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The IBR is a publication of the Indiana Business Research Center at IU's Kelley School of Business.

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Financial markets in 2023: Aggregate demand and inflation

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Associate Clinical Professor of Financial Management, Kelley School of Business, Indianapolis

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James W. & Virginia E. Cozad Chair in Finance, Kelley School of Business, Bloomington

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Associate Professor of Finance, Indiana University Division of Business, IUPUC

Last year, our financial forecast for 2022 mentioned that there was a “significant chance of a negative return.” Unfortunately, we were right about that. The stock market has lost about $10 trillion from this time last year. Surely, everyone has felt the loss in their savings and 401(k) plans, but it is shocking to see the largest negative return since the crash of 2008, with the market dropping more than 20%. As we predicted, value stocks outperformed growth stocks, but this is cold comfort since both were down and “outperformed” only means smaller negative returns.

Fixed income has also had a very rough year. Corporate bonds are down about 15% and U.S. Treasuries have had negative returns of between 6% and 12%, depending on the term to maturity. Of course, the negative returns are due to more than doubling interest rates.  Interest rates on three-month U.S. government debt is up 419 basis points (from near zero to 4.22%), while 30-year government debt is up 191 basis points (from 1.88% to 3.89%). Yes, the term structure is “hump-backed,” with short-term rates rising to roughly 12-month debt (4.67%) and then declining for long-term maturities.

In short, there is no place to hide. Unless you put your wealth in cash last November, you lost. Of course, on a real return basis, that cash is worth less than it was a year ago.

The returns from the previous five years make 2022 especially painful. When we gave this report last year, the stock market was at historic highs. The value of all common stock was $49 trillion, 32% above where it was in 2020. Certainly some of this stunning return was due to recovery from the damage done by the pandemic, but not all of it. Between 2016 and 2021, we saw a compound growth rate of 15.9%. This was one of the strongest five-year periods in U.S. financial history, which was remarkable given that we had two very different political administrations, a politically divided country, a pandemic, trade wars with many countries and growing inflation, not to mention supply-chain bottle necks.

Then it all fell apart and no, we are not talking about cryptocurrency or FTX. We are talking about the value of American firms.

What will happen next?

First, the Federal Reserve has raised interest rates, specifically the federal funds rate, six times in 2022 (see Table 1).

Table 1: Interest rate increases in 2022

FOMC meeting date Rate change (bps) Federal funds rate
Nov 2, 2022 +75 3.75% to 4.00%
Sept 21, 2022 +75 3.00% to 3.25%
July 27, 2022 +75 2.25% to 2.50%
June 16, 2022 +75 1.50% to 1.75%
May 5, 2022 +50 0.75% to 1.00%
March 17, 2022 +25 0.25% to 0.50%

Source: Tepper, T. and B. Curry. (2022, November 2). Federal funds rate history 1990 to 2022. Forbes. https://www.forbes.com/advisor/investing/fed-funds-rate-history/

This is obviously in response to increasing inflation. Given that the growth rate for inflation has, maybe, possibly stopped increasing (or at least the rate has stopped increasing), we think it is unlikely that the Fed will increase the federal funds rate as rapidly in 2023. It will be important how high the federal funds rate eventually goes, when it gets there and how long the Federal Reserve decides to keep it at a restrictive level before rates are lowered.

Second, inflation is clearly catalyzed by federal fiscal policy, which has added to the aggregate demand previously lifted by over a decade of quantitative easing and a zero federal funds rate. The federal government has run record (or near-record) deficits during both Republican and Democratic administrations. The Biden administration spent much of its first two years increasing the deficit. Given that the House of Representatives is now run by Republicans, we have a divided federal government. Therefore, additional new federal government spending will be far more difficult.

The third factor is that the American labor force is simply too small to do the job of delivering the goods and services that Americans demand. Companies are having difficulty keeping up with demand, with the result that prices are rising alongside profits. Shareholders are benefiting at least in the short run. But labor costs are rising fast and this factor could easily be a negative for 2023. While immigration and automation would, in theory, be solutions to our tight labor markets, gridlock will likely eliminate prospects for the former, while rising costs of capital will chill advancements on the latter.

A fourth factor is the potential for “land mines,” such as what the UK went through with the former Prime Minister Liz Truss, or what could possibly happen in the Ukrainian war. We also see risk in reliance on international partners to produce computer chips worldwide—affecting timely production of all kinds of goods. While reshoring efforts are underway (including the semiconductor industry), this effort is likely to take several years. There is, of course, always the potential for land mines in every year, but the possibilities seem higher today.

With this as a background, we turn to fundamentals, which we hope will give us a sharper forecast for 2023. Unlike cryptocurrencies, stock prices are, more or less, determined by the future streams of cash flows—driven by earnings—and the valuation of these cash flows (which is the present value using a set of discount rates that reflect risk). Typically, this is summarized by earnings forecasts and a valuation ratio—the price-earnings (P/E ratio). We call these “fundamentals.”

