“You get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready, you won’t do well in the markets.”
Peter Lynch, 1944 - present, legendary mutual fund manager, investor and philanthropist
A NOTABLE SHIFT IN INTEREST RATES HAS ALTERED THE INVESTMENT LANDSCAPE
According to ancient Greek legend, there was a kingdom named Phrygia in what is now modern-day Turkey, where the local people found themselves without a king and with no heir to the throne. When they asked for advice on how to find a new king, an oracle decreed that the next man who entered the city with an ox-cart should be declared king. When a peasant farmer named Gordias happened to walk through the gates of Phrygia the next day with his ox-cart, they made him king. To show his gratitude, he placed the ox-cart in a temple, tying it to a pillar with an intricate knot of cornel bark, which hardened over time. The knot was so elaborate that the Roman historian Curtius Rufus described it as “several knots all so tightly entangled that it was impossible to see how they were fastened.”
It became known as the Gordian Knot and for centuries, countless challengers attempted to untangle it without success. It was considered the hardest problem in antiquity and resisted all attempted solutions until 333 B.C., when a young king from Macedonia came through Phrygia with his army. It had been prophesied that any man who could unravel the elaborate knot was destined to become ruler of all of Asia, which made it too tempting a challenge for the Macedonian ruler. After trying over and over again to untie the famed knot to no avail, he stepped back from the mass of gnarled ropes and proclaimed, “it makes no difference how they are loosed.” He then drew his sword and sliced the knot in half with a single stroke.
The young king was Alexander the Great, who went on to amass the largest empire in the entire ancient world. As lore would have it, Alexander regarded his victory over the Gordian Knot as the most decisive battle he ever fought. Since then, the metaphor of the Gordian Knot has been used to describe any problem so large, complex, and intractable that it can only be solved by innovative thinking and bold, decisive action.
It is a well-suited analogy for the intractable challenges the world’s central banks are facing to solve the tangled knot of inflation, which in many countries is at or near its highest level since the 1980s.
The Economy
Inflation occurs when prices rise across the economy, causing consumers and businesses to spend more on the same amount of goods and services than they did in the past. That gradual loss of purchasing power affects all aspects of the economy, from consumer spending, employment, and business investment to government programs, tax policies, and interest rates.
Because rapid price gains are costly to society and detrimental to stable economic growth, monetary policy must be decisive. Unfortunately, central banks have a relatively limited toolkit to tame price inflation, with interest rate policy representing the primary tool used to carry out their mandate of price stability. They do that by increasing the short-term borrowing rate for financial institutions, which raises the cost of borrowing to damp consumer and business spending, slow economic activity, and ultimately reduce inflationary pressure.
The Fed’s delayed exit from its emergency policy responses to the pandemic has allowed a surge in inflation and inflationary expectations that pose a serious challenge to a sustained economic expansion. To bring those rapid price increases back under control, policymakers hoisted interest rates seven times in 2022, raising the benchmark borrowing rate at a rapid clip from zero to a range of 4.25% to 4.5%, the highest level in 15 years (see graph below). The cumulative rate hikes of 4.25 percentage points in just nine months - including, for the first time in modern history, three consecutive 75 basis-point increases - mark the fastest and steepest pace of monetary tightening since the early 1980s.
It wasn’t just the U.S. Fed, however. Central banks across the world followed suit and ramped up interest rates to varying degrees as stubbornly high inflation wasn’t isolated to the U.S. All major central banks, bar the Bank of Japan, raised rates last year, though policymakers in Tokyo roiled markets in December with a surprise policy tweak that fueled speculations that an actual rate hike might be forthcoming in the not too distant future.
Here in the U.S., price increases moderated in the fall from a four-decade high earlier in the year, providing a welcome indication that the period of painfully high inflation might have peaked. The Consumer Price Index (CPI), a closely watched inflation gauge that measures what consumers pay for goods and services, climbed 7.1% in November, down sharply from June’s 9.1% peak. The Personal Consumption Expenditures price index, or PCE, the Fed’s favored inflation gauge, showed that prices rose 5.5% in November from a year earlier, down from a 6.1% increase in October and the smallest gain since October 2021. Still, inflation by any measure remains far above the Fed’s inflation target of 2%.
A significant drop in goods prices accounted for the bulk of the easing inflation while services prices have proven stickier, a dynamic that policymakers are concerned about, since services other than housing and energy account for more than a quarter of all consumer spending. The divergent trends in goods and services data complicate things for the Fed as the outlook for services inflation is closely tied to labor costs. Sustained wage gains, particularly in service sectors, could keep inflation persistently higher than the Fed’s goal.
While financial markets expect the blistering pace of policy tightening to slow this year, policymakers emphasized that further rate increases will be appropriate in 2023, with the federal funds rate now forecast to rise to a “terminal rate,” or point where officials expect to end the rate hikes, of as high as 5.1%.
