It is a gross understatement that financial markets proved extremely difficult in 2022. Most of the pain emanated from hugely erroneous and widely held assumptions on the severity of inflation and the expected course of interest rates. These were so far off from what evolved that revisiting them in our minds seems surreal. The world has changed. Deutsche Bank states:
“With markets increasingly confident of a terminal rate around 5.00% and inflation getting back close to target in 2024, it’s worth remembering that exactly a year ago today markets were pricing a Fed funds rate of 0.68% by the end of 2022 and economists were calling for CPI of 2.6%.”
From this starting point, almost all asset classes suffered sharp losses. The U.S. consumer price index continued to rise, hitting a year-over-year high of 9.1% in June. The Minneapolis’ Fed estimate of the full year 2022 CPI of 8.6%, would be its highest since 1981 and the 6th highest measure since 1947. In response to the level and persistence of inflation, the Federal Reserve made 7 rate hikes totaling an increase of 4.25%. Quantitative tightening measures were enacted to reverse massive liquidity that had been created in response to the COVID-19 pandemic.
The Bloomberg U.S. Bond Aggregate lost 13.0%, the worst year in its 46-year history. The yield on the 10-year U.S. Treasury note finished at 3.88% after hitting a 15 year high of 4.32% in October. It started the year yielding 1.51%. The Bloomberg Barclays High Yield Bond Index dropped 12.2%. The S&P Municipal bond Index was down 7.4%. The average U.S. 30-year mortgage rose above 7% for the first time in over 20 years.
The S&P 500 index dropped 19.4% for the year. It suffered three consecutive quarterly declines before bouncing back 7.5% in the 4th quarter. The tech-heavy Nasdaq Composite index lost 33.1%. U.S. small stocks as measured by the Russell 2000 index fell 21.6%.
In tandem, U.S. stocks and bonds had one of their worst years in history. 2022 was only the 5th time since 1928 that U.S. stocks and bonds both dropped in value. Within these 5 occurrences, 2022’s loss in the bond market was more than twice as bad as the others.
Despite deep overhanging concerns over the Russia/Ukraine war, inflation spiking to double-digits, and the Eurozone’s struggle to secure vital oil and natural gas supplies, international stocks in developed markets outperformed U.S. stocks. The MSCI EAFE index lost 16.8% for the year, buoyed by its strong 17.0% rebound in the 4th quarter. The MSCI Emerging Markets index slumped 20.6% for the year. It recovered 10.3% in 4th quarter despite serious concerns over the strength of China’s economy and its widespread COVID lockdowns.
Despite 2022’s intent focus on oil prices and supplies, marked by it spiking to $120/barrel at the onset of the Ukraine crisis, crude finished only slightly higher. The NYMEX West Texas Intermediate Crude Oil continuous futures contract was up 7.0%. Any moderation of global inflation in 2023 will be widely dependent on energy pricing. The NYMEX Gold continuous futures contract was flat for the year, despite rebounding 11.9% in the fourth quarter.
Almost all the issues that weighed on markets last year persist as we move into 2023. The struggle to control inflation, and how significantly the Federal Reserve’s tightening measures slow or damage the U.S. economy, remains at center stage. The course of this battle will have great impact on employment, corporate earnings, interest rates, currencies, and asset prices in 2023. Torsten Slok, Chief Economist of Apollo Global Management, states: “The question for markets is not whether inflation is falling, everyone agrees that inflation is falling. The question is how fast. Some say very quickly, and others including some Fed working papers say 3 years. How much demand destruction is needed to get to the stated target 2% inflation?”
Inflation and the U.S. economy are joined by numerous serious issues troubling markets, including:
It is almost impossible for us to comment on all of these, or to surmise how they may affect investors. However, here are some of our key observations and commentary from respected strategists and economists:
Inflation should not be expected to recede smoothly.
We should take Jerome Powell at his word, and not attempt to ‘game’ Federal Reserve moves.
