Most investors will likely be happy to put 2022 in the rear view after a particularly tough year for the market, largely due to rising interest rates by the Federal Reserve in an effort to get inflation under control.

The Dow Jones Industrial Average, which is composed of 30 of the largest stocks trading on the New York Stock Exchange and the Nasdaq, is down close to 8% this year. The Nasdaq Composite, which essentially serves as a proxy for the tech sector, is down close to 30% this year.

There's still a lot of uncertainty heading into the new year, including the trajectory of interest rates and what kind of recession, if any, the economy might experience in 2023. Let's take a look at which index might perform better in 2023.

Slowing interest rates

A big question regarding which index will perform better has to do with how the Federal Reserve will proceed with interest rate hikes. The Fed, seemingly behind the eight-ball on inflation heading into this year, implemented a number of jumbo interest rate hikes. The Fed's key benchmark interest rate has risen from practically zero at the beginning of the year to a current range of 3.75% to 4%.

Person looking at computer.

Image source: Getty Images.

Rising interest rates have been particularly devastating to tech companies because they make the cost of debt and doing business much more expensive, which can eat into profits and decrease the future value of cash flows. Rising rates also make safer assets like U.S. Treasury bills yield more, which makes riskier assets less appealing. Many tech companies rose to incredibly high valuations in 2021, and there was very little margin for error.

Now, the question is where does the Fed go from here? Recent inflation data hints that consumer prices are finally starting to take a breather, which may allow the Fed to do only a half-point hike at its December meeting, representing a slowdown after all of the 0.75 percentage point hikes.

Many Fed members believe that getting the Fed's benchmark rate to 5% could be enough to win the war on inflation, although some members such as St. Louis Fed President James Bullard believe rates will need to go higher. Rising interest rates have hammered the Nasdaq this year, so if they slow and eventually stop next year that will likely help tech.

Thinking about a recession

The next thing that will likely be a big factor in the Dow's and Nasdaq's performance is whether there is a recession, and if there is one, how severe that recession might be.

Recessions can lead to higher unemployment and a slowdown in consumer spending, as well as business activity. It may also be problematic because the U.S. personal savings rate has gone from all-time highs to near-record lows, while outstanding consumer debt has really risen sharply this year and is now above pre-pandemic levels.

Now, just like any sector, some tech companies are more beholden to the consumer than others, and some companies in the Dow are in fact tech companies. But I would assume that larger and more stable companies in the Dow are likely going to fare better than a number of companies in the Nasdaq, should there be a deep recession. Companies like Johnson & Johnson and Microsoft (also on the Nasdaq) have incredibly strong balance sheets.

Which will win?

There's still a lot we don't know about where inflation and interest rates will go from here, and what kind of recession there will be in 2023.

But ultimately, given the information I have today, I think the Nasdaq will perform better next year. I think inflation is going to keep coming down over the next six months, which will allow the Fed to take its foot off the gas and ease up on rate hikes, which will benefit tech stocks.

I do think some kind of recession is likely, but because unemployment is so low right now, I'm more of the opinion that we would only see a mild recession in 2023 and that a more severe economic downturn, if it happens, wouldn't hit until 2024.