2023 Market Outlook: Diversifying Against the Unknown

By Dr. Sylvia Kwan

This time last year, I shared our 2022 market outlook: “cloudy, with a chance of meatballs.” My reference to the animated movie was meant to represent all that we couldn’t yet know about what might happen in 2022. With high inflation as a cloudy backdrop, the possibility of raining meatballs — things and events that seem so implausible we couldn't possibly predict them — felt high. And wow, what a year it turned out to be for meatballs.

In early 2022, experts predicted that inflation would be temporary, that the Federal Reserve would raise rates slowly, and that stocks would finish the year in the black. Those predictions … well, let’s just say they didn’t work out. Instead, inflation proved persistent, leading the Fed to raise rates aggressively, not just once or twice, but seven times. China’s zero-COVID lockdown lasted for most of the year, exacerbating global supply chains and adding fuel to the already-blazing fire of high inflation. And Russia invaded Ukraine, which further tightened constrained commodity supplies and disrupted oil supplies, particularly for Eurozone countries.

Oh … and the crypto world? So many implosions it makes my head spin. Bitcoin finished the year down 65%, and LUNA, along with its stable coin TerraUSD, plummeted mid-year, sending crypto firm Three Arrows Capital and others into bankruptcy. Most recently, cryptocurrency exchange FTX collapsed, and its founder is being charged with fraud and using customer funds for personal benefit.

Technology stocks suffered, as well. After becoming the most valuable automaker in mid-2020 and rising 50% in 2021, Tesla sunk 65% for the year, due to concerns over slowing demand, production challenges in China, and its founder’s highly public acquisition and focus on Twitter. FAANG favorites like Meta (Facebook) and Amazon fell, too, by 65% and 51%, respectively.

With surprises like these, it’s no wonder 2022 was a disappointing year for investors. The S&P 500 finished down 19%, the DJIA down 8.8%, and the NASDAQ down 33%. Overseas, Stoxx Europe 600 finished the year down about 13%, and both Hong Kong’s Hang Seng Index and China’s Shanghai Composite were down about 15%. The Federal Reserve’s aggressive rate increases also dragged bonds down, with the 10-year US Treasury note closing the year with its worst performance in more than 200 (yes, you read that right) years.

In times like these, how can we reduce risk?

If you’ve been with Ellevest for awhile now, you know what we’re going to say: investing consistently and diversification.

And for those with access and capacity: non-correlated alternatives.

Energy was the only S&P 500 sector with gains this year. But it wasn’t the only asset class with positive returns.

Since the beginning of private wealth at Ellevest, we’ve been discussing — well, hammering home, really — the importance of eligible investors having an allocation to private, alternative investments that have low correlation with stocks and bonds. When everything from stocks to bonds to crypto was going up, like it had for more than a decade until early 2022, it was hard to understand why alternatives matter. But 2022? These investments were flashing green (pun intended).

While tech, large cap growth stocks, and bonds were all hit hard by last year’s rising interest rates, alternative investments like renewable energy assets and affordable housing continued to perform. And it’s not hard to understand why: There will always be a demand for electricity, and when it’s generated using free natural resources like the sun and the wind, there isn’t much — not even a global pandemic — that can adversely impact its supply. With both supply and demand steady, renewable energy assets generate consistent returns, regardless of how stocks behave or where interest rates are heading. Similarly strong is the demand for affordable housing in the US, and that demand continues to outpace supply. This imbalance — which widens even more during recessions, when economic hardship creates even more demand for low-income options — is what helps drive returns in this asset class, as opposed to how stocks or bonds are performing. As long as this gap exists, investments in affordable housing can generate financial returns. (And let’s not forget the positive climate and social impact of these alternatives — those returns matter, too.)

So what comes next?

I don’t have a crystal ball, but the data makes it clear that we’re not out of the woods yet. Inflation is still high (if down from its peak), and the labor market is still strong (if showing signs of slowing). Retail sales are weakening and housing prices have softened. This all points to a slower economy on the horizon (one of the goals of the Fed’s rate increases). Most economists and experts are forecasting a mild to deep recession, judging from the inverted yield curve, a market indicator that has historically preceded recessions.

I (like Sallie) won’t be making any market predictions for 2023. Markets are impossible to predict, and even experts get it wrong. And long-term investors shouldn’t spend time worrying about whether or not we’re headed for a recession this year, anyway. Recessions help reset market prices; they’re a part of normal economic cycles. Since 1857, the US has had more than 30 recessions. Most of those were characterized by high unemployment and stagnant and/or slow economic growth. Today’s labor market, by contrast, remains uncharacteristically strong, and US GDP experienced higher growth than expected in Q3. So it’s still anyone’s guess.

The key to getting through recessions (if we do end up in one) is to have a long-term perspective and a financial plan with an investment portfolio diversified enough that it can keep performing despite market shifts, through recessions, contractions, expansions, rising and falling interest rates, and low and high inflation. If 2023 proves to be a continuation of 2022, consistent investing and diversification will still be your friend. And if you have the access, having alternatives with low correlation to stocks and bonds in your portfolio can help soften the impact of lower stock and bond prices. And if the economy instead starts to recover in 2023, or if the Fed pivots to lowering rates, bonds, and even possibly stocks, will benefit.

In short, diversification is still your best defense against the unknown. It’s like an umbrella for those raining meatballs, those unknown unknowns that we have no way of predicting. You’ll probably still get wet, but you won’t be soaked. While we hope for a positive 2023, hope isn’t a strategy. Being prepared with a diversified portfolio that can withstand market ups and downs is.

Here’s to a happy and healthy 2023, with fewer cloudy skies ahead.


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Dr. Sylvia Kwan

Dr. Sylvia Kwan is the Chief Investment Officer of Ellevest.