Midyear outlook: Expect a bumpy ride before sailing gets smoother

One of the engines on a large airplane, hanging down from the wing.”

Darrell Cronk explains how investors may want to prepare ahead of the moderate recession Wells Fargo Investment Institute expects.

Darrell L. Cronk, CFA; President, Wells Fargo Investment Institute; Chief Investment Officer, Wealth & Investment Management
Darrell L. Cronk, CFA
President, Wells Fargo Investment Institute
Chief Investment Officer, Wealth & Investment Management

Anyone who’s ever flown has likely experienced turbulence — from the kind that feels like you’re on a bus travelling a bumpy road to those flights when the pilot tells everyone to return to their seats and not roam around the cabin.

To be clear right off the bat, the subtitle of the 2023 Midyear Outlook from Wells Fargo Investment Institute — “Navigating End-of-Cycle Turbulence” — refers to something more like that first type of turbulence. What we’re expecting in the months ahead probably won’t be pleasant, but market volatility isn’t unusual before a recession, and we believe it will eventually run its course. Then we anticipate a smoother ride and more opportunities in 2024.

While it may be tempting for investors to let down their guard during the inevitable bear market rally, we continue to believe now is the time for investors to prepare for it by keeping their seatbelts fastened. By that, I mean we’re maintaining our guidance to remain defensive in portfolio positioning.

For help with determining what you may want to do with your portfolio to get ready for the coming months, I recommend reading our Midyear Outlook. It offers detailed guidance with a focus on the following four asset types.

Equities. Our view is that corporate revenue growth will stall in the remainder of 2023 as the economy likely falls into a moderate recession. Throw in fixed costs that take time for companies to reduce at a time of declining sales as well as stubborn input and wage costs, and we expect operating margins to continue declining toward pre-COVID-19 levels. We see these factors weighing on earnings in 2023 and early 2024, and our S&P 500 Index target ranges reflect that: 4,000 – 4,200 for year-end 2023 and 4,600 – 4,800 for year-end 2024.

We continue to prefer quality stocks and defensive sectors, and favor U.S. large-cap equities over mid- and small-caps. Playing defense at the sector level includes a preference for the Materials, Health Care, and Energy sectors.

Once the recession appears fully priced in to market valuations, we expect an opportunity to position for a 2024 recovery. Our 2024 targets anticipate that U.S. small-cap equities will outpace U.S. mid-cap equities, which in turn will outgain U.S. large-cap equities.

Fixed income. We believe the next 6 to 18 months will present fixed income with two distinct environments: recession and recovery. Against this backdrop, we favor a barbell strategy that emphasizes short term and long term. We envision positive returns for both taxable and municipal bonds through year-end.

Headwinds are rising in credit markets, and we prefer to focus on bond quality. We favor government securities, particularly U.S. Treasuries, and we believe that investment-grade corporates should retain strength. In contrast, we find high-yield securities to be currently overpriced and suggest caution given that spreads are set to widen further.

Real assets. We believe 2023 may see a short-term price pause before the resumption of a long-term commodity bull super-cycle (a multiyear period in which commodity prices climb together as a family). Even under the pressure of a global economic slowdown, we foresee modest upside for prices from current levels and stronger performance in 2024.

Our outlook for a weaker U.S. dollar should support gold and precious metals prices. We believe the bull super-cycle is very likely to produce performance across all sectors.

Rising interest rates continue to weigh on real estate values. How bad these headwinds may be for public real estate investment trusts (REITs) depends in large part on the timing of future Federal Reserve (Fed) policy actions. Should the Fed cut interest rates in early 2024, public REITs may experience some relief.

Alternative investments. In alternatives, we favor hedge fund strategies with low correlations to stocks and bonds to help offset potential volatility in these markets. We are focusing on Relative Value (especially Arbitrage and Long/Short Credit sub-strategies) and Global Macro (both Systematic and Discretionary sub-strategies).

From a private capital perspective, Small and Mid-Cap Buyout and Growth Equity could offer potential opportunities amid recession.

We favor Distressed Credit strategies among hedge funds and private capital as sources of opportunity as credit market stress develops.

For more on these recommendations, and others, along with our top five portfolio ideas for the coming months, download the report.

Wells Fargo Investment Institute, Inc. is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

Forecasts and targets are based on certain assumptions and on our current views of market and economic conditions, which are subject to change.

All investing involves risks, including the possible loss of principal. There can be no assurance that any investment strategy will be successful and meet its investment objectives. Investments fluctuate with changes in market and economic conditions and in different environments due to numerous factors, some of which may be unpredictable. Asset allocation and diversification do not guarantee investment returns or eliminate risk of loss. Each asset class has its own risk and return characteristics, which should be evaluated carefully before making any investment decision. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Some of the risks associated with the representative asset classes include:

Stock markets, especially foreign markets, are volatile. A stock’s value may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors.

International investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging and frontier markets. Investing in small- and mid-cap companies involves additional risks, such as limited liquidity and greater volatility.

Investments in fixed-income securities, including municipal securities, are subject to market, interest rate, credit, liquidity, inflation, prepayment, extension, and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in a decline in the bond’s price. High-yield fixed-income securities are considered speculative, involve greater risk of default, and tend to be more volatile than investment-grade fixed-income securities. Municipal securities may also be subject to the alternative minimum tax and legislative and regulatory risk, which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income.

U.S. government securities are backed by the full faith and credit of the federal government as to payment of principal and interest if held to maturity. Although free from credit risk, they are subject to interest rate risk. Although Treasuries are considered free from credit risk, they are subject to other types of risks. These risks include interest rate risk, which may cause the underlying value of the bond to fluctuate.

Real assets are subject to the risks associated with real estate, commodities, and other investments and may not be appropriate for all investors.

Alternative investments, such as hedge funds, funds of hedge funds, managed futures, private capital, real assets, and real estate funds, are not appropriate for all investors. They are speculative, highly illiquid, and are designed for long-term investment, and not as trading vehicle. These funds carry specific investor qualifications which can include high income and net-worth requirements as well as relatively high investment minimums. The high expenses associated with alternative investments must be offset by trading profits and other income which may not be realized. Unlike mutual funds, alternative investments are not subject to some of the regulations designed to protect investors and are not required to provide the same level of disclosure as would be received from a mutual fund. They trade in diverse complex strategies that are affected in different ways and at different times by changing market conditions. Strategies may, at times, be out of market favor for considerable periods with adverse consequences for the fund and the investor. An investment in these funds involve the risks inherent in an investment in securities and can include losses associated with speculative investment practices, including hedging and leveraging through derivatives, such as futures, options, swaps, short selling, investments in non-U.S. securities, “junk” bonds and illiquid investments. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. At times, a fund may be unable to sell certain of its illiquid investments without a substantial drop in price, if at all. Other risks can include those associated with potential lack of diversification, restrictions on transferring interests, no available secondary market, complex tax structures, delays in tax reporting, valuation of securities and pricing. An investment in a fund of funds carries additional risks including asset-based fees and expenses at the fund level and indirect fees, expenses, and asset-based compensation of investment funds in which these funds invest. An investor should review the private placement memorandum, subscription agreement and other related offering materials for complete information regarding terms, including all applicable fees, as well as the specific risks associated with a fund before investing.