Positive fundamentals

The positive fundamental factors for stock returns in 2023 include:

  • Earnings growth: Analysts are forecasting earnings will increase 5.8% in 2023 for the S&P 500. Sectors with above-average expected earnings are consumer discretion (36%), financials (14%), industrials (13.9%) and communications services (10.2%). Sectors that are expected to do poorly are materials (-9%) and energy (-11.7%).
  • Revenue growth: Revenues for the S&P 500 are expected to rise 3.3% in 2023. The best sector for revenue growth is financials (8.9%), followed by consumer discretion (7.4%). The worst sectors are materials (-2.5%) and energy (-7.9%).
  • Earnings and revenue for 2022: The end of the year is six weeks away at the time of this writing, so much of this is not a forecast, but the S&P 500 earnings are projected to be up 5.3% with revenue up 10.4%.
  • Analyst surprises: At this point, 69% of companies have reported earnings higher than analysts have forecast. Analysts tend to be optimistic and this is a strong indicator of earnings strength.
  • Volatility levels: The Cboe Volatility Index (VIX) measures expected volatility in the market by looking at S&P 500 options prices. It was moderately volatile—perhaps even flat—during 2022, but has come down considerably from the very high numbers in 2020. Basically, the market declined in 2022 in an orderly fashion in contrast to the dramatic volatility during the uncertainty of the pandemic.
  • Valuation:
    • Current P/E ratio is moderate. The current P/E ratio for the S&P 500 is 20.3, which is significantly above its median value of 14.9, but down from the highs of the past five years.
    • The forward 12-month P/E ratio, defined as the current price of the S&P 500 over forecasted earnings, is 17.1. This is below the five-year average of 18.4 and slightly above the 10-year average of 16.5.

Negative fundamentals

The negative fundamental factors for stock returns in 2023 include:

  • The Shiller P/E ratio (CAPE): The Shiller P/E ratio is currently at 28.92. This is above the long-term average of 17. In 2023, we expect most companies to continue to produce positive earnings over the coming year, which should help bring the Shiller P/E ratio measure for the market back into line, but there is not much room for valuation to grow.
  • Inflation is still surging: Led by energy prices, inflation is currently running at about 8%. The key question is how long will it take for the Fed to tame inflation? And will it trigger a recession to do so? A permanent or volatile inflation rate can choke off aggregate demand and make corporate investment risky.
  • U.S. energy policy: Energy prices are up 27% in Bloomberg’s broad index. However, the World Bank expects prices to decline by 11% in 2023, which is likely due to slower economic growth. The continuing effort by the White House and other members of the G20 to rebalance energy production away from fossil fuels to energy sources sensitive to climate change will likely add to inflation, in spite of a decline in demand due to the problem of supply.
  • IPOs: There have been 173 IPOs in 2022 versus 942 a year ago. The total amount raised in 2022 has been $60 billion.   
  • Pressure on interest rates:
    • The budget deficit for 2022 was $1.38 trillion. This means that federal expenditures were $1.38 trillion more than federal revenue. This is about $1.7 trillion less than 2020 and approximately half the deficit incurred in 2021. The deficit is 5.5% of GDP, above the 50-year average of 3.3%. Despite being down from 12.3% in 2021, this percentage is still larger than the 4.6% recorded in 2019.
    • The deficit has caused the largest expansion of federal debt since World War II. The total debt (held by the public) is $23.9 trillion, which is 95.5% of GDP. This ratio was 76% in 2018. Increasing the average interest rate by 1% will trigger an additional $140 billion in federal spending. 
    • The U.S. still faces a huge funding deficit in Social Security and Medicare payments. The present value shortfall is about $62 trillion. This is equivalent to $206,000 per person or $825,000 per U.S. household. These problems are not insurmountable, but they do require common sense and bipartisan leadership—something that appears to be in short supply in Washington, D.C.
    • If the Fed tames inflation without much of an economic downturn, we think U.S. Treasury short-term rates may settle toward 3.5% to 4%, with longer term rates about 4% to 4.5%. But these numbers could go higher if inflation is not reduced in the first half of 2023.


Looking forward to 2023, the positives might just outweigh the negatives for the market. Earnings are strong and likely to stay strong, but valuation is high even after the negative returns in 2022. Inflation is likely to increase interest rates, which will cut valuation ratios. A considerable number of ongoing geopolitical risks suggests our forecast this year has a wide distribution of potential outcomes, and the variance could be significant.

In this environment, we expect that the return to equities will be flat and well below the 7% average return over the past 50 years, and there is again a significant chance of a negative return. Value stocks are likely to outperform growth stocks given the high P/E ratios. We think that the 10-year U.S. Treasury rate is likely to be well above the current 4%.