Jan 09, 2023
In a year that finished none too soon for most investors, stocks and bonds managed to wind up 2022 on a positive quarter. While not much consolation to most investors, the markets absorbed a sea change of disruptive news this year. Many of the speculative excesses that had previously built up have been deflated. There are varying points of view on the near and mid-term path of markets from here, but the consensus seems to believe that the environment will remain difficult for risk assets for most of 2023.
2022 unraveled quickly. The release of Fed minutes in early January revealed that the pace of a planned gradual unwinding of pandemic support was not going to go as planned. What followed instead was a series of discouraging inflation reports and a more aggressive tightening agenda, triggering sharp swings in stock and bond prices. Markets recalibrated new data multiple times over the year and were subject to the drumbeat of Fed messaging that they were determined to stay the course against inflation, even if it resulted in inflicting pain on the economy.
In the commentary below, we look at the ramifications of higher inflation, handicapping the Fed’s current strategy, why bond yields matter, and our thoughts on the investment implications of all this.
Key Investment Issues
The End of An Era
The first decade of the millennium was bookended by the Tech Bubble and the Great Financial Crisis (GFC). From that decade of lost returns and from the GFC aftermath came a new era of ultralow interest rates and benign inflation. The Fed took a more active role in using unconventional monetary policy to manage the economy in a low growth, disinflationary environment. Returns from financial assets prospered and confidence in the sustainability of this model grew with each year. Then came the pandemic.
What followed took these policy tools to unimaginable levels, initially focusing on lifting the economy out from an unprecedented abyss. The magnitude of monetary and congressional stimulus was epic, and the duration of providing this aid extended beyond the crisis. Through a combination of Fed missteps, growing supply chain imbalances, war in Ukraine, and a shrinking workforce, the sleeping giant of inflation awakened.
More will need to be understood about the longer-term impact on inflation from supply chain constraints due to war-related disruptions and realignment of trading partners. Likewise, new on-shoring initiatives to protect supplies, like the domestic expansion of semiconductor manufacturing, will come with a higher cost. We will revisit this topic at a later date.
The developments of the past year would suggest that a new era has begun – one with higher inflation, shrinking liquidity, less Fed support, deglobalization, more reasonable valuations, increased geopolitical risk, and reduced speculation. These changes don’t spell doom for stock and bond returns, but they present a more challenging backdrop to the ideal conditions that prevailed in the past cycle. Some seasoned investors will see this as a return to normal. For others, this will require an appreciation for the impact higher inflation has on overseeing the economy, running a business, and thinking about investments.
Inflation will consume Fed policy decisions and success in containing inflation will risk raising unemployment beyond targeted levels. Higher inflation increases business financing costs, wage costs, and the cost of manufactured goods, putting pressure on margins and shareholder returns. Investors will have a higher bar for generating returns to exceed the loss of purchasing power. Most troublesome is when inflation expectations get built into consumer behavior, which perpetuates upward pressure on prices.
Why the Fed Is Set Up to Make A Policy Error
All things equal, there is nothing appealing to the Fed about causing a recession or driving up unemployment. But they will choose to do both to avoid the possibility that inflation could reemerge later in the cycle. The Fed has signaled their intention to take overnight rates to the 5.0% – 5.25% level and hold these levels through much of 2023. The bond market is pricing in a peak just below 5% and a pivot in policy before year-end. The market is making a bet that the Fed will back down from their guidance once they see signs that a recession is imminent and the labor market is starting to loosen.
The Fed is well aware of the inherent lags that higher rates have on demand and employment, and they know there is risk in pushing too far before signs of a slowdown become apparent. They also believe that letting up too early is the worst possible outcome, as what occurred in the 70’s. This decision is complicated by post-pandemic structural issues around labor shortages. This makes it more difficult to get a true read on wage pressures and unemployment. The perceived stability of a tight labor market may give the Fed a false sense of comfort in determining when to ease off. They made the same mistake in staying accommodative for too long in 2021, thinking they had the cover of low inflation.
There is a chance they get it right. Inflation in goods and commodities have declined significantly month over month and the slowdown in housing will soon show up in monthly CPI rental data. After two more projected smaller rate hikes, the duration of the final tightening phase of holding at these higher rate levels will likely sow Powell’s legacy. Most agree that he won’t have the luxury to hold off easing until inflation returns to the 2% level. For now, however, tough rhetoric serves their purpose of moderating inflation expectations.
