There were few places to hide in 2022 as both bonds and stocks dropped significantly.1 Interestingly, S&P 500 full-year 2022 earnings are likely to come in almost exactly as analysts predicted back in December 2021, meaning most companies actually performed fairly well financially last year.2 The problem was the huge rise in interest rates, caused by shockingly higher than expected inflation. As interest rates rise, existing bond prices fall as investors equalize new bond issues with older, lower-rate bonds. As the future returns of bonds rise, this also causes investors to demand higher expected future rates of return for stocks, thereby lowering the present value of future cash flows and valuation multiples like Price/Earnings.3
The spike in inflation was caused by many factors, including:
(1) Slower improvement in supply chains as China remained in COVID lockdown
(2) Russia’s war with Ukraine raising global energy and food prices
(3) High demand against tight supply as consumers spent COVID stimulus checks 4
(4) Central banks being too slow to hike interest rates and remove quantitative easing
(5) A tight labor market allowing big wage gains
(6) The post-COVID surge in housing prices and rents
In short, there are numerous sources of blame and no easy fixes to this issue. The Federal Reserve and other global central banks are now trying to mash the brakes, hoping that high interest rates will drop demand and prevent inflation expectations from becoming unanchored to its 2% long-term target.
We believe 2023 will be characterized as the Battle between Inflation and Growth. Many forecasters are now predicting a US recession to begin sometime in 2023. Europe may already be in one. In past recessions, central banks have been able to lower interest rates and/or perform quantitative easing to help reignite the economy. But as long as inflation remains high, this rescue option is off the table. Therefore, inflation numbers will continue to be the most watched piece of economic data this year, starting this Thursday, January 13, with the CPI report for December.
There is an optimistic inflationary case to be made. Recent inflation datapoints have been promising, with year/year inflation falling from its June peak of 9.1% to 7.1% in November.5 This drop has occurred despite a labor market that continues to be very strong, suggesting that it may be possible for inflation to cool without massive job losses as supply chains continue to improve and high interest rates lower demand but do not cause significant recession, if any. Alas, there are also two plausible pessimistic cases: (1) A situation similar to 2022 where inflation stays higher than expected, corporate earnings likely stay intact, but stocks and bonds both drop again, though likely not by as much, as interest rates continue to rise. (2) Inflation drops, but it is because the recession is much deeper than expected. This scenario favors Treasury bonds as the Federal Reserve eventually cuts rates back to near zero,6 but all risky assets drop and credit spreads widen to deep recession levels before eventually rebounding.
What are some reasons to stay positive in the face of a potential recession?
- Expected returns: As mentioned above, due to lower prices and higher interest rates, future expected returns are higher now for both stocks and bonds and much more in line with long-term historical norms versus last year at this time. This is not to say that bonds will be up 4% and equities will be up 9% this year, but that is now our long-term expectation once again.7
- The stock market is forward-looking: It is likely to correct and rebound before the bottom in economic data.8 We saw this most acutely in Q2/Q3 2020 when stock prices rallied to new highs despite the deep ongoing COVID-lockdown recession. The market can look through short-term economic pain and poor company results if the long-term still looks promising. If inflation gets under control and the recession looks like it will be mild and short, then we expect equities to perform fairly well.
- Sentiment remains negative: Investor sentiment hit its lows for the year in April and September 2022, but remains at well below average levels.9 Likewise, consumer sentiment remains very low.10 Both of these surveys have been historically reliable contrary indicators, as subdued expectations creates a lower bar for future events to clear.
- Companies cutting costs to preserve earnings: We will get a much better picture on this shortly as the first major day of Q4 earnings reports is this Friday, January 14. Years of low interest rates led many large companies to invest too heavily in growth, such as too much office space and employees. We have recently seen some major layoff announcements and expect many more. In addition, COVID and the Russia/Ukraine War have led to serious supply chain issues, which are now being rapidly resolved, lowering transportation and input costs for many companies.11
Other issues we are watching:
- China is reopening fast: China is a huge driver of both global supply and demand and it fully emerging from lockdown-mode is a positive for the global economy. However, the impact of this on inflation will be mixed as it will improve supply chains even further while increasing demand for all items.
- Debt ceiling negotiations: With a split Congress, we do not expect any significant market-moving legislation to get passed this year. One area where we do have concern is if the Federal debt limit gets used as a negotiation tactic as it did in 2011. Recall that this helped cause a US credit rating downgrade and major market sell-off. Many Congress-watchers believe that scenario could recur this summer.
Bottom Line:
Remember that there are always multiple global issues to worry about, and you are being paid to assume those risks by investing in the market. GGS pays close attention to the issues and risks above and how they could impact both the individual companies we are buying and the overall risk profile of client portfolios. We do our best to guard against unknown risks via scenario analysis testing, strict limits on client betas, and avoiding portfolio concentrations in any given geography, industry, or individual security. We continue to recommend clients avoid trying to time the market and stay invested to their target risk level in good times and in bad.