We're in the closing stretch of 2022, and if you're an investor you're probably saying "good riddance." The S&P 500 is down 16% year to date, on track for its worst performance since 2008, and the broad market index has been in a bear market for nearly six months after peaking in the first week of the year. In fact, only one sector of the 11 in the S&P 500 is positive for the year: energy.
However, there's some good news for investors. While a number of economists are predicting a recession in 2023, next year could also mark the start of a new bull market. Here's why.
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1. Inflation is cooling off
The latest inflation readings have been undeniably bullish for the stock market. In fact, the S&P 500 jumped more than 5% on Nov. 10 and the Nasdaq was up nearly 7% when the October Consumer Price Index report came out, showing inflation was lower than expected.
Year over year, the headline number was up 7.7%, less than the 7.9% economists had expected and below the 8.2% reading in September. At 7.7%, overall inflation was the lowest it's been since January, and core inflation, which excludes the volatile food and energy categories, slowed from 6.6% year-over-year growth in September to 6.3%.
While those numbers are still high, they are definitely trending in the right direction and the trend should get better as month-over-month inflation has already decelerated significantly. Over the last four months, consumer prices have increased just 0.9%, or an annualized rate of 2.7%. That's partly due to declining energy prices, but other categories have moderated as well.
The slowdown in inflation makes sense. Rising interest rates and expectations of a recession have created a feedback loop where businesses and consumers have become more cautious about spending. Digital advertising demand fell sharply in the third quarter and retail titans like Amazon and Target have predicted unusually weak holiday quarters. Oil prices are also down more than a third from their peak earlier this year and are now around the lowest they've been all year.
Plenty of unexpected factors could influence inflation next year, but the trend toward lower price growth is clear, and that could help propel stocks higher in 2023.
2. The Fed pivot is coming
Perhaps the most anticipated market event of 2023 is the so-called Fed pivot, or the central bank's expected move to stop raising interest rates.
With the fed funds rate already hovering near 4% after four straight 75-basis-point hikes, it's more likely that investors will get a change in policy from the central bank sooner rather than later. According to the minutes from the latest Federal Open Markets Committee meeting, a substantial majority though slowing the pace of rate hikes "would likely soon be appropriate." The Fed's "dot plot" from September, which shows the central bankers' forecast for future rates, indicated that they only expect to raise rates modestly in 2023.
The Fed's aggressive rate hikes, which it's doing in order to bring inflation under control, have been one of the biggest reasons for the decline in the stock market this year. Once the rate hikes stop, the market should find an equilibrium point.
Though a recession is very much a possibility, the good news for investors is that the labor market has held up well even as the Fed has hiked rates. So 2023 could see a scenario where benchmark rates range between 4% and 5%, but the labor market remains strong. In that event, the economy would likely avoid a recession and stocks would rebound.
3. The war in Ukraine could come to an end
Geopolitical events can also have an outsize impact on markets, and that's particularly true of the war in Ukraine. Oil prices soared after Russia invaded its neighbor and have remained elevated since then. Meanwhile, higher energy costs in Europe are threatening to sink the economy.
Ukraine and Russia are both major food commodity producers as well, and the conflict has led to significantly higher prices for food over the last year. The Organization of Economic Cooperation and Development recently warned that the war has taken a heavy toll on the global economy. There's no going to back to the time before the war happened, and Russia is likely to remain an international pariah, but the end of the conflict would help stabilize food and energy prices.
While the war could rage on for years, there are signs that both sides could prefer a faster resolution. As reported by The New York Times, Ukraine is hopeful that recent victories could be the beginning of the end of the conflict, while Russian spokespeople have expressed interest in negotiating toward a final resolution.
Though it may be speculative to anticipate the war's end next year, the possibility shouldn't be overlooked. That, along with the falling inflation rate and a change in the Fed's interest rate policy, could have investors singing a much different tune a year from now.
