Well, 2022 turned out just as we all thought, right? While the Russian invasion of Ukraine may have been the most significant geo-political event of 2022, from an economic perspective everything revolved around inflation.
While the Federal Reserve and most investors expected inflation to track lower over the course of 2022, inflation actually accelerated over the first 6 months of the year. U.S. inflation, as measured by the Consumer Price Index, opened 2022 at 7.0% peaking at 9.1% in June. Fortunately, inflation has begun to moderate, falling back to 7.1% as of November. Contributing to higher-than-expected readings were supply chain constraints impacting goods inflation (mostly resolved), commodity pressures exacerbated by Russia (improving) and wage inflation spurred by an imbalance in the U.S. labor market generally impacting services inflation (sticky - an ongoing problem). We will discuss inflation in greater detail in the Further Thoughts section.
Source: Refinitiv Datastream
Albeit delayed, the Federal Reserve’s reaction to high inflation has been nearly unprecedented in both its size and speed. The Fed abandoned the employment side of its mandate, instead fully focusing on fighting inflation – and rightfully so. The longer inflation permeates in an economy, the more it builds into consumer expectations, the more it can destroy economic value, the more painful and difficult it is to resolve.
The result has been the fastest series of Fed Funds rate increases since the Volcker Era over 40 years ago. Starting in March, and over a span of just 9 months, the Federal Reserve increased the Fed Funds rate from 0.125% up to 4.375% which included four separate 0.75% rate hikes. Inflation is generally caused by demand for goods, services or labor exceeding the supply. Interest rates hikes stifle demand but have less impact on supply.
It is important to note that tighter Monetary Policy is a global phenomenon. The European Central Bank (ECB) has been a few months behind the U.S. but has now moved firmly into the tightening camp. Even the Bank of Japan, which has employed a 0% interest rate policy for essentially 25 years, may be signaling a willingness to let interest rates rise.
Source: Refinitiv Datastream
Following 3 consecutive terrific years in both equity and fixed income markets, 2022 produced significant corrections in both stocks and bonds. The rapid pace of Fed rate hikes and uncertainty over the number of future hikes prompted financial markets to move into the worst phase of the Investment Cycle – the phase where financial markets anticipate recession. As a result, U.S. equities declined by 18.1% (S&P 500) with growth-oriented stocks declining much further. As a matter of perspective, the S&P 500 essentially gave up less than one year of the prior 3-years’ sensational gains. Fixed income also performed poorly. As the Fed was increasing short-term rates from 0.125% to 4.375%, the 10-year bond yield increased from 1.50% to 3.83%. As such, depending on the broad fixed income index, bonds generally declined by 8%-13%.
Despite 2022 going down as a very poor year in financial markets, some silver linings emerged: a) now that interest rates have increased, we expect bonds will act as a better hedge going forward and we can earn attractive returns on our excess cash, b) despite all the turbulence, the S&P 500 was actually stable during the second half of 2022 returning +2.3%, c) speculation has been punished with meme stocks, crypto and no-earnings companies all suffering large declines – a good sign for the long-term health of the markets.
In the end, higher than expected inflation and a more aggressive Fed were basically the difference between the “year of moderation” that we had predicted and the “year of correction” that ensued.
2023 Market Outlook
Despite the struggles of 2022, there is reason to be optimistic that times will eventually get better. Year-end price targets are less relevant in 2023. The true story will likely be the shifting of the phase of the Investment Cycle to move from anticipating recession to anticipating re-acceleration. In other words, moving from the worst phase of the Investment Cycle into typically the best part of the Cycle. During the next economic expansion, we should expect record economic activity, record corporate earnings and, eventually, new all-time highs in the stock market. The ultimate question is when will this shift in the Investment Cycle begin?
Roughly six months ago, we wrote a newsletter describing how the shift in Investment Cycle will likely boil down to three things:
1) Inflation on goods, services and wages - needs to trend sustainably lower.
2) Peak Fed Funds Rate - markets need to understand when and how high rates will go.
3) Earnings Estimates - need to come down to more realistic levels.
There has been significant progress made in all three areas (see Further Thoughts) but more needs to occur. It is important to note that because financial markets look forward, the stock market will likely bottom before Fed Funds peaks and before corporate earnings estimates hit their trough.
Timing is difficult to predict but, in the big picture, is not that crucial. In the long-term, it does not matter whether the next bull market begins in 3, 6 or 12 months. What is more important to realize is that, when it does commence, it will likely bring new highs in equities (over time). While we can’t accurately predict the official starting month of the next bull market, we do think that it will begin in 2023. But, whenever we enter that new investment regime, it would not be uncommon for equity markets to rise 20% or more during the first 12 months of the shift. As a result, while we continue to anticipate choppy equity markets for a little while longer, we believe that pessimism must be restrained. We view potential downswings in equity markets as an opportunity to prudently add to equities and position for the next and better phase to come.
