3 Things Investors Should Watch Closely in 2023

Most of the talking heads and analysts believe that the major indices will be slightly higher by the end of the year, with a high single digit gain. Most also believe, as do I, that this will be achieved with some weakness in the first half and a bounce-back in the second. Both my training and my nature make me a contrarian, especially in the face of what feels like unanimity among analysts but, try as I might, I can’t poke any logical holes in that vision, and so I find myself largely in agreement with these broad predictions.

However, market predictions, or predictions of any kind, are based on certain assumptions, and any kind of consensus usually means that everyone is working on a common set of assumptions. This year, such assumptions include things like the Fed slowing rate hikes to a stop by the end of Q2 and maybe reversing to cuts later in the year; a Republican House introducing business-friendly legislation; and no major geopolitical shifts or shocks. If something goes wrong and the predictions miss, it will probably be because one or more of those assumptions will be wrong.

With that table-setting and those caveats in mind, what should investors be watching for possible downside risk this year? Here are three things in particular to keep an eye on:

1. Recession and The Fed

Assumptions here are based around the Fed’s ability to hike rates just enough to counter inflation, but not so much as to destroy demand and cause a recession. There are two possible problems with that.

First, based on what they did last year, the Fed will always be behind the curve. They were late starting to raise rates, so why would we think they'll be on time stopping? The data they use to assess the economy are always a month old, and then to smooth out short-term volatility, they tend to use three-month rolling averages of month-old data. That makes sense in terms of not overreacting to volatility but doesn’t exactly make for nimbleness and perfectly-timed pivots. If anything, their methodology makes it far more likely that they will be behind the curve again this year.

Second, as powerful as the Fed is, they don’t act in a vacuum. Other central banks are also tightening, with even the Bank of Japan abandoning their decade long zero rate policy recently. If the assumptions are to be correct, it is not just the Fed who has to get it right, it is everyone. The Fed, the Bank of Japan, the ECB, the Bank of England, and a host of other central banks, all have to get a quick read on data and act decisively, something that history tells us is unlikely at best.

2. Politics

The assumption of a business-friendly Republican House face a major challenge even today, the first trading day of the New Year. Usually, the House minority leader becomes the Speaker when their party wins an election, but that is not a certainty for Kevin McCarthy. The election for that position today looks extremely close as I write this, which is indicative of the state of the Republican Party right now.

It is a party beset by division, with increasingly powerful extremists believing, as extremists tend to do, that the party’s electoral failures aren’t down to the public being turned off by said extremism, but rather because there wasn’t enough of it. And with Donald Trump having announced his candidacy for 2024, does anyone believe that is going to get better? And in the current partisan climate, don’t hold your breath waiting for Democrats to side with moderate Republicans to advance legislation for the good of the country.

Rather than a party finally getting power and pursuing their agenda, it is possible that we will see a party, and therefore a Congress, in chaos as a battle rages for its very soul. That may be fun for Democrats and even entertaining in some ways for neutral observers, but political chaos is hardly conducive to market strength.

3. Geopolitics

In many ways, assuming geopolitical stability is even more naïve than assuming stability in domestic politics. The leaders of the world’s two largest autocratic countries face some challenges to their authority, and dictators who are challenged often make desperate decisions that threaten stability, even if doing so avoids the chaos that would result from their ouster.

In Russia, we are already seeing an increasingly desperate Putin stepping up the war on Ukraine. I have no idea what his endgame is here, but escalation is always possible when a desperate dictator is fighting on NATO’s border. And there are rumblings of discontent within Russia that could result in internal problems, so even the overthrow of the current regime is not out of the question.

In China, a heavy-handed response to resurgent Covid-19 and slowing economic growth have put President Xi under pressure, too. The protests that erupted at the end of last year were dealt with, but concessions were made, and the people will now know that they have at least some power. Of course, if they were distracted by an appeal to patriotism and the possible “reclamation” or “liberation” of Taiwan, they would forget that.

That is not to mention the potential for instability in the developing world if a global recession results in even more grinding poverty than currently exists, or the consistent threat from North Korea, or any one of a number of other potential flashpoints. With all that in mind, when it comes to geopolitics, stability seems unlikely for 2023.

Final Thoughts

Obviously, I am not saying that all or any of the above will happen. However, when you start to question the assumptions behind the conventional wisdom of a small drop in stocks early in the year and then a decent bounce, you start to realize that for that to happen, the stars have to align perfectly. That rarely happens, so investors should be watching the news closely for signs of an impending shift in conditions, especially in the three areas outlined above.

* In addition to contributing here, Martin Tillier works as Head of Research at the crypto platform SmartFI.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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