It is quite possible that markets are expecting that inflation will decline smoothly and steadily. Imbedded into this is the hope that the Federal Reserve will negotiate a “soft landing,” which will soon stabilize interest rates, asset prices and corporate earnings. This is unchartered macro territory, and we are not economists, but VWG does not believe this should be investor’s base case assumption.
Bob Elliott, former head of research at Bridgewater Associates, recently commented “what many are missing is how hard it is to bring inflation down once it gets going.�� Look at the 1970’s and 80’s (following chart). There were several tightenings and easings before inflation was sustainably controlled. And there was a whole lot of uncertainty through the process. Why would you expect this to be such an easy ride today? Markets are priced for near perfection in inflation and the odds that happens are low.”
Although many areas of economic activity have turned negative or are clearly headed in that direction, employment is persistently strong. Economist Jim Bianco states “the jobs market is not weakening (see following chart of weekly initial jobless claims). The Fed has signaled that it will not change stance until the labor market shows unmistakable signs of weakening. There are still 1.7 open jobs for every unemployed person. Payrolls have beaten estimates in 11 of the past 12 months. There is typically a 12-month lag between rising unemployment and decreases in wages.” With demographics and immigration restraints significantly impacting the (lack of) labor slack, it is unclear whether monetary policy alone can soften employment without severely damaging the economy.
Bottom line: We should expect higher interest rates for longer, until economic conditions sustainably soften. We should take Jerome Powell at his word, in that regardless of where the Fed’s increases end, interest rates will not be cut in the foreseeable future:
“It is likely that restoring price stability will require holding policy at a restrictive level for some time. History cautions strongly against prematurely loosening policy. We will stay the course until the job is done.”
We should not expect a quick return to massive zero-interest rate policies (ZIRP), quantitative easing (QE) and other easy monetary policies enjoyed over the past 12 years. The genie is out of the bottle. It is quite apparent that the limits of these policies have been reached. Even Japan’s more closed monetary system and demographically challenged economy has begun displaying this. Strategas Research Partners’ CEO Jason Trennert comments:
“The ‘unconventional monetary policy’ that came to be called quantitative easing is no longer tenable in the face of persistently high inflation. The bill has come due. Even for the US as the world’s reserve currency – no longer will spending one’s way out of economic and financial difficulties be without cost.”
As such, investors should rethink investment strategies that have overly relied on abundant liquidity and cheap leverage. In his recent memo “Sea Change,” Howard Marks, legendary investor and co-founder of Oaktree Capital observes:
“Although most of us believe the free market is the best allocator of economic resources, we haven’t had a free market in money (cost of capital) for well over a decade. (Going forward) the Fed might prefer to reduce its role in capital allocation by being less active in controlling rates and buying bonds.” (link)
Aside from the pain inflation unproportionally inflicts on lower income households, and the self-reinforcing behavior inflation creates, there is another potential stress that cannot be ignored. This is the cost of interest payments on the federal debt. Massive debt has been accumulated by central banks over the past 40 years. As shown in the following chart, interest payments on the federal debt as a percentage of total tax receipts topped at over 50% in the 1980’s when the total U.S. federal debt was only 31% of GDP (and the interest rate on the debt was much higher). Federal debt now stands at 120% of GDP. Simply doubling the interest rate paid on refinancing this debt will place huge stress on our government’s finances and balance sheet. Inflation and interest rates must somehow be controlled.
Not always apparent during their midst, bear markets often mark economic and investment regime changes. One example is the 1973-75 recession that marked the end of the ‘Nifty-50’ stock era, and the start of a 15-year struggle to contain inflation. Another is the 2001 recession and the bursting of the ‘Dot.com Bubble.’ One cannot fully predict the future. However, if the end of ‘free money,’ QE and ZIRP central bank policies are over for now, we should expect that the “investment strategies that worked best may not be the ones that outperform in the years ahead.” Howard Marks instructs us:
“The (positive) effect of declining rates over the past 40 years are nearly impossible to overstate. It increased investor risk taking. Paltry yields on safe investments drove investors to buy riskier assets. FOMO – the fear of missing out – became the prevalent behavior among investors. Buyers were eager to buy, (and buy more on every dip), and holders weren’t motivated to sell.”
