The Bull Case for Next Year: It Won’t be Worse Than This Year

These days it’s all too easy for investment conversations to turn dark amid the worrying economic data and fiery political rhetoric. But while it’s clear that inflation is a problem and the world economy is slowing, the savvy investor also knows that even a slight improvement in either one can give markets a sudden boost.

The only question is when.

To be clear, we are not calling the bottom here. The Fed looks determined to keep rates rising until it does some damage to robust U.S. consumption trends. Europe faces winter with a breathtaking spike in energy prices and a central bank that acts more hawkish than ever. Meanwhile, China’s headwinds from COVID lockdowns, energy shortages, and real estate turmoil show few signs of dissipating. It has been a while since a global slowdown was so synchronized.

Through all this gloom, the S&P 500 did manage a 17% summer rally as the U.S. consumer price index seemed to peak, but the euphoria didn’t last. It's tempting to hope that slowing inflation allows the Fed to stop hiking next spring as gasoline, copper, and steel prices drop.

But America is still running hot. Household savings are still high and consumer credit is growing. The jobs market is tight and wages are rising. Even if inflation has peaked—and we’ll get an important update Tuesday this week—the path lower will have to be clear and persistent before there’s any chance of the Fed pausing, let alone easing, next year.

And if there’s one thing we have learned about data over the last few years, it’s that it is neither clear nor persistent for very long. This seems like a time to keep cash levels high, favor quality over value, and fill a portfolio with companies that will pay a reliable coupon or dividend.

Still, there will come a time when the data stops getting worse. Investment funds are hording larger-than-normal cash levels. Surveys suggest maximum bearishness. A little bit of good news could go a very long way in reversing the trend.

Even if the Fed still struggles to reach its 2% inflation target, a narrower range of, say, 3–5% would make it much easier for investors to make more predictable forecasts. Unemployment that inches higher from the current 3.6% will be greeted as good news that wage pressures will soon abate.

Elsewhere, we may not even need actual good news for markets to recover. The absence of bad news may be enough. Indeed, next year is unlikely to deliver an economic and political shock comparable to Russia’s invasion of Ukraine. European energy prices will be high, but it’s hard to imagine a jump that rivals this year’s.

China’s picture looks difficult but may not deteriorate more. The property market should stabilize further, even if it doesn’t return as a major driver of growth. While Chinese cities may face more COVID-related restrictions, global supply chains elsewhere should still ease.

What could sustain a rally next year when sentiment turns less sour?

If ever there were a U.S. economy that could withstand a Fed tightening cycle, it’s this one. The higher household savings and stronger corporate balance sheets mean U.S. demand may not suffer as much, even if rates rise. Unlike the aftermath of the Global Financial Crisis, U.S. banks are healthy and stand ready to lend when borrowers reappear.

Meanwhile, U.S. price expectations have remained mostly anchored in both surveys and financial markets. There is still abundant confidence that the Fed will bring inflation back down, which means it may not need to overtighten, as in previous cycles. If recession does come, it need not last long.

Of course, this may all be a mirage. If some investors can see this slightly less-dire picture through the current gloom, there are others who believe a world that looks like it has hit bottom can always find a way to dig deeper.

But just as the challenge of chess is to look ahead more than one or two moves to narrow the range of likely outcomes, the challenge of investing is to see through today’s economic numbers to envision what might come next. The important reminder here is that while we will never recognize the bottom when it comes, we have to keep watch.

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