Geopolitical tensions, energy market imbalances, persistently high inflation numbers, and rising interest rates have many investors and economists concerned that a U.S. recession is inevitable in 2023.
Recession risk has been rising throughout 2022 as the Federal Reserve has raised interest rates in its ongoing battle against inflation. The good news for investors is that the U.S. economy has remained strong up to this point. Unfortunately, the higher interest rates rise, the less likely the Fed will be able to navigate a so-called soft landing for the economy in 2023.
Economic recessions are no reason for panic and have been a regular occurrence over the past century. However, investors can make the most of a tricky situation by knowing which risk factors to watch and how to position their portfolios to optimize their performance if a recession is looming in 2023:
- 2023 recession risk factors.
- Will there be a recession in 2023?
- What to invest in during a recession.
2023 Recession Risk Factors
Many factors can trigger or contribute to a recession, but there is no question that two specific factors are the biggest risk to economic stability in 2023.
Any investor who has not been living under a rock for the past year is already aware that the primary economic risk factor heading into 2023 is inflation. In June 2022, the consumer price index gained 9.1% year over year, its highest inflation reading in more than 40 years.
The Federal Reserve has taken an aggressive approach to combat inflation, but the best solution to the inflation problem is also the second major economic risk factor in 2023: higher interest rates. Higher interest rates increase the cost of borrowing money, discouraging companies from taking on debt to invest in expanding their businesses. Higher rates also reduce consumer spending, easing demand pressures that have contributed to rising prices.
Will There Be a Recession in 2023?
Inflation and rising rates have not yet dragged down the U.S. economy. In fact, the U.S. economy added 261,000 jobs in October, and the U.S. unemployment rate remains historically low at just 3.7%.
Investors should continue to monitor the labor market as interest rates rise. The bond market is currently pricing in a 61.5% chance that the Fed will raise interest rates by at least another 1.25 percentage points by June 2023, bringing its target rate up to at least 5% to 5.25%, according to the CME Fed Watch tool.
Bank of America chief U.S. economist Michael Gapen says two more 0.5-percentage-point interest rate hikes in December and February followed by an additional 0.25-percentage-point rate hike in March will tip the U.S. economy into a recession.
What to Invest in During a Recession
There are several general strategies investors can use to manage risk and take advantage of opportunities during a recession.
First, consider reducing exposure to volatile stocks and increasing cash holdings. Cash may not be the most exciting play, but it reduces market risk and provides financial flexibility if a recession creates potential buying opportunities in 2023. In addition, investors can earn 3% interest or higher in an online saving account right now, and those rates will only continue to rise if the Fed issues more rate hikes.
In addition, value stocks have historically outperformed growth stocks during periods of elevated interest rates. Higher interest rates harm companies’ discounted cash flow valuations, which can hurt high-growth stocks. For example, in the past 12 months, Vanguard Value ETF (ticker: VTV) Has generated a total return of 2.8% as of Nov. 25, while Vanguard Growth ETF (VUG) Has lost 28.4%.
Finally, certain stocks and market sectors are more defensive than others and tend to outperform the rest of the market during recessions. Utility stocks, healthcare stocks, and consumer staples stocks are considered defensive investments because their earnings tend to be insulated from economic cycles and swings in consumer confidence.
