Ever since the global financial crisis 15 years ago, the financial markets have had no greater ally than the Federal Reserve. Investors counted on the central bank to patch every kind of economic wound, from the deepest of contusions to the barest of skinned knees. The Fed’s sharp reversal of that investor-friendly approach contributed heavily to the markets’ plight last year. Whether policymakers stick to their shock-and-awe inflation fight — and whether that tips the economy into recession — are among the biggest question marks in 2023.

A virtual waterfall of factors hit the markets in the past 12 months, from blistering inflation and strife in technology stocks to war in Ukraine and zero-COVID policy in China. Progress has been made on some fronts. Tech stock valuations have exited nosebleed territory. The lifting of China’s pandemic rules could provide a balm for the soft global economy. Most important, inflation appears to have peaked, with last year’s heaping interest rate hikes slashing the U.S. consumer price index to 6.5% in December from 9.1% in June.

Nevertheless, inflation is still running at more than three times the Fed’s preferred level. Though goods prices have simmered down as pandemic restrictions have eased and supply chains have been rebooted, services inflation has barreled higher. Prominent layoffs at erstwhile tech darlings belie the fact that airlines, hotels and restaurants are scrounging for staff in a labor market with more job openings than available workers. That raises the specter of a wage-price spiral in which workers clamor for higher pay to offset inflation, forcing employers to compensate with more price hikes.

Inflation has shifted from goods to services

Sources: Federal Reserve Bank of St. Louis. Core goods represented by CPI: Commodities less food and energy commodities; and core services by CPI: Services less energy services. As of November 2022.

The bottom line: The Fed may have little choice but to maintain its muscular posture longer than the market expects, raising the odds of recession. Capital Group economist Jared Franz predicts U.S. GDP will contract about 2% this year while corporate earnings could slide 10% to 15%. That would mark a sharper drop than the burst tech bubble of the early 2000s, but it would be far less severe than the economic squall during the global financial crisis. All that, however, could aggravate the pressure on the financial markets, especially if corporate earnings estimates drop as the year unfolds.

Don’t overreact to short-term conditions.

Capital Group Private Client Services portfolio managers have boosted holdings in sectors such as energy, materials and industrials that may benefit from the shift to regionally based supply changes and the transition away from Russian gas and oil to more renewable sources of energy. They also trimmed exposure to the tech and consumer discretionary sectors, where financing costs have risen. In addition, they’re prioritizing businesses with pricing power to help weather potentially persistent inflation, as well as companies with steady earnings and less debt, in case of a recession.

Despite the near-term obstacles, the longer-term picture remains very encouraging. Though recessions are painful, they are a natural part of investing and have historically cleared the way for renewed growth. In fact, given the markets’ declines thus far, the prospective returns over the next five to 10 years in stocks and bonds appear to be the most attractive in a decade.

The market’s forward-looking nature has historically caused stocks to fall in advance of recessions, but also to bounce back an average of six months before downturns ended. Furthermore, the recovery from those retreats has tended to be quick and pronounced. Since 1950, the S&P 500 has risen an average of 21% in the first three months after the turn and 44% in the first 12 months.

Markets have often recovered quickly after downturns

Sources: Capital Group, S&P Global. Bear market is defined as a peak-to-trough decline of greater than 20%. Indices are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index. Past performance is no guarantee of future results. As of June 30, 2022.

The specific elements of the current downturn — especially the removal of the halo from tech stocks — could be a blessing. Bull markets have historically been spearheaded by new industries and sectors rather than the ones that led the previous advance. That could mean greater breadth beyond the handful of tech leviathans that dominated the center stage over the past decade.

Rather than pinning their hopes on the distant prospects of digital businesses, investors could favor more traditional companies that churn out tangible goods and feature more dependable revenue streams. There also could be a revival of interest in dividends, which have historically been a central component in total returns but were relegated to afterthought status during the elongated tech honeymoon.

High rates could pay off for investors this year and beyond.

Despite a modest fourth-quarter rally, the surge in interest rates resulted in one of the worst-ever years for bonds. Treasuries were off 12.5% while taxable bonds skidded 13%. Municipals were down a more palatable 4.5%, although that was still dispiriting for investors drawn to the normally staid market.

Our investment team continues to pursue a cautious approach, given the economic hazards and potential for further rate hikes. That means reducing sensitivity to interest rate moves and preferring securities with comparatively low credit risk.

On a positive note, the jump in rates that caused deep indigestion in 2022 could nourish bond investors in 2023 and beyond. Higher yields mean more income for investors — and yields are far more attractive now than a year ago. As of year-end, investment grade bonds, as represented by the Bloomberg US corporate investment grade index, yielded about 5.4%. Munis, as represented by the Bloomberg municipal bond index, earned about 3.5% tax free, with a higher tax-equivalent yield. Yields at these levels have historically ushered in strong returns over the subsequent five years.

Additionally, the financial underpinning of issuers remains strong overall. The credit quality of muni bonds, for example, is the best it’s been in 40 years, with many states having amassed substantial savings thanks to federal assistance during the pandemic.

Finally, our investment team doesn’t expect the double whammy of simultaneous declines in stocks and bonds to repeat itself in 2023. The bond market sting was especially acute last year because of the inflation surge and the fact that rates were coming off exceptionally low levels. As the inflation threat recedes, bonds are expected to once again provide a respite to stocks should the economy struggle.