As we head into the New Year, we finish the worst year in the financial markets since the “2008-2009 Great Recession.” The combination of the highest inflation in forty years with rising geo-political tensions created a rough year all around. Last year, according to William O’Neil + Co, the S&P 500 (symbol SPY-the largest 500 companies in America) finished down - 19.5%, the technology heavy Nasdaq (symbol QQQ) finished down -33.1%, the Investment Grade Bond Index (symbol LQD) finished down -20.4%, the Vanguard Real Estate Investment Trust Index (symbol VNQ) finished down -28.9%, and the IShares Emerging Markets (symbol EEM) finished down -22.4%. In this commentary, we will talk about the conflicting forces within the U.S. government which are affecting inflation, how geo-political tension affects inflation, and when we expect the financial markets to bottom out.
To offset the shutting down of the U.S. economy during COVID, the independent Federal Reserve Bank flooded the financial system with capital and zero interest loans to help companies cope with large drops in revenue. This, combined with massive federal government stimulus packages from elected officials to both individuals and businesses helped the U.S. economy to weather a deep but relatively short recession. In other words, the Federal Reserve Bank and federal government worked together to bail out the U.S. economy. However, as the famous economist Milton Friedman once said “inflation is always and everywhere a monetary phenomenon.” As more money chased the same amount of goods, prices began to rise. Further complicating the matter, the Federal Reserve miscalculated the impact of COVID on supply chain disruptions and the price impacts of the war in Ukraine on food, energy and fertilizer 2 products. The UN estimates Ukraine supplies up to 16% of the world's corn exports and more than 40% of the world's sunflower oil. Meanwhile, the European Union (the largest economic zone on earth) relies on Russia for the lion’s share of its energy. Eurostat reports that the share of fossil fuels imported from Russia is: 29% oil. 54% coal. 43% gas. As the Western world reduced trade with Russia because of their invasion of Ukraine, energy prices in Europe and around the world shot up further, driving up prices and acting as a headwind to growth. Because of these factors, inflation, which had been dormant since the early 1980’s roared back to life.
By March of 2022, the Federal Reserve realized they had been too aggressive with their monetary stimulus given the jump in inflation and began to aggressively raise interest rates and reduce money supply. The Federal Reserve’s standard playbook for beating inflation is to raise interest rates, with the goal between slowing growth enough to curtail inflation while at the same time avoiding a recession—a feat known as achieving a "soft landing". Usually the Fed fails, but the resulting recessions due lower demand, and with lower demand, lower prices. Once prices level out, the Fed then declares victory, and then begins to stimulate the economy. In 2022, the Federal Reserve raised interest rates seven times, with more rate hikes expected for 2023.
In conjunction with higher interest rates, the Federal Reserve has also reduced money supply. Money supply acts as a blood flow in an economy, more money supply translates to faster growth while lower money supply leads to slower growth. The U.S. money supply has fallen to a -1.7% rate over the last 8 months, the largest decline over an 8-month period on record (note: M2 data goes back to 1959).
The Federal Reserve’s actions have already started to slow the economy. Big ticket items get hit the hardest as the cost of financing them goes up. Housing, which the NAHB, (National Association of Home Builders) reports accounts for 17% of U.S. GDP (Gross Domestic Product) is undergoing the fastest slowdown on record. Meanwhile, Cox Automotive reported in the first week of the new year that full-year new-vehicle sales in 2022 are forecast to finish at around 13.9 million units, down about -8% from 2021, and the lowest in over a decade.
An inverted yield curve also points to a slow down for this year. An inverted yield curve, where the short-term bond pays a higher interest rate than the ten-year bond, has historically been a reliable recession relationship to watch according to the New York Federal Reserve. The 10 year and 3-month relationship first inverted in October. All of this implies a recession could be coming in 2023. The reason why inverted yield interest rate curves are followed so closely is because banks pay depositors short term interest rates on their savings and lend out that money at long term interest rates. The bank profits are the spread. The larger the spread, the more money the banks make. When interest rates invert, (short term rates are higher than long term rates) then banks cannot make money when they lend, so they stop lending, which in turn causes recessions as business and consumer lending dries up. The Federal Reserve has historically corrected this market imbalance by lowering short term rates to put markets back in balance.
