Quarterly Letter
“When the Fed jams the brakes, someone goes through the windshield.”
– Wall Street Adage –
The over-riding theme for 2022 was all about inflation, for, as Will Rogers noted, “Letting the cat outta’ the bag is a whole lot easier than puttin’ it back in.” As a result, it was a poor year for investors, with negative returns for stocks, bonds and real estate. There were China headwinds, supply chain issues, the largest conflict in Europe since the end of World War II, a crypto-market meltdown and dramatically higher energy costs.
Amidst it all was inflation, and the need to unwind some of the expansive fiscal and monetary policies of the Covid era (2020 – 2021). For its part, the Fed is attempting to do something it has not had to do in years – increase interest rates (which removes excess liquidity from the economy) to slow inflation without causing a severe recession.
It is fascinating how quickly the Fed had to pivot in early 2022. Just thirteen months ago, the Fed was still adamant that inflation was “transitory,” a passing fad. Against a growing crowd of doubters, they, as recently as December 2021, predicted no interest rate increases for the 2022 year. One is reminded of the Scotch-Irish prayer, “Lord, grant that I might always be right, for thou knowest I am hard to turn.”
To their credit, the Fed did turn, and with such vigor that by year-end 2022, seven increases to the Fed Funds Rate had occurred. That is 4.25% of interest rate increases in aggregate, to its highest level in fifteen years, and additional increases seem to be on the way. So, the issue as we enter 2023 is what will it take for the Fed to curtail their current aggressive interest rate stance?
For the Fed, there are three components to watch relative to cooling economic growth and reducing inflationary pressures.
- First, the Fed wants to see evidence that the price of goods, such as those for cars, furniture and appliances, is slowing. Indeed, data over the past six months indicates some slowing is occurring, with the second-half 2022 decline in commodity prices particularly telling.
- Second, the price of services, which is reflected in such items as the cost of health care, dining and travel, needs to see a significant slowdown. Again, there seems to be progress on this front, but there is clearly a ways to go.
- Finally, the Fed would like to see unemployment rising, an unpleasant medicine for the labor market which they consider necessary to reduce pressures for wage increases. We are indeed seeing some layoffs in the tech world, but jobless claims remain stubbornly low.
In summary, there is good news, although not enough to get to the low inflation levels ultimately desired. Thus, the conundrum for the Fed. They know their actions take months, sometimes years, to reflect their full impact. As they read the tea leaves for the future, how do they guard against easing (reducing interest rates) too soon, versus being overly restrictive (increasing interest rates) and creating a deeper recession than necessary? It is, to say the least, not an easy task. And that is why it will likely be the big story for 2023, as the Fed walks the tightrope between too much and too little.
We are prone to viewing most glasses half-full, and, indeed, we see this one that way. However, we are oddly in a market where bad news is good news, and good news is bad news. If unemployment goes up, it is bad news for those losing their jobs, but it demonstrates to the Fed that their actions are working and that further interest rate hikes may be unnecessary. Thus, good news for the long-term health of the economy. Likewise, for corporate earnings. If they stagnate or decline, it is bad news for the business, but good news for the Fed and future inflation figures.
We see this good news bad news convolution lasting for some time, perhaps the entire year. However, markets tend to turn upward long before positive news is reported, so the guessing-game now is when investors will have confidence that stock prices have declined far enough to look attractive for investment.
Peter Lynch of Fidelity fame says, “The key to making money in stocks is not to get scared out of them.” He knows equity markets cannot be timed and that the future is not predictable. Markets tend to be manic depressive, it is often feast or famine, and markets do move quickly. Thus, by the time the news is getting better, markets have usually already recovered. Many today who hold cash equivalents probably feel comfortable. Our advice – don’t. History tells us stock markets periodically give us twenty to fifty percent off sales, and such a sale is currently occurring. The sale will continue . . . until it doesn’t, and no one knows when that will be. We believe that the year 2023 will have both disturbing and exhilarating news, including some in areas we have not even thought about. However, knowing markets bottom before news gets better means we will keep it simple and stay invested for the inevitable rally to come.
“The key to making money in stocks is not to get scared out of them.” – Peter Lynch, Fidelity Magellan Fund
Market Commentary
- After a remarkable year of gains in 2021, investors faced a far different landscape in 2022. Realizing inflation was anything but “transitory,” the Fed aggressively raised interest rates throughout the year to increase borrowing costs and dampen demand.
- Without the benefit of record-low interest rates, U.S. stocks, as measured by the S&P 500 Index, declined 18%, posting their worst year since the 2008 Great Financial Crisis. International stocks also struggled due to a strong dollar, ongoing war in Ukraine, and China’s rigid zero-COVID policy to finish modestly better than U.S. stocks, albeit still down 14% on the year.
- Amid rising interest rates, bonds provided little relief from the stock market’s turbulence. U.S. bonds, as measured by the Bloomberg U.S. Aggregate Bond Index, declined 13%, marking the Index’s second consecutive year of losses. Most bond investments lost 10-20%, primarily depending on duration.
