2023 Market, Policy & Planning Outlook

As we approach the end of the year, it is time to reflect on the past year and prepare for the year to come. We recently sat down with our market and policy experts Jason Trennert and Dan Clifton at Strategas to understand their outlook for 2023. To put these insights into context for your plan, Heather Osborn and Tim Steffen highlight key strategies to consider for the year to come.

Market Outlook

Jason Trennert
Chairman and CEO of Strategas

What is your outlook for inflation and, subsequently, Federal Reserve policy in 2023?
Unfortunately, I think I have a little bit more of a bearish view than consensus. We probably wouldn’t quibble with the idea that inflation has peaked, but we're also of the view that there are structural elements of inflation—whether it's due to tight labor markets, energy markets, de-globalization, or other factors—that could keep inflation higher for longer (and certainly higher than the Fed's target of 2%). As a result, we think that the Fed may finish its tightening program in the first quarter of 2023, but is likely to leave rates quite a bit higher and for longer than the stock market believes.

What informs Strategas’ below-consensus outlook for corporate profits in 2023?
That is largely driven by our opinion that the chances of a recession are quite high in 2023. We also believe that corporate profits will be pressured by wage gains (shown in the chart to the right). We're looking for earnings to be down about 10% year over year (our S&P 500 EPS estimate is $200; consensus is around $230). In a typical recession, earnings contract by around 30% on average. So, we don’t think it will be as bad as that, but it will probably be quite a bit lower than consensus is expecting.

How are you positioning your firm’s portfolios to reflect your outlook?
We’re positioning our portfolios a lot more defensively than we normally would given our expectation for a recession in the next two years. As a result, we're holding more cash than would normally be the case, and our sector weights tend to be quite bit more defensive. So, we're overweight Healthcare and Consumer Staples, two classically defensive sectors. We also have an overweight in Energy, but that's really driven more by structural issues in the energy market than any sort of cyclical call. But whatever sector an investor is looking at, we believe that they should be focusing on companies that are generating cash flows and profits. Our view is that, because of the shift in monetary policy, companies that can fund their own growth (as opposed to relying on capital markets) are going to have a robust advantage over the next couple of years.

What is something that you feel is currently being underdiscussed?
One of the things that I am looking at pretty carefully is government spending as it relates to inflation. Over 60% of government spending is indexed to inflation. As an example, the cost of living adjustment for Social Security was 8.7% in 2022. So, despite the Fed's best efforts to tighten policy, they're going to end up fighting the federal government in a way. We're watching to see how much that will affect the Fed’s efforts to bring inflation down. We’re also watching profit announcements and earnings revisions very carefully because thus far, expectations for earnings have slowed quite a bit, but there haven't been many layoffs aside from Silicon Valley. So, we're watching profit projections to see whether more layoffs are in the offing.

Policy Outlook

Dan Clifton
Partner and Head of Policy Research at Strategas

What happened in the midterm elections and what does it mean for governing in 2023?
The 2022 midterm elections had a bifurcated outcome. Voters removed the party in power for the eighth time in the past nine elections. This is the most political volatility in the United States since the end of the Civil War. At the same time, voters gave the Republicans a razor thin majority in the House of Representatives (similar to the Democrats’ narrow majority over the last two years). A five seat majority indicates to us that the U.S. is essentially a 50/50 nation, and we just keep passing the baton back and forth in these razor thin majorities. That argues for not much getting done in 2023. We anticipate that the Democrats in the Senate will pass messaging bills that are unlikely to be signed into law. At the same time, Republicans in the House will pass similar bills on energy, immigration, and other key policy issues. When you pull all that together, the only legislation likely to actually pass in the beginning of the year will deal with the budget and the debt ceiling—bills that must pass and will require compromise.

Why will 2023 bring the return of “deficit politics,” and what are the ramifications?
As we head into 2023, we're going to start seeing a deterioration in the US budget deficit. Tax revenues will begin to slow as the economy slows, but more importantly, the net interest cost on the national debt is set to rise meaningfully over the next few years. This is because the Federal Reserve has been raising interest rates to stamp out inflation, which will make the cost of servicing the U.S. debt much more expensive. This is going to come at a time—probably around July—when Congress will be forced to raise the debt ceiling.

In exchange for raising the debt ceiling, Republicans are going to demand some level of cuts after the spending of the last two years. The Democrats did a deal very similar to that in 2011, but it’s unlikely the parties will reach the same agreement this time around. That means we can expect some brinksmanship on these fiscal issues in the first half of 2023. Ultimately, we think there will be a compromise—possibly centered on some sort of commission to study recent federal spending and ways to make entitlement programs more solvent for the future.

