2022 4th Quarter Market Commentary
I don’t always agree with what is written on The Wall Street Journal’s editorial pages, but the following was part of a particularly insightful editorial from its year-end edition:
“[F]ree money can’t last forever… is the reality that financial markets brought home in 2022 as U.S. stocks finally fell back to earth after being inflated for years by the Federal Reserve’s detour into monetary illusion. Asset prices soared as the Fed showered the economy with money that cost essentially nothing, as real interest rates stayed negative…. The surprise, if there is one, is that there haven’t been even more financial casualties as the Fed has tightened money. Perhaps the financial system is sturdier now than in 2008, or perhaps the debt dominoes have yet to fall. But the end of free money always does harm that is unanticipated during the mania.”
The editorial’s caution may or may not be meaningful in the short term, but the Journal’s words frame the long-term concerns I have talked about in these commentaries for years. In this issue I will attempt to evaluate prospects for the next several quarters and the factors that may determine their outcomes.
A strong fourth quarter merely reduced the damage inflicted upon investors in both stocks and bonds over the course of 2022. On a total return basis, the S&P 500 declined by 18.1% for the full year with the Barclay’s Capital Aggregate Bond Index falling 13.0%. The commonly recommended 60/40 portfolio allocation would have produced a 16.1% loss. Most investors did even worse, because the most popular stocks were hit far harder. We are pleased that we spared Mission clients most or all that pain.
After a decline of 2.2% in 2022’s first two quarters, GDP bounced back by 3.2% in quarter three, and most forecasters see another positive reading in the fourth quarter. Consensus forecasts for full year GDP approximate 2%.
As I write, the World Economic Forum has just begun its annual meeting in Davos, Switzerland. Its survey of chief economists found the majority forecasting a recession in the United States and many other countries in the year ahead. A few days ago, the World Bank lowered its world economic growth forecast to 1.7% for 2023. It forecasted a minimal 0.5% growth in the U.S. and the composite of all advanced economies. Recognizing the still strong level of inflation and lagged impacts of already introduced stringent monetary policy measures, the World Bank indicated that risks exist that could produce even lower global readings.
We can’t know in detail all the factors they are evaluating, but several are obviously important. Most importantly, will there be a recession in 2023, and, if so, how widespread will it be? As mentioned above, the majority of chief economists believe there will be a recession in the U.S. and most parts of the world. Most expect the recession to be relatively mild.
In the U.S., and now globally, yield curves are inverted. In other words, the yield on short-term fixed income securities is higher than the yield on longer-term securities. Over the past half century, yield curve inversion has been an infallible precursor to recession. Similarly, over more than a half century, a six-month decline in the Conference Board U.S. Leading Index, which has recently been recorded, has invariably preceded or accompanied eight consecutive recessions.
Notwithstanding these unblemished precedents, there are analysts who disagree with the majority about the inevitability of recession. Some believe that inflation will decline rapidly this year and that worldwide central banks will soon begin to relax their hawkish monetary policies. On top of that, the recession disbelievers see China’s emergence from its Covid lockdowns as a powerful boost to global economic growth.
In this country, several factors lead me to expect a recession in the year ahead. The American consumer has been fueled by an unprecedented amount of government transfer payments in the post-pandemic period. Recent measures of expanded credit card debt indicate that consumers at the lower levels of the wealth spectrum have exhausted savings and are putting an increasing amount of purchases on credit cards. A New York Fed survey shows that households have been taking on debt at the fastest pace in 15 years. At the same time, the savings rate in the U.S has hit a historic low. As a result, demand is crashing.
The consumer is not the only one suffering. A recently released Fed Flow of Funds report shows signs of corporate balance sheet corrosion. As corporate managers evaluate deteriorating economic conditions, many are anticipating declining earnings and some are turning to staff reductions, which will eventually further reduce consumer purchasing power.
An additional hit to economic growth comes from a decline in worker productivity. Through the third quarter, the year-over-year decline in nonfinancial productivity was the steepest on record. All in all, the factors pointing towards recession in the year ahead look more convincing that those pointing to GDP growth.