The sharp rate hikes have started to filter through the economy, with their effects showing up in areas such as real estate, where the average rate for a 30-year fixed- mortgage was 6.27% at the end of December, more than double the rate seen at this time last year, according to Freddie Mac data. The cumulative effect of this sharp rise in rates has cooled the housing market, with November existing home sales slumping to the lowest level since May 2020. Sales have now declined for 10 straight months, the longest such stretch since 1999. Meanwhile, homebuilder sentiment dropped for the 12th consecutive month in December to the lowest level since 2012, according to the National Association of Home Builders. The S&P CoreLogic Case-Shiller National Home Price Index, which measures average home prices in major metropolitan areas across the nation, fell for the fourth straight month in October.
As mentioned earlier, the intended effect of higher interest rates is to slow economic activity and reestablish price stability by containing inflation. Those hikes, however, work with what economists call ‘long and variable’ lags, so central banks might not know for months to come if they have tightened too much, or not enough. Research shows that it can take one to two years for tighter monetary policy to materially affect the economy and inflation once they have been implemented.
For instance, when former Fed Chair Paul Volcker took office in the summer of 1979 and quickly pushed interest rates to about 20%, it brought an almost immediate recession, but inflation took about three years to fall to manageable levels. It’s therefore conceivable that some of the easy money rolled out at the start of the Covid-19 pandemic is still being felt, while rate increases to date have barely cooled either inflation or growth.
With policymakers maintaining their focus on fighting inflation, concerns are growing that their actions will ultimately lead to a recession. Although the Fed’s latest economic projections show the economy growing at a sluggish pace of 0.5% this year, it does not forecast a recession. That contradicts with surveys of economists and forecasts from economic think tanks, which increasingly point to a growing likelihood that the U.S. economy could face economic contraction sometime this year. Likewise, the Conference Board predicted in October that there was a 96% probability of a recession in the U.S. within the next 12 months.
The bond market, where the yield on the short-term 3-month Treasury bill moved above that of the 10-year Treasury note in October, seems to agree. Inversion between yields of those two bonds is a rare occurrence and is viewed by many economists as one of the most reliable warning signals of an impending recession. Usually, longer-term bonds offer higher yields than shorter-term ones because investors demand higher returns for committing money for a longer period. The negative gap between three-month and 10-year yields inverted as wide as 0.90 percentage points in December, the widest since late 1981 (see graph above).
Several other reliable indicators are flashing warning signs of a coming slowdown:
- The Conference Board’s Leading Economic Index (LEI) continued to move lower for a ninth consecutive month in November, falling a sharp 1% with only four of the ten components improving. Labor market, manufacturing, and housing indicators all weakened - reflecting serious headwinds to economic growth.
- Consumer spending, which makes up two-thirds of U.S. economic activity, slowed sharply in November, up just 0.1% following strong monthly gains over much of the year.
- The U.S. manufacturing sector weakened in November, as the ISM’s Manufacturing PMI fell to 49 in November, down from the 50.2 reading recorded in October and its weakest reading since May 2020. A reading below 50 indicates contraction in manufacturing, which accounts for 11.3% of the U.S. economy.
Yet, despite a barrage of indicators showing weakness, the economy still looks like it has momentum. Consumers remained relatively resilient for much of the year and continued to spend, thanks in part to a strong labor market, excess savings built up during the pandemic, and pent-up demand.
- The U.S. economy grew faster than previously estimated in the third quarter last year, according to the Commerce Department’s latest report, which showed that Gross Domestic Product (GDP) rose by an annualized rate of 2.9%, a marked turnaround from contractions of 1.6% in the first quarter and 0.6% in the second.
- American consumer’s confidence in the U.S. economy spiked in December to its highest level since April as inflation expectations eased and gas prices dropped. They were also slightly more upbeat about current business and labor market conditions.
- A recession is typically characterized by job losses, but the labor market has remained resilient and job growth has continued, despite ongoing global uncertainty and rising interest rates. Since January 2021, the economy has added over 200,000 jobs every month. Growth has been widespread throughout the economy, with the number of available jobs continuing to outstrip the number of workers available to fill them. Layoffs remain historically low and the latest unemployment rate is holding steady at a healthy 3.7%, close to where it stood at the outset of the pandemic. Competition for workers has been pushing wages up at a rapid rate though, which raises the likelihood that the central bank could keep interest rates elevated for longer.
The Markets
Persistent inflation and the Fed’s radical policy shift over the past year have brought an end to an extended period of near-zero interest rates and drastically altered the landscape for investors who had become accustomed to cheap money. Tightening financial conditions contributed to major headwinds for the economy and weighed on investment markets with almost every major listed asset class posting negative returns.
The benchmark S&P 500 index peaked on the first trading day of 2022 and never came close to revisiting its high point. It went on to post its worst first half of the year since 1970 and repeatedly moved in and out of ‘bear market’ territory – defined as a decline of 20% or more. While persistently high inflation and a significant change in monetary policy were investors’ top concerns, deteriorating company profit estimates and uncertainty about whether a recession will occur were also weighing on stocks. The benchmark S&P 500 closed a punishing year with a 19.4% decline, its biggest pullback since 2008 when it lost 37%. The Dow Jones Industrial slid 8.8% and the Nasdaq dropped 33%, as growth and momentum stocks – darlings of the pandemic – crumbled.
