ECONOMIC AND MARKET REVIEW JANUARY 2023

“Without your health, your money is worthless.” – Suze Orman

Fourth Quarter Summary

Global financial markets generally rose in the fourth quarter, but still ended 2022 with steep losses.

Equities rose nicely in October and November, buoyed by better-than-feared earnings reports and persistent hopes for a Federal Reserve pivot in 2023. December marked a return to a sobering reality, as Fed efforts to dramatically slow inflation weighed on the markets. The fourth quarter also saw the rise of fixed income with 10-year Treasury yields first falling then rallying as the holidays approached. The U.S. dollar staged a reversal, giving up half its gains for the entire year. This benefited commodities such as oil and copper. Gold joined the group but ended flat for the year.

A Gradual Shift of Investor Focus

As 2022 progressed, investors turned from inflation concerns to speculating about the Fed Funds terminal rate. Keeping in mind the rapid pace of tightening from 0.25% of last March to the present target of 4.50%, it is generally believed that rates will reach 5.00-5.50% by May of this year.

After that, there is a disconnect between Fed guidance and market expectations regarding how long higher rates will prevail. Fed officials indicate keeping rates at higher levels through the rest of 2023, while bond futures indicate a Fed pivot to lower rates as early as summer. This has resulted in a tug of war between equity and fixed income markets, with a trading range prevailing in both

The Fed’s Dilemma

Fed members, including Chairman Jerome Powell, believe the labor market is still too hot. They insist it must loosen considerably (that is, unemployment must go up) to contain wage inflation and avoid a wage-price spiral developing, similar to the 1970s. The inflation problem is compounded by a permanent reduction in the labor force due in large part to the pandemic, requiring the Fed to hold rates higher for longer. Currently, job openings stand at 1.7 times the number of available workers, down from twice that in early 2022. However, numbers are still substantially above full employment levels which prevailed before the pandemic.

The Economic Outlook

The economy has been growing at a good pace, though pockets of weakness have developed, especially in manufacturing and housing. Consumers are still spending, thanks to a residual cash balance of about $1.2 trillion from pandemic stimulus checks. However, spending continues to favor such services as restaurants and travel (including airlines and lodging), which benefited from the pandemic. Going forward, hefty cost of living increases for Social Security recipients, as well as pay increases for federal, state, and local employees will provide more funds for consumer spending. This should help support the economy until at least mid-year.

Sometime in the second half of 2023, the economy could slow considerably due to cumulative effects of rapid Fed tightening and consumers depleting pandemic stimulus checks. With demand slowing, unemployment will begin to pick up and a recession, or at least a “stall speed” economy with little to no growth, will become a real possibility. Events abroad, such as the war in Ukraine and China’s uncertain emergence from Covid, remain risks to the global outlook for economic growth.

Investment Strategy for 2023

Recall that throughout 2022 we reduced the equity weightings for portfolios and increased fixed income allocations. At first, we added to short-term instruments such as money market funds, which were one of the few investments that did not lose principal value in a down market. As yields on longer dated Treasuries such as the 10-year note rose over 3.50%, we began to slowly reallocate a portion of the short-term fixed income into longer maturity bond investments. As the economy weakens and longer yields peak, we will continue to reallocate towards longer-term fixed income from money market funds.

We also rotated many of the equity holdings into lower valuation and defensive stocks, which should do better in a slow growth or recessionary environment. Further large reductions in US equity weightings are not likely, since at current levels, the upside to downside potential return is much better than it has been since the pandemic. At some point, we may add to international holdings, as some countries are very attractively valued while possessing above average growth potential for the next several years.

2023 will feature numerous cross currents still due to the pandemic. This includes the uneven progress of supply chain issues, effects from a structurally smaller labor force and changing consumer spending patterns. Other factors such as Fed tightening and its effects on the economy will also play a leading role. We advise our clients to be patient and not overreact to individual events, as such actions could detract meaningfully from investment returns.

