Key Takeaways

While the Fed’s interest rate hikes have stressed domestic stock and bond markets, the US dollar has been a prime beneficiary.

Global economies and companies are both feeling the effects of a strong dollar through multiple channels, while many investors wonder if they should brace for a reversal.

We see a plausible path towards depreciation, but the dollar rallied for good reason. Investors will be best served in the long run by maintaining balanced exposure.  

Key Takeaways

While the Fed’s interest rate hikes have stressed domestic stock and bond markets, the US dollar has been a prime beneficiary.

Global economies and companies are both feeling the effects of a strong dollar through multiple channels, while many investors wonder if they should brace for a reversal.

We see a plausible path towards depreciation, but the dollar rallied for good reason. Investors will be best served in the long run by maintaining balanced exposure.  

After years of feeling like they’ve overpaid for a European hotel room, US vacationers can finally enjoy trips abroad at a much more favorable exchange rate. They have the Federal Reserve to thank. While the Fed’s interest rate hikes have stressed domestic stock and bond markets, the US dollar has been a prime beneficiary.

But is the strengthening dollar likely to persist—or should we expect a reversal in the near future? It’s one of the key questions for the global economy and markets but requires a bit more digging to answer. Let’s start with the broader picture surrounding the US dollar’s climb. 

Why Is the Dollar So Strong?

Of late, the dollar has been supported by a few key factors:

• The Fed winning the footrace to raise rates: Differences in countries’ monetary policies have helped fuel the dollar’s appreciation. The gap between nominal interest rates has widened as the Fed has raised rates more quickly than many foreign central banks, especially those in developed economies. Higher US interest rates make US bonds (which investors purchase with US dollars) more attractive, driving increased demand for the currency.

• Best house in the worst neighborhood: Having snapped back smartly after the initial phase of the pandemic, the US’s growth outlook continues to compare favorably to other developed economies. More recently, Europe has been affected by reduced exports of Russian natural gas and rising energy costs, dampening activity and likely leading to a recession.

• Alarm bells spur dollar buys: The dollar has continued to benefit from its enduring safe-haven status. As higher interest rates sow doubts about global growth prospects, capital flocks to the dollar as the world’s reserve currency.

What’s the Impact?

US dollar appreciation matters for more than just vacations. Global economies and companies both feel the effects of a strong dollar through multiple channels. From a US perspective, the surge in the dollar makes goods priced in foreign currencies relatively cheaper, though the initial magnitude is likely to be small given the high share of US imports priced in dollars.

Dollar strength also impacts companies in the S&P 500 Index. Broadly speaking, roughly 40% of the index’s revenues come from foreign markets (Display). But in some sectors, like technology, the share is even higher. This year, with earnings from abroad worth less in dollar terms, foreign currency translation is having a larger impact on the earnings of US-based multinational companies. Even without further dollar strengthening, we expect those headwinds to adversely affect S&P 500 earnings growth in the first half of 2023.

The situation differs abroad. Overseas, an outsized (and stable) portion of cross-border trade is invoiced in dollars. This means that countries purchasing commodities and other goods on global markets with US dollars are paying more in their own currencies. Effectively, the US is exporting inflation. In turn, central banks with inflation mandates are responding with tighter monetary policy, weighing on global growth.

But some aren’t complaining. On the corporate side, companies with dollar-based earnings—such as European-headquartered global pharmaceutical companies—are benefiting from a relatively stronger dollar. And for investors in countries like the UK who have invested in the S&P 500, the decline in US stocks has been offset by the dollar’s appreciation.

Must All Things Come to an End?

What could end the dollar’s remarkable run? Some argue that dollar valuations appear stretched compared to recent history. After all, the dollar’s real effective exchange rate (REER)—which adjusts for differences in price level to capture how much any currency can actually buy—stands at a 22-year high (Display). An elevated REER indicates that the dollar remains strong in terms of its purchasing power. 

Yet, a potentially expensive valuation alone does not imply an impending reversal. Valuation measures come in handy for anchoring to fundamentals. In practice, though, currencies often deviate substantially from “fair value” for extended periods.

