Grandmother and grandson contemplating at home looking out of a window.

It has been a tough year for investors across the risk spectrum. Stocks and bonds have posted big losses even after a modest rebound in the last two months. We see some rocky times ahead in 2023, but those dips may prove to be worthy buying opportunities for long-term investors. Staying the course and keeping with your investing plan are key, but so many are downbeat about what the financial markets may bring next year.

According to a survey conducted by Ally this month, more than 40% of respondents think that another year of lousy annual returns is in store. That data jibes with other sentiment gauges in the market and even bleak outlooks from some of the major Wall Street research firms that forecast modest declines for the S&P 500 next year. Now’s the time when you should resolve not to fret about past returns but think of lower prices today — and next year — as a possible opportunity to pick up shares at lower prices.

Chart titled What do you expect to happen to the financial markets in 2023. Investors downbeat after a lousy year. Shows the percentage of what investors expect to happen in 2023 in the financial markets. 16% of investors expect the market to go down a great deal, 25% expect the market to go down moderately, 21% expect the market to stay the same, 19% expect the market to go up moderately, 5% expect the market to go up a great deal and 14% don’t know what to expect. Source: Ally

It’s not surprising to read about such doubtful opinions given the constant chatter of a looming economic slowdown and corporate earnings growth that is at two-year lows. Indeed, the consensus U.S. real GDP forecast for the first half of 2023 is about 0%, well below the positive rate seen in the third quarter of this year and what current projections show for Q4. We expect rocky times ahead in the economy with troubling economic data points along the way. Monthly job losses are certainly on the table toward the middle of the year.

For investors, though, it’s important to remember that stocks almost always lead the economy – meaning, the S&P 500 will probably bottom out before the quarter of weakest GDP growth. Moreover, even if a recession strikes, data from BMO Capital Markets found that the S&P 500 returns a decent 5.8% in all recession years since 1945. Therefore, if you have capital to allocate, then “the Warren Buffett way” to buy when everyone else is selling could turn out well. There are a few key variables that may determine how 2023 plays out on the economic front.

1. The Federal Reserve

Chair Powell and the rest of the Fed members will closely monitor how economic gauges develop during the first quarter. As it stands, after this week’s 0.5 percentage point hike, two more rate increases are priced into stocks. The Fed might then pause and assess the macro backdrop before making their next move.

With a Fed Funds rate just shy of 5% during the middle of 2023, yields on savings accounts and certificates of deposit will offer an appealing alternative to stocks, but those lofty yields might not last long. The Fed might become a friend for equities by late next year if traders see rate cuts, perhaps as a result of sluggish GDP growth.

2. Inflation

Driving Fed policy is inflation. There’s good news here — the headline CPI rate appears to have peaked at 9.1% way back in June. This week’s November reading revealed an acceleration of a downward trend. And we think CPI continues to cool through next year.

Investors and consumers can’t wait to see year-on-year inflation figures in the 2.5% to 3% range, and that’s exactly what the inflation swaps trading market discounts right now. Look ahead five years, and the average annual rise in consumer prices is seen at a reasonable 2.3%. Expect to hear less about inflation on the evening news over the coming quarters. (The 5-year TIPS/Treasury Breakeven Rate is calculated as the difference between the 5-year Treasury rate and the 5-year Treasury Inflation-Indexed Security rate. Market participants use this value as what they believe the expected inflation rate should be in the next five years, on average.)

Chart titled 5-Year Inflation Breakeven Rate. Future inflation rate expectations have fallen hard since March. Chart dates from December 2021 to December 2022, shows the inflation rate at about 2.7% and rising in March to 3.6% and falling in April before bottoming at 2.1% in September. The rate rises again in October to 2.6% and drops again in November before breaking at 2.3%. Source: Ally Invest, St. Louis Federal Reserve.

3. Earnings

What will make headlines and keep forecasters on their toes, though, are trends in corporate profits. This is the big unknown. What will 2023 S&P 500 earnings per share be?

Currently, the consensus forecast, according to FactSet, is for $232 of earnings per share for the stocks in the S&P 500 Index, but some banks have bleak forecasts near $200. Using a 25-year average S&P 500 forward price-to-earnings (P/E) ratio of 16.8, and $200 of EPS would put stocks about 12% lower from here. If a more sanguine $232 of earnings happens, then the index trades at near average 16.5 earnings multiple. Once again, though, equities often start rising before the low in earnings – by six months, on average since 1950, according to Ari Wald at Oppenheimer.

The bottom line

There’s a reasonable chance of an economic and earnings recession next year. The good news is that stocks often sniff out an eventual recovery before the worst of the data crosses the wires. Investors should expect more volatility ahead but be prepared to consider buying on weakness in the first half while GDP growth may be back on the upswing later in 2023.