- Although inflation has moderated some in recent months, it remains above 6%, and the Fed is likely to maintain its aggressive stance (i.e., increase interest rates). For the Fed to moderate its stance, it needs to see evidence of three things – slowing of the increase in the price of goods, slowing of the increase in the price of services, and higher unemployment to reduce wage pressures.
It’s The Fed Versus Inflation
- To quash stubbornly high inflation, the Federal Reserve in 2022 imposed the most rapid rate-hiking cycle in history. Higher interest rates create a headwind for consumer and business spending.
- In recent months the lagged effects of the Fed’s tightened policy have begun to show up in moderating inflation figures. Consumer spending, in particular, has shown signs of cooling, important because it accounts for roughly two-thirds of GDP.
- Most currently see the Federal Funds terminal target interest rate at around 5.25%. Lest anyone assume that will be the actual target, remember just one year ago the Fed forecasted no interest rate increases for 2022.
Finally Time For International?
- The U.S. dollar strengthened to a 20-year high in 2022, as the Fed reacted to inflation faster than other Central Banks, and geopolitical and global growth concerns continued to dampen the international outlook.
- A weakening dollar in 2023 and beyond, even marginally, could provide a backdrop for international equity outperformance for U.S. investors.
- For more than a decade domestic equities have outperformed international, largely due to a stronger economy in the U.S. History would suggest, however, that international stocks could, over the next several years, fare particularly well given current valuations and low expectations.
Value Stocks Return To Favor
- For more than a decade, Growth stocks significantly outperformed Value stocks. Growth in these years benefited enormously from a risk-on investor attitude and ever-lower interest rates. As shown below, however, 2022 experienced a stark reversal in that trend.
- With rapidly rising interest rates and uncertainty about the economy’s future growth, downward pressure has been exerted on Growth stocks as investors seek more defensive Value sectors.
- Among S&P 500 sectors, Value plays in Energy and Utility sectors were the only winners in 2022. Growth stocks found in Consumer Services, Consumer Discretionary, and Information Technology sectors, however, typically had losses of 30-40%.
Tough Year For Bonds
- The pace of rising interest rates in 2022 was a surprise. In January, the 2-year and 10-Year Treasury notes were paying 0.73% and 1.50%, respectively. At the end of December, they were paying 4.41% and 3.88%, respectively, a stunning climb resulting in an inverted yield curve.
- Bonds, on average, experienced double-digit losses in 2022, with the U.S. Aggregate Bond Index down 13%, and other bond indices generally down 10 to 20% depending upon their average duration and credit quality. As shown below, it was the worst year for bonds in more than four decades, and this was the first time since 1981 that both stocks and bonds posted negative returns.
- The increase in bond yields could be viewed as a positive when considering recent periods of ultra-low bond returns. As the spread between government-backed, corporate, and non-investment grade bonds has widened there are more options for investors to earn higher rates and lower their duration risk.
Recessions, In Perspective
- The prospect of recession can strike fear among investors, but stocks have historically performed surprisingly well during recessions, with the S&P 500 Index rising during all U.S. recessions since World War II.
- As shown below, markets have not reacted well leading into a recession, but they have historically bottomed well before the conclusion of the recession. Stock prices historically tend to be based more on future expectations rather than today’s results.
- Looking at the returns that would be required to breakeven with the January 2022 all-time high (chart at right), the road ahead is encouraging. In the 12 bear markets since World War II, the longest recovery period, from trough to prior high, was four years, and the average was less than two years.
Contributors
© 2023 The Finerty Team
The S&P 500 Index is a free-float capitalization-weighted index of the prices of 500 large-cap common stocks actively traded in the United States. The Bloomberg US Aggregate Bond Index is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
Advisory services offered by Moneta Group Investment Advisors, LLC, (“MGIA”) an investment adviser registered with the Securities and Exchange Commission (“SEC”). MGIA is a wholly owned subsidiary of Moneta Group, LLC. Registration as an investment advisor does not imply a certain level of skill or training. The information contained herein is for informational purposes only, is not intended to be comprehensive or exclusive, and is based on materials deemed reliable, but the accuracy of which has not been verified.
Trademarks and copyrights of materials referenced herein are the property of their respective owners. Index returns reflect total return, assuming reinvestment of dividends and interest. The returns do not reflect the effect of taxes and/or fees that an investor would incur. Examples contained herein are for illustrative purposes only based on generic assumptions. Given the dynamic nature of the subject matter and the environment in which this communication was written, the information contained herein is subject to change. This is not an offer to sell or buy securities, nor does it represent any specific recommendation. You should consult with an appropriately credentialed professional before making any financial, investment, tax or legal decision. An index is an unmanaged portfolio of specified securities and does not reflect any initial or ongoing expenses nor can it be invested in directly. Past performance is not indicative of future returns. All investments are subject to a risk of loss. Diversification and strategic asset allocation do not assure profit or protect against loss in declining markets. These materials do not take into consideration your personal circumstances, financial or otherwise.