Could a policy development prove to be a catalyst? It’s difficult to see the US mustering the political will to join a coordinated agreement, such as the Plaza Accord—an intervention in the mid-80s that intentionally weakened the US dollar. Such a move seems unlikely since the strong dollar aligns with keeping inflation in check, a key policy goal in DC at the moment.1 And unilateral intervention (which we’re currently seeing in Japan) is more likely to slow, rather than stop, the trend.

A fundamental catalyst prompting a reversal seems more plausible, with a shift in the Fed’s policy topping the list. The Fed has sent a strong message that interest rate hikes will continue until inflation is on a sustainable path lower. A successful battle against inflation could reverse any—or all—of the factors driving dollar strength laid out above. For instance, in the same way that widening interest rate differentials fueled the dollar’s appreciation, a pause in rate hikes could give other countries time to catch up. This would narrow (or at least maintain) nominal rate differentials, unwinding the effect we’ve seen this year.

Timing Is Tough

With so much uncertainty around inflation (and, therefore, the path of the dollar) in the near term, how should investors react? Trying to time a dollar reversal is fraught with risk. While there is a plausible path towards depreciation, the dollar rallied for good reason. Investors will be best served in the long run by maintaining balance. Incorporating non-US stocks into a long-term strategic allocation will provide exposure when the dollar eventually shifts gears. Until then, consider taking that trip to Europe.

A recession is likely in 2023, but investors should look beyond it and position for recovery in a new investing environment shaped by higher rates, lingering inflation, and hawkish central banks.

KEY TAKEAWAYS

1. A mild global recession is likely, with a recovery toward the end of 2023.

2. Inflation moderates but remains elevated above the post-global financial crisis level of near 2%. 

3. The Federal Reserve (Fed) is likely to hike and hold due to elevated inflation in the services sector.

4. Bonds are back as higher yields can now provide attractive income and a ballast in portfolios.

5. A new equity regime emerges as the era of ultra-low rates and enhanced liquidity recedes and investors face a new world of higher borrowing costs and lingering inflation.  

What Will 2023 Hold for Investors?

2022 will soon be behind us, and not a minute too soon. It has been a year of unprecedented volatility. Inflation at a 40-year high and the fastest Fed interest rate hiking cycle since 1980 resulted in negative returns for most asset classes.

Will 2023 be any better? We think the answer is yes, eventually. Inflation appears to have peaked, which will eventually enable central banks to slow the pace of rate hikes and ultimately shift into a holding pattern. However, risks have now shifted to the lagged impact of aggressive monetary policy tightening on economic growth and earnings. 

We see a 70% probability of a global recession, but in our view it will likely be mild and short-lived. However, the market has yet to price this in, which is why we expect volatility to continue in the first half of 2023. History tells us that markets can rebound before a recovery in the real economy. These rallies are very hard to pinpoint and can happen quickly, making it critically important to stay invested. It’s likely to be a challenging investment landscape, but one that will undoubtedly present opportunities. 

Exhibit 1: Tightening Cycle Journey

Recession or No Recession? 

The U.S. economy has remained resilient to date, despite high inflation and the rapid pace of rate hikes totaling 4.25% over 10 months. Aided by a tight labor market, increasing wages and more than $1 trillion of savings leftover from the pandemic, consumer spending continued to drive U.S. growth through the third quarter. November’s consumer price index (CPI) helped to confirm that inflation has peaked, with both year-over-year headline and core readings slowing for the second consecutive month. Yet, even as inflation is easing and the Fed begins to slow its pace of tightening, we are concerned that stickier inflation drivers, namely labor and shelter costs, will keep monetary policy tighter for longer and push the economy into a mild recession. 

Exhibit 2: Inflation Peaking, but Still at Multi-Decade High

In Europe, energy shortages caused by Russia’s invasion of Ukraine have already taken a toll on growth in the Eurozone and the U.K., and will keep upward pressure on inflation as long as the war continues. Despite inflation remaining at 10%, the Eurozone’s growth has surprised to the upside thus far, but the region will likely fall into recession in the first quarter. China’s growth is expected to improve and could get a boost from the end of its zero-Covid policy, although there is still uncertainty surrounding the pace of its reopening. 

