: What could surprise us in 2023

In December, we released our outlook for 2023.There, you can find why we believe that even as growth weakens throughout 2023, markets will probably have a better year than they did in 2022. We also discuss how we are managing portfolios through continued turbulence, and where we think investors can find opportunity.

But what might surprise? Here are three scenarios that we think are realistic, but aren’t part of our base case.

1. Do you believe in miracles? China and Europe will materially outperform. China’s surprise reopening after three years of stringent COVID-19 containment policies will not only provide a tailwind to domestic Chinese economic growth but also to many global companies that are also exposed to spending by Chinese households. Luxury players (like LVMH) and travel (like Hilton) are two areas that immediately come to mind. There are also signs that the onerous regulatory environment that deflated public company valuations is starting to shift. In December, U.S. authorities announced that they will have full access to audits of Chinese companies that trade on U.S. exchanges. This removes the risk that those companies would have to de-list, which has been a clear overhang.

Europe, meanwhile, now has a surplus of natural gas after a keen focus on building storage in the fall, the rapid construction of LNG import facilities in Germany and a very mild winter. China is the third largest source of revenue for European companies, so economic reopening should provide an earnings tailwind. Finally, the end of negative interest rate policy in the region should encourage capital that fled due to paltry yields to return, and could help boost European bank earnings. A weaker dollar provides another tailwind for U.S. based investors in assets outside the U.S. Oh, and one of our least favorite market segments, mega-cap tech, is much less represented in European indices.

In 2023, Chinese and European assets could outperform their U.S. peers to the tune of 15-20%.

2. Forget hard landing or soft landing. We won’t have any landing at all in 2023. Many outlooks that we have seen expect equity markets to have a tough first half of 2023 as they anticipate a U.S. recession (a hard landing) by the second half of the year. Those that are more sanguine believe that the Federal Reserve can stop hiking rates because price inflation and the labor market will settle in a much more balanced place without too much economic damage (a soft land ing). But there is a case to be made for no landing at all.

Despite headlines that big tech firms are planning to reduce their workforces, the broad labor market has shown no signs of weakness. Initial jobless claims are still remarkably stable at very low levels, and survey data suggests that most of those who are fired from tech jobs are finding new work relative quickly. The quits rate, which is a good indicator of how comfortable workers feel about their prospects of finding a new job, actually rose last month.

This strength in the labor market comes at a time when price inflation is falling. This means that real income for workers is rising, which could support more spending, which would encourage companies to continue hiring. Of course, this would keep upward pressure on wages, and would incentivize the Federal Reserve to keep hiking rates through the balance of the year.

In 2023, we may not see the end of the tightening cycle for the Federal Reserve or a recession in the U.S.

1. Wall Street: Don’t call it a comeback. The industries that felt the impacts of higher rates most acutely last year were finance and real estate. Initial public offerings, high yield debt issuance, mergers & acquisitions, mortgage applications, and home sales all collapsed at their fastest rate since the Global Financial Crisis. Of course, the Fed is probably to blame. Higher financing costs are meant to slow down activity, but the rate of change in interest rates also had a material impact. Businesses, bankers, and prospective homeowners all paused to see where the ceiling on interest rates was before borrowing and dealmaking.

Even though rates will remain at a higher level in 2023, their stability will help spur more activity in interest rate sensitive sectors. Take mortgage rates for example. Over the last 5 years, they have been about ~180 bps above the 10 year treasury rate. Last year, they were ~270 bps above the 10 year treasury rate. As rate volatility comes down, so too should mortgage rates, which could breathe some life into the housing market.

As for the rest of Wall Street, there are deals that need to get done. The technology, media, and telecom space needs to restructure after a painful year. Could Alphabet spin off YouTube? What is the long term plan that Disney has for Hulu and ESPN? Could a Hulu/Peacock merger and spin-off make sense? Why does Amazon have a retail and a cloud computing business under the same roof? Warren Buffet always seems to be looking for a deal. Could a company like Textron, which makes Cessna airplanes and E-Z-Go golf carts, make sense? Peloton still has a loyal following an a large user base. Could a large company like Nike or Apple use it as a catalyst to build out a connected fitness platform?

In 2023, lower volatility in markets could lead to a recovery in mortgage activity, M&A, and IPO and debt issuance.

No matter what surprises 2023 might have in store, your J.P. Morgan team is here to help guide your financial plan.