Quarterly Market & Economic Update & Review
January 11, 2023
By, Peter Mueller, CFP®, Steve Taddie, CBE® CFM,
& the HoyleCohen Investment Committee & Advisory Board
After a series of many good years in the investment markets, 2022 represented a step back. Longer-term investors have experienced the ebbs and flows of the markets in the past, so a year like this is no real surprise, but for those not mentally prepared for such years, it was more than a mild disappointment.
In a forward-looking market, estimating things like the cost of money, the cost of materials, the cost of capital (human, property, plant, and equipment), and the demand for goods and services is important. 2022 was an active year for fiscal policy, monetary policy, global instability, and the collateral consequences related to those three issues. After about 7 ½ years of a near 0% Federal Reserve Funds rate in the wake of the “great recession”, the Fed began, and kept raising that rate for the next 3 years, pausing for roughly 6-months, then lowering the rate to buoy the economy, then reacting to the Covid-19 engulfed world, taking the rate back to near 0% in March 2020. After spending another 2 years at nearly 0% and in response to surging inflation, it was time to tighten things up. Rather than the measured 3-year process used from 2015-2018, the rate hikes in 2022 took the Federal Funds from 0% to 4.50%, well above the 2.50% rate at the end of 2018. With a market expectation at the beginning of the year for the Fed Funds rate to reach .75% by year-end and realizing 4.50%. During the year, in each of the five worst weeks for American stocks, all of them took place either immediately before or immediately after a Fed Meeting. For bonds, it was more of a continual grind towards lower prices and higher yields. The market we just experienced was about as bad for stocks and it was for bonds, with alternative investments not subject to day-to-day pricing volatility putting in one of its better relative performance years.
There is much debate about the state of, and the future for the U.S. economy, and there is also a very wide range of expected outcomes from some of the smartest economists out there. At present, the estimates of GDP for 2023 ranges from about -2.7% to +3.0%, so it is tough to draw conclusions about many things market related, corporate earnings being just one of them. There is also much debate about the state of, and future for U.S. inflation. The issues in flux are; whether the current level of wage growth will continue, the current impact of the war in Ukraine and subsequent rebuilding, and the on and off again Chinese economy impact on commodity prices. While those are significant issues to contend with, the odds of inflation remaining this high seem quite low, all else being equal. For example, looking forward to the next 4 months of CPI reports, we begin by looking back at the 4 months that will drop off the year-over-year CPI figure, that is December 2021, and January through March 2022. The month-over-month CPI rate was 0.60%, 0.60%, 0.80%, and 1.20% respectively, and the last 4 months reported have averaged 0.25%. If the recent trend continues, and all else is equal, it stands to reason that year-over-year reported inflation will continue dropping as it has from the June 2022 peak of 8.7% and could approach 3.0% +/- by summer 2023. The U.S. economy is one of the more resilient economies in the world due to a much lesser reliance on trade than most others. While not completely self-contained, our self-reliance is one of the strengths of our foreign policy, and our ability to use the economic sword of persuasion.
The more centrist concern is that past monetary policy action will begin to bite, impacting the incredible job growth machine we have developed, and ultimately pushing the U.S. economy into a recession. While that doesn’t sync with a country using an economic sword to persuade the rest of the world to fall in line, the risk of a recession is what plagues the market. Over the past 12 months, Wall Street analysts have lowered expected 2023 corporate earnings by about 7 percent, with market participants pricing in a bit more of a decline, as the Price to Earnings ratio has dropped from about 21 times to about 17 times 2023 earnings. A lever that has yet to be turned in corporate America is improved worker productivity. Productivity growth was the lowest in the first half of 2022 since that statistic began being measured in 1947. Although productivity growth is very volatile, especially when measured in short intervals, the big picture is that output growth is slower or even negative as compared to job and wage growth. Productivity improvements is one of “the” topics boardrooms are taking up all over America. Historically, U.S. corporations have been wonderful profit generating machines, and frankly, nothing will likely stop that from being the case in the future for well-managed companies.
For bonds, with interest rates at levels we have not seen in more than 14 years, there seems to be more upside potential than downside risk with respect to price movement. With respect to credit quality and risk of payment of interest and principal, the spread (a measure of risk) between corporate bonds and government bonds increased from late 2021 but has dropped back towards the 15-year average as we headed into year end. The yield curve remains inverted with short-term interest rates higher than long-term interest rates, which is typically a precursor to lower long-term rates, and we have seen the yield on the 10-year U.S. treasury drop from about 4.15% in late October to about 3.86% at year end, during the same period, corporate bonds yields (BBB) have dropped from about 6.50% to about 5.70%.
We view client portfolios as a properly allocated collection of businesses and income generating investments.. Markets place a value on each business or stream of income minute by minute, and while we may not agree with that assessment, or like it, that is the way highly liquid markets work. One of the most significant advantages we have as investors is the gift of time, and the ability to use that time to look past the present. We have to remember to use that advantage during times when the markets do not meet our expectations in the short term. Engaging in tax minimizing transactions, using those proceeds and/or cash flow from existing investments to reallocate, improve, and/or reposition a portfolio for the next 5-10 years is how one succeeds in the markets over time. In many cases, investments will last longer than the individuals benefiting from the growth and/or income, so a long-term perspective is more than warranted.
With respect to market pricing in the short term, like it or not, we are in a Fed driven market, with both the Bulls and the Bears listening for what they want to hear. If the CPI numbers come in as we expect, then the Fed should ease up a bit on the hawkish rhetoric and the tightening. If the economy shows a significant downward shift, then the Fed should ease up as well. After a 12-month cycle where the Fed Funds rate rose from near 0% to 4.50%, the odds of a rise of equal magnitude over the next 12-months is next to zero. That said, Fed forecasters are split somewhat on whether the Fed holds the rate at the 4.50% to 5.0% level (there is some plus/minus around those rates) through the year or pivots mid to late year taking Fed Funds rate lower. Either way, the ongoing pain from a rising Fed Funds rate may be on the verge of subsiding. The question is when, and there is no real consensus on that from forecasters or the Fed itself.
All the Best,
Steve Taddie Peter Mueller
The discussions and opinions in this correspondence are for general information only and are not intended to provide investment advice. While taken from sources deemed to be accurate, HoyleCohen makes no representations about the accuracy of the information in the communication or its appropriateness for any given situation. HoyleCohen’s quarterly statements are provided as a convenience and we encourage clients to refer to custodian statements as well.