Exhibit 3: Our Global Growth and Inflation Estimates

The Fed’s Battle Isn’t Over

The Fed increased interest rates another half percent to a target rate of 4.25% to 4.50% in December, after headline inflation slowed in October and November. With the central bank hiking at a slower pace, the focus is turning to when the rate cycle may come to an end.  

In prior tightening cycles, the cycle ended when the federal funds rate was greater than the inflation rate. With the current inflation rate nearly three percentage points above the fed funds rate, the Fed likely has more work to do. We expect the fed funds rate to peak around 5% by the middle of next year. While market consensus has priced in interest rate cuts by the third quarter of 2023, we think the Fed is likely to hold rates steady after its final hike.

Exhibit 4: Fed Has More Work to Do 

At the center of the Fed’s battle against inflation is the U.S.’s chronic shortage of labor. Better-than-expected gains in both wages and employment in November underscored the labor market’s resiliency. While goods prices have declined, and the housing market’s sharp downturn should soon be reflected in inflation through lower shelter costs, a strong labor market continues to add to inflationary pressures. 

Inflation should continue to decelerate in 2023, but it’s unlikely to reach the Fed’s target of 2% until at least late 2024. BNY Mellon Wealth Management’s forecast is for the headline consumer price index to fall to 4%-5% by the end of 2023. 

Fixed Income More Attractive 

Bonds suffered their worst performance in 40 years in 2022, with the Bloomberg Aggregate Bond Index down about 11% after partially recovering from even steeper declines.1 But the inherent upside of a decline in fixed income prices is that bonds now offer their most attractive yields in more than 10 years.  

Exhibit 5: Bond Yields at Their Highest Levels in a Decade

For investors, it means that TINA (There is No Alternative to Equities) is over, with the focus now on generating income through higher yields. At a 3.6% yield, 10-year Treasuries offer greater income than the S&P 500’s 1.8% dividend yield. With these improved yields, we are upbeat about the potential for more attractive total returns moving forward and for bonds to revert to their traditional role as a ballast in portfolios.

The Treasury market has endured extreme volatility in the past year. Historically, a yield curve inversion – when short-term yields are higher than long-term yields – has been a reliable predictor of recessions. As of mid-December, the yield curve was the most inverted it has been since the early 1980s.

Looking ahead, we expect the yield curve to invert further in the first quarter of 2023 as markets price in peak rates and weaker economic data appears. The Treasury yield curve should normalize as markets price in an eventual economic recovery in the latter part of the year. We forecast a 10-year Treasury note yield in the 3.5%-4.0% range by the end of 2023. That’s close to where it is today, but investors should be prepared for significant volatility in the interim. 

Exhibit 6: Inverted Yield Curves Signal Recessions

More Pain Before Gain in Equities 

2022 was a volatile year for equities with an environment of higher inflation and higher interest rates putting downward pressure on valuations. 

Equity price-to-earnings (P/E) multiples weaken with higher inflation, particularly when the rate is above 6%, as we’ve seen this year. The 12-month forward P/E fell from 21.5x in January, which is historically high, to the 2022 low of 15x in October.  

Exhibit 7: Impact of Inflation on Multiples

Looking ahead, we don’t expect stocks to bottom until the market prices in a recession and Wall Street’s consensus 2023 earnings per share (EPS) estimate falls further. At $232, the consensus EPS estimate is considerably higher than our $205-$215 estimate, which reflects the weakening economy. 

Our 2023 year-end range for the S&P 500 is wide at 3,800 – 4,500, reflecting the considerable macro-uncertainty ahead. Based on the midpoint of this range, that’s a gain of about 9% from today’s S&P 500 level of about 3,800. Markets are discounting mechanisms and will begin to price in an earnings recovery before we start to see improvements in the economy itself. Assuming an economic recovery by the end of 2023, we anticipate earnings will move higher in 2024 and have estimated an earnings of $240-$250. Although it is unlikely the market will have a V-shaped recovery given the prospect of higher rates and inflation continuing in the coming years, we do expect returns to be positive in 2023. 