How do you see Deglobalization—one of Strategas’ highest conviction themes—evolving over the course of the year?
While the U.S. remains a highly polarized, 50/50 country, the one bipartisan item in Washington right now is bringing home supply chains due to greater national security risk stemming from geopolitical events in Russia and China. We are likely to see a continuation of the policies of the last two years around onshoring (i.e., bringing key supply chains and manufacturing back home). This included paying the semiconductor companies $75 billion to bring their factories to the U.S., and now, over the course of the next few years, we’ll have eight new semiconductor facilities being built here. Congress is now looking at other critical industries that might make sense to start bringing supply chains home. At the top of that list is the antibiotic industry and, more broadly, the biotech and pharmaceutical industry. This is to ensure that we have proper medications and are not subject to supply chain disruptions in health events. We're also seeing more and more companies wanting to be located closer to their end customer, not just in the U.S., but in all other places they’re selling. Ultimately, will likely see more companies starting to say, “Let's relocate in the United States and let's create American jobs.” And we expect Congress to continue to push legislation to incentivize these companies to locate here closer to the American worker.

Planning Outlook Takeaways

Heather Osborn
Director of Wealth Planning

Tim Steffen
Director of Advanced Planning

Planning Takeaway No. 1: Market Turmoil Can Create Planning Opportunities
As investors, we’ve been pretty spoiled in recent years with positive market returns, with any pullbacks being relatively short-lived. That changed in 2022, when it seemed there were negative returns everywhere we looked. Even still, there are strategies that can benefit from a market correction:

• Any losses in a portfolio can provide tax savings, especially when they’re used to offset gains that are realized elsewhere. Even if you don’t have gains to offset those losses, there can be value in carrying them forward to use in a future year.
• Significant volatility can mean your portfolio has drifted from your target asset allocation. Rebalancing back to that target in a year where the market has performed positively can be difficult to stomach because of the tax costs associated with selling things at a gain. But, in a year like this, the tax cost may be much less when it comes to rebalancing.
• Converting dollars from a Traditional IRA to a Roth IRA does trigger a tax liability, but at today’s lower asset values, that tax cost can be much less. Any gains that follow from a market recovery can be captured inside a tax-free account.
• In a market with declining asset values, you may be able to transfer additional shares of a stock or mutual fund to heirs without running afoul of the gift tax limitations.

Planning Takeaway No. 2: Inflation Has Surprising Upsides for Tax Planning
While inflation has been one of the biggest headlines in 2022, it does present some meaningful planning opportunities for taxpayers in the upcoming year. Tax numbers are adjusted every year for inflation, but because of the significant increase we saw this year, the adjustments for 2023 are especially noteworthy:

• In 2023, the annual gift tax exclusion will increase by $1,000 to $17,000. That’s the second consecutive year we’ve seen such an increase – the first time that’s ever happened.
• The amount of income subject to the various tax rates will be increasing as well. While the tax rates themselves won’t be changing, the amount of income subject to each of those rates will go up dramatically, meaning more income will be available to be taxed at the lower rates.
• The standard deduction will be increasing by nearly $2,000. Roughly 90% of taxpayers use the standard deduction versus itemizing. For those taxpayers, they’ll see almost $2,000 additionally exempt from tax in 2023.
• Lastly, retirees will see their social security benefits increase by 8.7% in the coming year – the largest increase in benefits in more than 40 years.

Planning Takeaway No. 3: Take Time to Review Your Goals and Plan
The end of the year is an especially useful time to reflect on your plan. Spend some time reflecting on your goals for the year to come: whether it’s retirement, that trip-of-a-lifetime, a wedding, or a new home. Visualizing and writing down your goals can help make your savings plan all that more successful.

Many savings plans begin by maximizing your retirement plans. Contributions to these types of plans adjust each year for inflation and so they will increase significantly in 2023. For those aged 50 and over, an additional catch-up contribution is available as a means to supercharge your overall savings plan. Most plans offer both a Traditional and Roth options, weigh the pros and cons of each option to decide which is best for you.

Another place to consider saving is a 529 plan, which is a great tax-advantaged vehicle for future education expenses. Doing this via automatic deposit can be a great way to maintain automatic savings as part of your plan.

Planning Takeaway No. 4: To-Do’s for Year End
This time of year is also great to check-in on elements of your plan to make sure they still align with your circumstances:

• Estate plans are often viewed as a set-it-and-forget-it, but it’s important to make sure your estate plan is still in line with your overall financial situation, your family circumstances, and even where you live.
• Insurance coverage should be reviewed – not just life and disability, but home and liability as well. If your home has increased in value, or you’re an empty nester who does not require the same amount of insurance as you used to, you’ll want to make sure your policies reflect your living situation.
• Digital footprints seem to get larger every year. Be sure to reset online passwords as needed, and enroll in an identity theft program to monitor and stop any activity before it becomes a problem for you.

As we head into the end of 2022 and begin to look forward to 2023, use this time to take stock of where you are both personally and financially, and make sure you’re taking the steps necessary to meet all those financial goals you’ve set for yourself. Your Baird Financial Advisor can help you identify those opportunities and make sure you start 2023 off on the right foot.

The information reflected on this page are Baird expert opinions today and are subject to change. The information provided here has not taken into consideration the investment goals or needs of any specific investor and investors should not make any investment decisions based solely on this information. Past performance is not a guarantee of future results. All investments have some level of risk, and investors have different time horizons, goals and risk tolerances, so speak to your Baird Financial Advisor before taking action.