New Year, New Outlook
By Paul Morrone, CFP®, CPA/PFS, MSA
Investors have gladly hit the reset button after last year. What started with a record high on the first trading day of 2022 quickly fizzled out, and what followed was a volatile bear market resulting in nearly a 20% decline in the S&P 500 by year-end. From a historical perspective, this marked the fourth worst year calendar year return for the index since 1950 – a lifetime for most investors today. It was a year marked by many firsts, notably the worst bond market ever (yes, ever) which exasperated the pain as fixed income did not provide the diversification benefit that it traditionally has during periods of equity declines. Even those holding significant amounts of cash saw the purchasing power of their money erode quickly as everything from cars to eggs got more expensive by the day.
There is not much to say that hasn’t already been said with respect to the downward spiral we experienced in 2022. We’ve spoken at length about the confluence of issues that caused this in the past, and at the risk of sounding like a broken record, we’ll keep the recap of 2022 short and sweet. What we do want to highlight, however, is where we are today and how 2023 has flipped the script on much of the uncertainty that plagued investors virtually all last year. That’s not to say we are out of the woods just yet, but markets, and investors, are starting to feel a bit more confidence as the future becomes a little clearer.
All things inflation: Taming inflation is akin to the process of putting out a fire. As any Boy Scout would tell you, it is imperative not just to stop the flames, but to make sure enough water has been poured on the wood to ensure even the embers smoldering at the bottom of the ashes are put out. By taking a pause, or worse, making a cut in rates too soon, the embers of inflation can quickly reignite into a fire, forcing our policymakers to react even more aggressively.
Going into 2022, some would argue the Fed was asleep at the wheel and waited too long to start raising rates as it was clear that inflation was a persistent, not a transitory, problem. But make no mistake; they are now committed to stomping out the inflation problem and plan to do so with their most effective blunt force tool: control over the Federal Funds rate. Led by Chairman Jerome (Jay) Powell, the Federal Open Market Committee (FOMC) fearlessly raised rates and began to strongarm the economy into a slowdown – despite strong criticism from both sides of the political spectrum. These drastic measures resulted an increase in the federal funds rate from virtually 0% at the beginning of 2022 to 4.25-4.5% by the end of the year. To provide some color, in January of 2022, markets were pricing in a year-end federal funds rate 0.5%, a far cry from where we ended up. When expectations deviate materially from reality, chaos can, and will, ensue.
The outcome speaks for itself, with virtually all asset classes (save for commodities) posting negative returns for the year ended 2022. Looking forward, we caution against being too bullish in the short-term. Although the beginning of 2023 is off to a strong start, the fight is far from over. Chairman Powell has repeatedly said that they intend to hold rates at a ‘sufficiently restrictive’ rate as long as necessary to quell the forces of inflation and regain price stability throughout the economy.
The good news is that appears to be working. After peaking 9.1% year-over-year in June, subsequent CPI data has revealed prices are staring to come down. That being said, we are still a long way from the Fed’s long-term target of 2%. It is going to take time for the data to reveal we are confidently heading in the right direction as the impact of a rate increase is not often observed for several months after it occurs. And the risk of a misstep is great. Tighten too much and a recession will be almost inevitable. Cut rates too soon and inflation can come roaring back worse than before. It’s the equivalent of an economic tightrope that is nearly impossible to navigate. For now, we find solace that the investors have trust in the Fed’s ability to control prices and remain cautiously optimistic that there is a light at the end of the tunnel.
China: From COVID-Zero to zero restrictions, the Chinese government did a quick about-face on the controversial policy which has stifled their economy, mobility, consumption and output since the start of the pandemic nearly 3 years ago. With the unexpected reopening announced at the end of 2022, there was a flurry of activity from the Chinese population, similar to what the US and many developed countries experienced in 2021 as pandemic restrictions were eased around world. This is good news not just for the Chinese, but for the world, given China’s dominant position in global commerce.
The ripple effect of China’s reopening has already reverberated through global financial markets and was one of the drivers of the rally in emerging market and developed European equities that started late last year and has persisted through most of January 2023. Barring an unexpected change in policy, the reopening of China should serve as a platform for economic growth in the world’s second largest economy.
The inverted yield curve: Always a hot topic during market volatility, the yield curve is deserving of the attention it commands as an inversion of the closely watch graph that plots various maturities of treasury yields has preceded every recession since the 1960s. That being said, the yield curve has also inverted without being subsequently followed by a recession, so it does have a history of generating false positives as well. The fact that the cure is inverted does not mean we’re guaranteed to head down the recessionary path – although the likelihood is higher than in recent past, largely because of the discretion the Fed needs to exercise to maintain its objectives. Furthermore, in the event we do experience a recession, this does not give us an indication of how severe it will be or how long it will last.
Now that the Fed has slammed the door on easy-money policy in favor of a more hawkish tone, we believe that fundamentals will play a larger role in investors’ decision-making process, especially if the US enters a recession. As earnings season kicks off, we have already seen a renewed focus on core metrics of financial health such as earnings, profitability and the ability to manage expenses in the face of rising input and labor costs, not to mention how companies are positioning themselves in preparation for potentially slower economic growth.
Despite what may sound like bad news, there is a silver lining: reduced asset prices mean that future expected returns are now higher for virtually all risk assets. Additionally, because of the higher interest rate market we’re now in, bonds are starting to generate meaningful income for fixed income investors, and, (gasp!) savers are starting to see interest earned on their savings deposits and CDs at rates that haven’t existed since the early 2000s. As we now have more clarity on some of the big issues impacting valuations, it is also not unreasonable to expect that bonds will have some tailwinds going into 2023, benefiting conservative investors who rely heavily on this asset class as a source of income and returns. Because of this, we have a firm belief that broad diversification across multiple asset classes is poised to provide long-term value to investors.
As long-term investors and planners, we believe in the resilience of markets and understand that economic cycles do not yield linear returns. Disruption and periods of volatility, despite the obvious negative consequences also provide opportunities for those who are disciplined enough to tune out the noise.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
All investing involves risk including the possible loss of principal. No strategy assures success or protects against loss.
The content is developed from sources believed to be providing accurate information.
Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.