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Eric Freedman, U.S. Bank’s Chief Investment Officer, talks about what he’s expecting for global financial markets as the economy slows and interest rates rise.

The past year has been a wild ride for the economy and global financial markets: record-high inflation, rising interest rates, and slowing consumer and business spending.

Eric Freedman, U.S. Bank’s Chief Investment Officer, talks about what we expect to see from the Fed, company earnings and the housing market in 2023.

What are you watching going into 2023?

We’re keeping an eye on three major and related themes going into the New Year: the U.S. Federal Reserve (Fed) and interest-rate increases, inflation pressures and souring consumer and business sentiment.

Interest rates

In 2022, the Fed raised interest rates six times – including the most recent 50 basis point increase in December. We don’t think that’s all coming to an end as soon as Jan. 1 hits. Inflation’s still at an all-time high, and the Fed wants to get it down to an annualized rate of 2%.

Inflation pressures

Prices have surged for almost everything around the world: food, heating, transportation and housing. The Fed is trying to bring this down with interest-rate increases, but it will take some time. They are aiming for a “soft landing:” cooling the economy without widespread housing market pain, business bankruptcies or high unemployment. We’re watching how both consumers and businesses react to ongoing inflation. Will they continue to spend money? We’re already starting to see people change their shopping habits (buying off-brand products) and increase their reliance on credit cards. However, we do see inflation pressures dwindling in the second half of 2023 as the economy slows.

Souring sentiment

High interest rates and inflation are already making consumers and businesses less confident about the economy. In November, the University of Michigan Survey of Consumers – a key indicator of how individuals feel about the economy – showed a sharp drop. Will sentiment keep falling as interest rates continue to rise? It’s something we’re watching closely.

We've seen higher prices on just about everything in the past year -- gas, groceries, electric bills, even cars. But consumers have remained surprisingly resilient. Why do you think that is, and will it continue?

Several factors are at play here. First, during the pandemic, people weren’t spending as much on travel or eating out. Second, people received several rounds of stimulus payments, which many put in their savings accounts. Third, the job market has remained strong, and wages have been going up around the country. But savings rates are dropping to historic lows as people spend money on experiences like travel and as inflation takes a bite. We don’t think the current pace of spending will continue. If the economy continues to deteriorate in 2023 – like if companies lay off workers or inflation continues to rise – that could slow spending even more.

The markets have had an extremely volatile year. What should investors now be doing with their money to outrun inflation?

Right now, we are recommending investments with consistent and growing cash flows, such as global infrastructure, which includes utilities, toll roads and midstream energy investments. These defensive-oriented, dividend-paying equities were among the best-performing companies in 2022, and we look for this trend to continue into 2023.

In addition, companies in the health care, real estate, consumer staples, financials and energy sectors present relatively stable growth in a variety of economic environments.

We also believe that high-quality, short-term bonds will deliver favorable returns in 2023. Treasuries offer attractive income, and opportunities in long-term Treasury bonds could improve as interest rates peak and the economy slows.

Many companies that have recently reported earnings have performed better than expected. Do you think this will continue into 2023? What will that do to the markets?

We believe investors will reset their expectations around corporate earnings in 2023 as companies digest higher costs like wages and rising borrowing costs thanks to elevated interest rates. We also believe the economy is losing momentum.  If consumers slow down their spending at retailers and on things like airfare, hotels and restaurants, that will also impact corporate earnings. Higher interest rates amid a slowing economy increases the possibility of a recession in 2023.

Investors seem to think the Fed is going to take its foot off the gas as far as interest-rate increases and that inflation is easing. Do you think that's the case?

We do anticipate that the Fed will slow the pace of interest-rate increases. However, if the Fed maintains interest rates at a high level for longer than businesses and consumers can withstand, that’s a risk. Investors have been very focused on where interest rates may peak, but what’s more important is how long the Fed keeps interest rates elevated.

Housing prices -- both for mortgages and for rent -- are at all-time highs, and it's getting harder and harder for most people to afford a home at all. What's your outlook there, and what's the impact on the markets?

We think high mortgage rates will remain a drag on the housing market into 2023. With 30-year mortgage rates near 7%, housing is less affordable, hurting potential new home buyers and reducing the number of potential buyers looking to “trade-up” (as well as people looking to refinance their current mortgages). Housing prices have important implications. First, data show that people tend to spend more money when they perceive that the value of their home is increasing. Second, home prices are tied to mortgage rates, which are of course tied to interest rates. If the Federal Reserve starts to slow its rate of interest-rate hikes and even switches to an easing strategy (markets think the Fed will start to cut interest rates at some point in 2023), that may help stabilize home prices. However, the housing market will also take a cue from the broader economic climate, so lots of variables in the mix here.  

When do you think things will start to get better (for investments, for prices)?

We believe inflation may start to slow but will remain high by historical standards as workers demand wage increases to fill vacancies, businesses face a worker shortage, and everyone is impacted by ongoing supply constraints due to COVID-related shutdowns in countries such as China and the ongoing Russian/Ukrainian conflict.

Markets have to digest both higher interest rates and a slowing economy. Some investors also think companies’ profit expectations for 2023 need to come down; Wall Street can be overly optimistic to begin with, and adding in a slowing economy and the impact of cumulatively high interest rates may help drive expectations back to more reasonable levels. As is often the case, the pendulum that swings between optimism and pessimism can swing too far in either direction, providing opportunities for patient investors with long time horizons. We don’t think this time period will be any different.

Read more about U.S. Bank's 2023 investment outlook.