On the fixed income side, the silver lining to the substantial rise in interest rates is that we can now lock in more attractive fixed rates of return for clients for the first time in many years. In addition, we do expect bonds to resume their historical benefit of being a good portfolio hedge during volatile equity periods. As for the Federal Reserve, we expect roughly 75-125 basis points in further rate increases during 2023 establishing a peak Fed Funds rate of 5.125%-5.625%. This would be a dramatic slowdown from 2022’s pace of rate hikes and hopefully the end of the cycle.
We thought we would provide a little more color on some of the points made in our review and outlook.
Pre-conditions for a sustainable recovery:
b) Federal Reserve / Monetary Policy
c) Corporate Earnings Estimates
Inflation can be broken into two main components: Goods and Services. Each are at different stages in terms of their trajectory and closely mirror trends from the pandemic. During the early stages of the pandemic, consumer spending focused on goods (real tangible things) but as people emerged from lockdowns spending shifted away from goods towards services (restaurants, experiences, travel). Services also happen to be more labor intensive than Goods.
Goods inflation was exacerbated by supply chain disruptions and bottlenecks. Goods inflation peaked in February 2022 at 12.3% and has settled down to an almost mundane 3.7%, as of November 2022. In the end, the Federal Reserve was correct that this inflation was “transitory” once supply chain issues mostly resolved.
Services inflation is stickier and more difficult to contain. It appears to have peaked in September 2022 at 6.8% but is holding firm at 6.4% as of November 2022. Labor (wages) plays a much larger role in the services industry and feeds into the cost of services. The imbalance in the labor market (too many jobs for too few workers) is probably the largest imbalance in the U.S. economy and is currently the main focus of the Federal Reserve. Ultimately, this should get under better control but we likely need more time to pass.
Federal Reserve / Monetary Policy
After hiking from 0.125% to 4.375% over the last 9 months, we are getting closer to the eventual peak Fed Funds rate but we still need some time to better understand when and how high. The Fed is looking to get labor costs under control. Presumably the Fed will continue to raise rates, albeit at a slower pace, until they see employment start to fall. The good news – while the pace of rate hikes was shocking, the Fed essentially ripped the bandage off of 0% interest rate policy. This is highly desirable as the Fed will be able to rely on traditional Monetary Policy (i.e. adjusting the Fed Funds rate) during the next downturn rather than emergency Quantitative Easing. What should we infer from Federal Reserve monetary policy and guidance? What has been clear is that the Fed has been reactive rather than pro-active. As a result, it is important not to get too caught up in Federal Reserve projections and “dot-plots”. No one at the Fed anticipated the level of inflation seen in 2022 (of course, neither did we) and no one at the Fed anticipated anything close to the 4.25% increase in the Fed Funds rate over the course of 2022. As a result, why should we put faith in current Federal Reserve forecasts of a 5%-plus Fed Funds rate throughout 2023? Should inflation continue to cool and should the economy stall and unemployment rise, could we not see the Federal Reserve pivot away from their current hawkishness before the end of 2023?
Corporate Earnings Estimates
Decent progress has been made on the reduction of 2023 corporate earnings estimates to more realistic levels given the economic environment. 2023 estimates have declined 9% from their peak in May 2022 but earnings are still forecast to grow 4% above 2022 levels. It is likely that estimates will deteriorate during the January reporting season and again during the April earnings season. At that point, earnings expectations should be much more reasonable. Similar to inflation and the Fed, it seems that we just need a little more time to pass here as well.
Labor Market Imbalance
As mentioned, the labor market imbalance is probably the most significant imbalance facing the U.S. economy. It is extremely rare for the U.S. to have too few workers for available jobs. Job openings have exceeded available labor supply for multiple years. This has created atypical behavior in corporations who are now hesitant to fire people because they want extra worker capacity given how difficult it has been to hire new quality workers. At the same time, as labor demand has been elevated, labor supply has been disrupted. Many potential workers have permanently left the workforce (retirements/deaths), others are still hesitant or unable (residual effects of stimulus, caring for others) and, significantly, immigration has plummeted which used to soak up many service-oriented jobs. Federal Reserve rate hikes may be just beginning to have an impact on labor demand in interest-sensitive industries. Also, many technology companies have begun to cut back on labor after over-expanding but we have not yet seen a true impact on the overall employment market. In time, we do expect better balance to emerge in labor.
While geo-political risks surrounding China are omnipresent, we expect the most significant news from China in 2023 will be the shift away from its zero-COVID policy. Akin to U.S. re-emergence, we expect many initial dislocations both as COVID spreads but also as consumers/factories find their footing. The path may not be smooth yet could ultimately add to global economic growth.
So now let me end my 2023 outlook as I end all my outlooks: Of course, despite our best laid plans, events through 2023 will likely conspire to force us to alter our thinking in one direction or another. We will continue to be vigilant and adjust our thinking and strategy as events warrant.
Wishing you a Happy, Healthy, Safe and Successful 2023!