VWG does not believe that the first Fed pause, or even the first Fed rate cut, will be the ‘all clear’ signal to pile back into more risky strategies. Counterintuitively, many strategists are concerned that a Fed pausing too quickly, or a market that front-runs the Fed too far in advance, threatens long-term stability. Jim Bianco states that “this would raise a real risk of higher inflation for longer.” Patience is going to be required.
The U.S. stock market is already displaying signs of a possible regime change. 2022 was the first year since 2013 that mega-cap stocks detracted from the performance of the S&P 500. During this period the total weighting of the five largest stocks in the index rose from 8.5% to a staggering 22% in September 2020 (per Bespoke Investment Group). With more than half of 2022’s S&P 500 losses coming from the mega-caps, this weighting has dropped to 17%.
One hint of possible regime change is 2022’s outperformance of stocks in international developed markets versus the S&P 500. This despite the Eurozone’s intensely negative economic narrative in the shadow of the war in the Ukraine. Another is the relative low valuation of U.S. small stocks versus large stocks which peaked in 2021 and has not meaningfully narrowed. 2022 saw small stocks reach their cheapest valuations since 2008 on a price-to-earnings (P/E) basis. We must be reminded that stocks do not appreciate based on valuations alone. Past performance, and periods of recent underperformance, are no guarantees of future results.
Higher interest rates, the retraction of massive stimulus and liquidity, and potential regime changes – will eventually bring opportunities. It is very possible that 2023 continues as a slow slog. It is also possible the Fed overtightens monetary conditions, plunging the U.S. economy into painful recession. The myriad of concerns weighing on the global economy and markets could very well take a few years to clear. Jason Trennert cautions:
“In this environment, investors should expect greater economic and financial market volatility, slower economic growth, a rationing of investment capital, and more modest returns from financial assets.” However, the opportunity set for assets and strategies offering better risk-adjusted returns are growing. Pessimism abounds, and asset prices reflect this uncertainty. The end of the chase for yield in an artificial zero-interest environment could lead to less crowding into overvalued assets. The investment landscape could become more rational and healthier, offering patient long-term investors opportunities to buy assets at more attractive prices. There are already broader alternatives of assets generating true cash flows and yields, that offer the potential for ‘equity-like’ returns.
VWG continues to stress moderate and highly diversified portfolio positioning:
As difficult as 2022 has been, VWG is comforted by our belief that a lot of the pain is behind us, and that attractive opportunities will emerge. Our faith – in entrepreneurship, the creator economy, American business, the American rule of law, and on disruptive emerging technologies that will improve quality of our lives – remains absolute. We are deeply touched by the dialogue and compassion so many of our clients have expressed this year as we have attempted to navigate a most complex situation.
Please accept our wishes for good health for you and your family in 2023. We hope everyone gets to spend lots of time with family and friends, sharing good times, activities, laughter, and passions. We look forward to speaking with you in the New Year!
VWG Wealth Management
Suzanne, Ashley, Rashmi, Kay, Brandi, Lynette, Ona, Michelle, Ryan, Ryan, Ryan, Susan, Marnie, Justin, Elana, Patricia, John, Rick and Jeff
* All stated index returns are as of 12/30/2022 unless otherwise indicated.
* Index Data and Charts Sourced from FactSet Research, Morningstar, Bloomberg, Strategas Research Partners, Bianco Research LLC., McClellan Financial Publications, U.S. Bureau of Labor Statistics.
|VWG Wealth Management is a team of investment professionals registered with HighTower Securities, LLC, member FINRA and SIPC, and with HighTower Advisors, LLC, a registered investment advisor with the SEC. Securities are offered through HighTower Securities, LLC; advisory services are offered through HighTower Advisors, LLC. |
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