Positioning for Potential Recession and Recovery

While 2022 was a challenging year, we believe some of our asset allocation shifts over the last year have allowed portfolios to adapt to an environment of higher rates, lingering inflationary pressures and a hawkish Fed. These adjustments included a neutral equity posture, an underweight to non-U.S. equities, an early underweight to fixed income, increased exposure to alternatives and building more liquidity, which will allow us to take advantage of forthcoming market dislocations.

With a 70% chance of a recession in 2023, our cautious positioning with a neutral weighting in equities, a small underweight in fixed income and a small overweight to less correlated diversifiers remains prudent. Until we see more evidence of earnings weakness and an economic slowdown, we will remain cautious.

For the first time in more than a decade, fixed income will provide more yield than equities and play its traditional role as a diversifier to offset stock market volatility. We have shifted positioning within our fixed income allocation to capture yield, increase quality and modestly extend duration ahead of a recession. We continue to favor credit, especially investment grade corporate bonds given their attractive yields and improving corporate balance sheets. We are a bit more cautious on high yield bonds and may reduce our neutral weighting should credit ratings and profitability begin to deteriorate. While off their highs, municipal bonds still offer attractive after-tax yields, especially within intermediate and long maturities. 

Our equity allocation favors the U.S. relative to other markets, with a preference for large cap stocks. There has been a regime change within equities, with companies that outperformed in the era of ultra-low rates and ample liquidity expected to underperform in an environment of higher borrowing costs and lingering inflation. High-quality companies that generate strong cash flows and profits, as well as those that offer sustained dividend growth, should provide better value.  

Although we maintain a small underweight to non-U.S. equities, there is the potential to increase exposure to beaten down areas of the market in the new year, especially if the U.S. dollar’s strength softens. This could occur as the U.S. economy slows and interest rate differentials begin to converge as the Fed nears the end of its tightening cycle. We are also watching for opportunities in small cap stocks, which tend to outperform large caps when bear markets end. 

Importantly, alternative investments, or diversifiers, should continue to help enhance risk-adjusted returns and deliver diversification benefits via their low correlation to public markets, as we saw in 2022. 

Within alternatives, non-traditional strategies can take advantage of dislocations in markets and the economy while providing less correlated sources of return to portfolios. Real assets, such as infrastructure and private real estate, can benefit from rising prices and should continue to provide a good inflation hedge. Strategies such as global macro, distressed investing and opportunistic real estate are positioned to take advantage of dislocations that may occur globally as central banks continue to reduce liquidity and increase the cost of capital. 

We also believe recessionary and post-recessionary periods are opportune times to allocate to private equity as skilled managers can purchase companies at lower prices and utilize an active, hands-on approach to driving growth and creating value. 

Exhibit 8: Asset Class Positioning 

2023 and Beyond 

Investors should also remember the importance of maintaining a long-term perspective. Often after a challenging year of negative returns, markets gravitate toward their historical averages. In fact, our 2023 10-Year Capital Market Assumptions forecast higher returns across most asset classes compared to last year’s projections.

Exhibit 9: 2023 vs. 2022 10-Year Capital Market Return Assumptions

While we expect a better return environment in 2023, volatility is likely to persist until we gain more clarity on the lagged impact of the Fed’s tightening cycle on the real economy. However, any downturn from here will likely present investors with good entry points as markets tend to move higher over time.  

With that said, timing the bottom of the market is extremely challenging. We encourage clients to stay invested, as the best days in the markets often quickly follow the worst – and we have seen this play out this year during several bear market rallies. Most importantly, investors should remember that markets are forward looking and anticipate changes in the real economy, roughly 6-12 months ahead of when they appear in economic data. While the market is unlikely to bottom before the recession starts, it can rally before that data turn uniformly positive. 

Exhibit 10: Dangers of Market Timing

There will be an inflection point where markets see through to the recovery. This transition to an environment of higher rates, higher inflation and tighter monetary policy has been fraught with volatility. We believe the combination of timely asset allocation shifts, broad diversification, and the discipline to stay invested over the long term will be critically important. 

We will keep you informed of key developments and their impact on investment strategy and, as always, help you uncover opportunities that can help build and preserve your wealth.