By any metric, 2022 was also a historically bad year for fixed income investors. Bonds failed to offset plummeting equities and had the worst year since the Great Depression as central banks ratcheted up interest rates. The Bloomberg US Aggregate Bond Index saw losses of almost 15% and had investors questioning the safety of bonds. The carnage was widespread, with all major bond categories showing losses for the year.
With both asset classes, equities and bonds, selling off at the same time, the traditional 60/40 portfolio (consisting of 60% stocks and 40% bonds), a longtime favorite of individual and institutional investors alike, had a particularly bruising year, posting a negative total return of -15%(see graph above). That model portfolio has long served its purpose by providing investors with attractive investment returns while assuming a low level of risk. While much ink has been spilled over the ‘death’ of the 60/40 portfolio lately, we believe that the drop in stock valuations and the rise in bond yields have increased the potential rewards for long-term investors willing to bear the risks of an unusually challenging macroeconomic outlook. That is the good news about bad markets: last year’s pain may be laying the foundation for better future gains.
Takeaways for 2023
‘Tis the season for year-ahead forecasts.’ However, these attempts at clairvoyance are stymied by a fundamental problem: it’s simply impossible to forecast the path of the markets or the economy six months or a year ahead with accuracy or consistency, as many academic studies have shown. To quote Warren Buffett: “The only value of stock forecasters is to make fortune tellers look good.”
For his part, Fed Chair Powell acknowledged as much last month when he said, ‘I don’t think anyone knows whether we’re going to have a recession or not – and if we do, whether it’s going to be a deep one or not. It’s not knowable.” Similar to the ancient tale, he seems uncertain that he can solve the complex knot of inflation. Unfortunately, there’s no Alexander to help him untie it.
So, what’s next for the economy and investment markets? Below are some key factors that could impact investors in 2023:
- Elevated inflation and Fed rate policy have weighed down global financial markets last year and remain top of mind for investors. Slowing consumer demand and modest job losses should put inflation on a downward trend this year and it’s reasonable to expect the Fed to slow the pace of - or even pause - rate hikes. Should inflation rebound or remain stubbornly high, the central bank could be forced to continue raising interest rates, which would pose the biggest risk to market stability.
- Disappointing corporate earnings: S&P 500 companies reported a tepid 2.2% earnings growth in the third quarter of 2022 - a weak number when compared to the 47.4% growth for calendar year 2021, according to FactSet. Consensus analyst estimates project earnings to rise 4.4% in 2023, according to Refinitiv IBES. Yet Ned Davis Research found that earnings actually fall by an average annual rate of 24% during recessions. Few investors appear to be pricing in such a scenario despite the apparent prevalence of recession forecasts. Slowing or negative earnings growth could lead to more downside for stocks.
- Recession: While recession risk increased throughout 2022, the U.S. economy has remained relatively strong up to this point. If a recession starts in 2023, stocks could be set for another slide: historic data show that bear markets never bottomed before the beginning of a recession. The magnitude of such a selloff would largely depend on the depth and length of the recession and the speed of the Fed’s counter-response. On average, market returns are negative during the first few months of a recession, but expectations of a future recovery in the economy and corporate earnings usually lead to strong rebounds, with the market typically bottoming on average 4 months ahead of the end of a recession.
- Geopolitics are complicated and often unpredictable. This usually lends itself to downside shocks since few surprise developments are unabashedly positive. In addition to the Russia-Ukraine conflict, escalating tensions between China and Taiwan and saber-rattling between Serbia and Kosovo could also weigh on investor sentiment.
With the economy in uncertain territory and the Fed signaling more interest rate hikes to come, 2023 will most likely continue the be a volatile and challenging year for investors. To better withstand the challenging macroeconomic headwinds that we currently face, we have applied a more defensive, value-oriented tilt to many of our clients’ portfolios. In any case, last year’s downturn has set the stage for a much-improved long-term investing environment for stocks and bonds as these occasional pullbacks have historically been followed by rebounds. As a result, we believe that most investors are best advised to stay the course and remain invested. If you are having difficulties weathering this down market, we encourage you to reach out to your Telos financial advisor who can walk you through a complete portfolio review and help prepare you and your portfolio for the next bull market.
After everything 2022 threw at us, from inflation, rising rates, geopolitics, and unsettled markets, most of us are happy to look forward rather than back. But as Jean Paul Sartre wrote: “Look back, look forth, look close, there may be more prosperous times, more intelligent times, more spiritual times, more magical times, and more happy times, but this one, this small moment in the history of the universe, this is ours.” Life is a succession of moments - make each one count. Let’s not miss that!
As we welcome the arrival of yet another new year, we are hopeful for the opportunities it brings and look forward to sharing it with you. May it be filled with new adventures and good fortunes! Happy New Year! JANUARY 2023