The Relevance of Bond Yields to Equity Investors
More often than not, weakness in stocks this past year followed the upward movement in bond yields. Both assets classes were negatively impacted by accelerating inflation and the Fed’s aggressive rate hikes. While bonds typically cushion the risk of losses in stocks, this dual bear market was a likely outcome given the circumstances of low interest rates and inflation exceeding expectations. With bond yields now resetting at higher levels, fixed income should again provide a useful offset to stock volatility.
Higher bond yields, not declining earnings, were a primary cause of the decline in stocks as they directly impact how investors assess the value of a company. Corporate earnings on the S&P 500 for 2022 actually came in right on target per estimates of a year ago. And most companies ended the year with record profits and revenues, not something that would ordinarily result in an almost 20% market decline.
Instead, higher bond yields reduce the value of future earnings on stocks because there is now a safer alternative to earn a respectable return. The farther out those earnings are projected, the less they are worth in today’s dollars. The most vulnerable companies in this valuation reset were growth companies in general and tech companies specifically, especially those expected to earn outsized profits in the distant future.
For much of the year, an increase in bond yields translated directly to underperformance of growth stocks, though not all rate hikes led to higher bond yields. Toward the end of a tightening process, bond investors start to price in an expected slowdown as higher rates take a bite out of economic activity. That is why longer maturity bond yields will begin to come down while shorter maturity yields still track ongoing rate hikes. This has resulted in today’s inverted yield curve – where yields on shorter-term bonds exceed longer-term yields, often a precursor to a recession.
While growth stocks become less vulnerable to higher bond yields at this stage, their underperformance in the fourth quarter suggests they were still priced too richly and that their earnings assumptions too optimistic heading into a possible recession. To earn the premium valuation that growth stocks typically support, they need to get back to providing superior earnings and revenue growth. In the meantime, stocks that provide attractive dividends will remain alluring to investors because of the cash return in current, not future, dollars.
Outlook and Investment Implications
The consensus outlook expects 2-3 more rate hikes, waning inflationary pressures, the Fed pulling back on rates by year-end, 4.1% year-over-year earnings growth, and a mild recession. The consumer side is expected to weaken, but hold up better than usual in a recession. Corporations will be expected to play it safe and guide down earnings projections, giving them an easier target to beat by year-end. The base case narrative expects more downside risk in the first half of the year and a stronger second half as a recovery in 2024 begins to be priced in.
Our macro work shows a potentially weaker consumer if disposable income growth continues to lag inflation. We also see longer-term weakness in the labor markets, service economy inflation not yet peaking, and an additional 12% – 14% downside in stock prices. This comes from earnings revisions and P/E multiple contraction to 15X forward earnings, still well above previous recessionary valuations. This narrative would allow for a more consequential recession which would push back the recovery scenario into 2024.
We respect these macro projections as they evaluate existing data in an historical context, but as bottom up stock pickers, we don’t hang our hat on being able to foretell the future. Projections of these kind are highly dependent on the flow of new information as well as unanticipated developments. Still, they are helpful in providing a potential backdrop to assess the attractiveness of new investment opportunities and to affirm the structure and diversification of current holdings.
Our inclination is to lean cautiously in our security selection and style mix on the equity side and lock in current interest rates for longer on the fixed income side. Outright bearishness is tempered by the negative developments already known to the markets and the belief that forward-looking markets will sense a recovery before it is visible to most. Just looking at where consensus was a year ago should be enough to be mindful of the perils of overconfidence.
Before we conclude, we should make some reference to cryptocurrencies and the FTX debacle. Two issues are worth commenting on here. First, the ascension and popularity of cryptocurrencies and digital tokens was largely enabled by the speculative fervor of the times. This doesn’t preclude a useful role for either bitcoin or tokens, but the valuations these digital currencies attained were always hard to justify and remain difficult to determine.
Second, the fall of FTX, a major crypto exchange, was also a product of this same environment, but the underlying cause appears to be plain, old-fashioned fraud. Fear of missing out (FOMO) is more likely to occur when access to capital is easy, but something like this can happen anytime. What’s notable about this collapse is that it was not a contagion that spread to broader markets and unrelated parties. This was primarily because crypto has been more of a closed system and for a change, there was no significant exposure to the traditional banking system. In this case, the losses were shared among the digital currency faithful.