Inflation will remain the key factor in determining how markets perform
Markets are pricing in a rosier 2023, with inflation rates falling dramatically from 2022 — a year of upheaval. However, investors who bet on the future currently informing financial market valuations are unlikely to make money. They need to have a different view, be it positive or negative, and that view needs to pan out.
Where do we stand today? Most indicators point to a steep drop in inflation in 2023. First, US inflation has started to trend downwards, having peaked at 9.1% in June and falling each month to 7.1% in November. Equity valuations are by no means “cheap”, with the blended forward price-earnings ratio of the S&P 500 still above its long-run average , and there is a substantial risk that 2023’s earnings come in below what the market expects. Blended 12-month forward earnings were being upgraded as recently as June and have been cut by less than 5% since then.
Once inflation and interest rates start declining, these stocks may outperform the market. In addition, less defensive sectors that have performed poorly due to fears of a recession may, counter-intuitively, outperform when a recession arrives as the market looks forward towards a recovery.
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