Impact of Recessions On Markets
How important is it whether a recession unfolds in 2023 or not? Historically, bear markets that include a recession are far more destructive to stock prices and far longer lasting than bear markets without a recession. Since 1900, the median decline in bear markets accompanied by a recession has been -34.6%. In those bear markets, the decline’s price bottom has never taken place before the recession began. If that holds true again, and if we experience a recession, stocks would give up the recent rally and descend below the October lows. In fact, the bear market could extend far longer than virtually anyone is talking about. If such a decline should reach the median length since 1900, it would last for 13.6 months beyond the end of the Fed’s current tightening cycle, which is expected to end sometime in 2023. In the three cases in which the bear market ended before the end of the tightening cycle, a second bear market occurred before the end of the subsequent easing cycle. All these factors considered, if there is a recession, history argues strongly that equity market distress could last quite a while.
Those that believe that the economy will escape a recession expect that Fed Chair Jay Powell would shrink in the face of a weakening economy then pivot to monetary easing before the economy would reach recession. It is a curious phenomenon that Powell and his fellow Fed members have been steadfast in their commitments to even higher interest rates for longer while investors, voting with their money, are anticipating a Fed pivot to lower rates before 2023 ends. Over the decades, the Fed has followed the market far more often than the other way around. Today, however, we have a Fed that probably has to hold its word to reestablish its credibility after erroneously and continuously expressing its belief that inflation would be “transitory.”
What the Fed has already done has had a huge effect on the fixed income markets. They have raised the Fed Funds rate from zero to 4.25% at the fastest pace ever. Fed members have most recently expressed their expectation that the terminal rate in this tightening cycle will exceed 5%. If that expectation is realized, rates would certainly continue to rise on short maturities and likely on longer maturities as well, unless the market anticipated a near-term recession in which case longer rates might recede.
We have largely avoided bond market carnage for Mission clients over the past year by investing solely in short-term securities. As cash was available in individual portfolios, we constructed two U.S Treasury ladders. The longer of the two centered around 2-year Treasury notes; the shorter in 3-month T-bills. As the Fed raised rates, existing securities in the 2-year ladder retreated slightly in price, but we used cash from maturing T-bills to buy more of the higher yielding notes. When the year ended, client fixed income yields-to-maturity exceeded 4%. Should rates continue to rise, more T-bill maturities will provide the opportunity to raise portfolio yields even further. Should rates surprise by rising significantly from current levels, portfolios will still be well protected as already short-dated securities move inexorably toward maturity.
With the strongly negative 2022 equity market in the rear view-mirror, stocks have jumped off the mat in the new year with the S&P 500 up more than 4% in the first two weeks amid a plethora of conflicting technical signals. The rally has been worldwide, even stronger outside the U.S. Going into year-end, negative economic prospects led to significant levels of investor pessimism that frequently precede at least short-term rallies. The strong price gains in the new year have, however, prompted a surprisingly rapid return to the heady speculation that often marks market tops. Some stocks like GameStop, AMC Entertainment and Bed Bath and Beyond once again showed outsized gains. Junk bonds received hefty capital inflows. Crypto currencies experienced big bounces. With the S&P 500 up about 4%, the most heavily shorted stocks exploded upward by almost 20% in just two weeks. That’s a characteristic of traders playing for a quick profit.
While such frothy characteristics rarely last long, one can never rule out sustained market gains even in the face of negative fundamental conditions. It is more likely, however, that equity prices will progress roughly parallel to underlying fundamental economic conditions. As outlined above, a recession is likely in the year ahead, and corporate earnings are expected to be anywhere from flat to down more than 10%. Such expectations would rarely precipitate rising equity prices even if stocks were trading at historically average valuations. With the S&P 500 trading at 22.1 times earnings in mid-January on a Generally Accepted Accounting Principles basis (about 40% above the long-term average), the more likely path for equity prices points down.
As the first two-plus decades of this century have conclusively proved, the 800-pound gorilla affecting U.S. stock and bond markets is the Federal Reserve. Its decision to stay on its hawkish anti-inflation path or to pivot to a more dovish position to support the economy will have a potentially profound effect on securities prices, at least in the near-term. In the long run, valuations will invariably revert to historical means. Unfortunately, it is not given to us to know how and in what time frame that will occur. While we always defer to client objectives, it is our approach to accept more investment risk when markets are historically undervalued and less risk when markets are overvalued, as they are currently. We will always, however, remain flexible and willing to take advantage of attractive opportunities that the markets may offer.
Please contact us if we can provide additional information about your portfolio or our investment thinking.
By Thomas J. Feeney, Managing Director and Chief Investment Officer
Mission’s market and investment commentaries reflect the analysis, interpretation and economic views and opinions of our investment team. They are not intended to provide investment advice for any individual situation. Please contact us if we can provide insight and advice for your specific needs.