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Inflation has slowed, and interest rates have reached their peak. Is it time to reinvest in stocks and bonds?

Inflation is finally slowing, and interest rates may soon reach a peak. That means that, despite the possibility of a recession, some strategists believe that now is the time to re-enter the market.

Last year, people’s portfolios were battered by four decades of high inflation and the Federal Reserve’s most aggressive interest rate hikes since the 1980s. Stocks and bonds, which normally move in opposite directions, fell at the same time, destroying the traditional diversified 60% stock/40% bond, or 60/40, portfolio and leaving investors with nowhere to hide. Morningstar’s U.S. Moderate Target Allocation Index, designed as a benchmark for a 60/40 allocation portfolio, fell 15.3% in one year, the most since 2008.

However, 2023 is on a different trajectory, giving investors hope that they can begin rebuilding their retirement balances, according to some.

“Overall, the inflation pendulum is now swinging back,” said David Russell, vice president of market intelligence at TradeStation, an online securities and futures brokerage firm. “The bond market and the stock market both see it. That entire 60/40 strategy can be put back into action, and I believe we’re seeing it today. Money is flowing into bonds, the S&P 500, and the Nasdaq.”

What happened the previous year?

To combat inflation, the Fed raised its short-term benchmark fed funds rate by a whopping 425 basis points last year, including three consecutive supersized 0.75-point increases. Higher interest rates raise the cost of borrowing for consumers and businesses to invest in future earnings growth, slowing demand, the economy, and inflation.

Bond prices fall when interest rates rise because older bonds become less valuable. Their coupon payments are now lower than those of new bonds offered at higher rates in the market.

The combination of high inflation and aggressive rate hikes set the stage for an unusual occurrence: the values of stocks and bonds fell at the same time.

“Since 1929, there have only been three years when bonds did not rise when stocks fell,” investment firm BlackRock wrote in a report last year. It said the last time it happened was in 1969.

What if there’s a downturn?

Perhaps it won’t matter.

“There’s so much negative sentiment, it almost feels and appears like a recession has already been priced in,” said Peter Essele, head of portfolio management at Commonwealth Financial Network. “This has been the most over-promised recession. “I believe people are numb.”

According to a CNN poll, three-quarters of Americans believed the economy was already in a slump last fall. According to the fourth-quarter AICPA Business and Industry Economic Outlook Survey, 51% of business executives believe the US economy is already in recession or will be by the new year.

Because people are already preparing for the worst, Essele says “usually, stocks bottom 60% or so way through a recession, but I think we will – or already have bottomed – a lot sooner in this one. Recent data also point to a slower economy, but possibly no or a shallow recession, according to some economists.”

What might this imply for investors in 2023?

Some strategists believe it is time to return to the market if inflation continues to trend lower, the Fed pauses rate hikes as expected, and all of the bad news has been priced in.

“We have a better understanding of where the end game is for rates and inflation,” Essele said, and that is what is most important. Markets are roiled by unpredictability, not the level at which the Fed stops raising interest rates, he claims.

Also, if the economy enters a slump, the Fed may begin lowering interest rates in late 2023, which could jumpstart the economy, according to some strategists. The CME’s FedWatch tool, which shows where investors expect the fed funds rate to be at each policy meeting throughout the year, reflects this view, with most expecting a quarter-point rate cut in November.

What are some potential investments?

“We’ll see strength in housing stocks,” Russell predicted, citing signs that 10-year yields have peaked or are nearing a peak. “Homebuilders will be extremely powerful. The country has a very strong structural demand for housing.”

He also likes steel and metals companies that have underperformed but may benefit from infrastructure projects.

Furthermore, “the combination of high home prices and high rates put buyers off last year, but as home prices fall, people will be more willing to buy with the hope of refinancing in the future when rates are lower,” according to Jon Klaff, general manager of investment platform Magnifi. He believes that a recession will cause a drop in home prices.

Don’t overlook the importance of diversification.

Diversification is essential for weathering volatility in case markets rise in fits and starts, or if, as other strategists believe, the stock market hasn’t yet priced in all the bad news and has room to fall.

According to Morgan Stanley’s chief U.S. equity strategist Michael Wilson, corporate earnings forecasts remain too low, implying a drop in stock prices “for which most are unprepared…the main culprit is the elevated and volatile inflationary environment, which is likely to wreak havoc on profitability.”

But, according to bullish strategists, this is where the traditional 60/40 portfolio comes in handy.

They claim that while the 60/40 portfolio did not perform well last year, it was an outlier. Bonds can generate income for investors this year, which will help insulate them against any stock market downturns.

“Risk is gradually returning to normal,” Russell said. “After three years of intense turbulence, we’re regaining equilibrium. Although it is not a straight line, the economy is returning to normal.”

If you’re still concerned, strategists advise using dollar cost averaging. “You average out the price you pay for the security by making regular investments in the same securities over time,” Klaff explained. That way, you can take advantage of market drops without having to worry about paying top prices.

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