Despite this, the U.S. unemployment rate has remained stubbornly low. Normally, low unemployment is a good thing. However, during times of rising inflation, unemployment contributes to rising inflation, because employment wages is an input cost for business. Thus, raising the unemployment rates has been a goal for the Federal Reserve because rising unemployment rate would indicate lower wage pressure, a key component of inflation. The Fed has stated that they will not stop on raising interest rates until inflation gets under control. Moreover, financial markets usually do not begin to recover until the Fed changes policy on interest rates. As a result, Wall Street has been watching the unemployment rate very carefully.
One problem is that the independent Federal Reserve Bank and federal government are not on the same page. While the Federal Reserve Bank is actively trying to slow the U.S. economy, to lower inflation, the federal government and Congress that control spending, are still deficit spending which acts to stimulate the economy. No Administration wants a recession on their watch, and voters do not like to see rising unemployment. While we like to see the federal government help people in need, we agree with Michael Burry, the investor who became famous in the role he played in shorting the housing market in the 2015 movie “the Big Short,” that the large federal deficits will prolong the Federal Reserve’s fight with inflation, give future policy makers less policy options due to the expanding debt load, and not prevent a recession, given a rising interest rate environment. In fact, the Wall Street Journal (1-3-23) reports that two-thirds of the economist at 23 large financial institutions that do business with the Fed are betting the U.S. will have a recession in 2023. However, the federal stimulus programs do appear to be keeping the labor market tighter than would be expected, but we are starting to see employment tightness dissipate (see chart below).
More encouraging signs are that businesses are starting to see some employment pressures ease, as well. According to the Wall Street Journal, nearly 25% of the more than 650 entrepreneurs in the December survey by Vistage Worldwide, a business advisory firm, said it was easier to fill job openings in December than at the start of 2022 - an increase from 18% in November. Meanwhile, 20% said it was harder to fill open positions, down from 25% in 7 November. This could be a sign that worker scarcity (and inflationary pressures) could be easing.
Moreover, the Index of Leading Indicators is already at the point of showing a recession and also near the point when the Federal Reserve has historically begun to reverse the course and start to stimulate the economy.
With this in mind, we are seeing signs that the Federal Reserve and other central banks around the world are beginning to at least slow down the speed of rate hikes. Indeed, the U.S. Federal Reserve has already slowed down the pace of rate hikes from 75 basis points (bps) in November to 50 bps in December. Likewise, the Bank of Canada stepped down from 75 bps to 50 bps in late October. The central banks of Australia and Norway also stepped down their rate hikes from 50 bps to 25 bps at their meetings in October/November. In addition, the central bank of one of the largest emerging market economies, Brazil, and the central bank for the largest emerging market economy in Europe, Poland, both paused, leaving rates unchanged. This is positive for stock markets because it indicates that the Federal Reserve is getting closer to its goal of containing inflation, and thus setting the stage for an expansionary monetary policy and economic growth policies once inflation is subdued. Once the Federal Reserve pivots to expansionary policies, stock markets typically rise in tandem.
In conclusion, we expect in the near term the economy and the financial markets to be choppy. We believe that neither the economy or the stock market will make much headway until the Federal Reserve bank pivots on interest rates. Furthermore, we do expect the Federal Reserve to pivot on interest rates sometime in 2023, but only after wage pressures ease and unemployment ticks up. After this happens we would expect the Federal Reserve bank to pause and eventually reverse their trend on hiking interest rates which historically has signaled the bottom for financial markets. How many months this takes is open to debate. Kiplinger’s (Jan 2023) reports that since 1948, bear markets have lasted an average of 13 months and declined an average of -33%. A bear market is a market that has dropped -20%. The S&P 500, as of the first week over January, was down over -21% (at its low the S&P 500 was down over -25%) from its high while the Nasdaq Composite is down over -33% from its high. Kiplinger’s reports it has taken an average of 22 months for financial markets to recoup all of the losses. The good news is that it appears that most of the damage in terms of price losses in financial markets, when compared to historical bear markets, has already occurred.
Moreover, equity valuations, asmeasured by expected earnings divided by current price, which were stretched coming into 2022, have now returned to historical averages (see chart above from Schwab). Therefore, while waiting for the Federal Reserve to change course, we continue to like large capitalization, brand name companies who provide goods and services that both consumers and businesses need to use on a daily basis, and who are returning cash back to investors from either or both dividends and shares repurchases as the best investments in an uncertain world. We thank you for your continued support.
Happy New Year.
Sincerely,
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