ECONOMIC AND MARKET REVIEW OCTOBER 2022

“The dollar is our currency, but it’s your problem.”  —  John Connally, U.S. Treasury Secretary, 1971-1972

Third Quarter Recap

Financial markets fell broadly after a roller-coaster summer. Equities rose sharply for the first several weeks of the quarter, but swooned in the last half of the period. Fixed income did the same, as did oil, copper and other commodities. Even gold and other safe havens fell. The U.S. dollar was an exception, marching upward against all other major currencies with rising U.S. interest rates proving attractive to foreign investors.

After a dismal six months, oversold conditions and better-than-feared second quarter earnings led to a sharp 14% rally in the S&P through mid-August. Indeed, many market strategists and technical analysts surmised that the bear market was over and that an entirely new bull market had begun.

A Fed Plateau, Not a Pivot

The major rationale for market bulls at the beginning of the quarter was that the rate of inflation had peaked and the Fed would soon taper increases in the Federal Funds rate, perhaps even lowering rates early next year. Unfortunately, inflation reports continued to run hot with some Fed officials lamenting that the market rally made financial conditions too loose to cool off prices.

In late August, Chair Powell delivered a toughly worded speech at the annual Jackson Hole Symposium stating that lowering inflation was the number one goal. However, it would involve some economic pain, possibly even a recession, though he stopped short of actually predicting one.

Both stock and bond markets sold off sharply following Powell’s remarks and continued to do so after Labor Day, with strong non-farm Payroll and Consumer Price Reports reflecting the persistence of inflation in the economy. This was followed by another 75-basis point (0.75%) increase — the third in a row — at the Federal Open Market Committee (FOMC) meeting in late September. Committee members signaled that the Fed Funds rate could approach 4.50% by early 2023, remaining at that level for most, if not all of next year.

The Problem of “Sticky” Inflation

The rate of inflation remains uncomfortably high, even though gasoline and food prices have dropped somewhat since spring. Housing-related costs, another major inflation factor, have been weakening, although rents will continue to stay up for a while. This is due to rental contracts renewing annually and still reflecting elevated market prices from the previous 12 months.

Wages may be even more intractable, as the job market remains very tight. Salary increases are running over 5% and will continue with close to 10 million jobs still open from the pandemic. Although some companies are anticipating a recession and have announced layoffs, many others recall the difficulty of hiring people over the last two years and are hoarding employees to keep from losing them.

The Strong U.S. Dollar and Its Effects, Both Here and Abroad

A strong dollar may help the economy somewhat by making imports cheaper. At the same time, it makes our exports more expensive, hurting the earnings of U.S. multinational corporations. It also causes problems for other currencies. The quote at the top by John Connally (a former Treasury Secretary and the Texas governor who was seriously wounded during the JFK assassination), sums up a long-held fiscal and monetary truism: the American economy is looked at first, and foreign markets will be taken into consideration only if something goes horribly awry.

The U.K. recently had a brush with adversity when its new government introduced a stimulative fiscal policy that clashed with the tight monetary policy of the Bank of England (BOE). Fortunately, the British government soon reversed its course and dropped its more controversial tax proposals, which helped to stabilize the pound and its bond market. Nevertheless, the U.S. Treasury and the Fed will have to keep an eye on foreign developments.

The Outlook for the Remainder of 2022

As mentioned in previous reports, we have consistently dialed down portfolio risk this year by:

  • Reducing equities
  • Increasing short-term fixed income investments (such as money market funds, whose principal value does not fluctuate while their yields have jumped since spring)
  • Adding to satellite (alternative) strategies

At this point, a recession by late 2023 is a 50-50 probability.

  • Inflation will have to fall significantly than it has so far to cause the Fed to relent from its tight monetary policy.
  • One key to inflation is the job market, which must cool off to cause inflation to follow suit.

 

THE RICE PARTNERSHIP MARKET UPDATE VIDEO AUGUST 2022: BEAR MARKET RALLY


The Rice Partnership’s Chief Investment Officer, Orest Saikevych, discusses whether the recent market rebound is a new bull market or a bear market rally.

ECONOMIC AND MARKET REVIEW JULY 2022

Economic and Market Review and Outlook, July 2022

“It’s absolutely essential to restore price stability. Economies don’t work without price stability.”  —  Jerome Powell

Second Quarter Review

Financial markets fell again in the spring. Posting its worst first half since 1970, the S&P was down 16% while the NASDAQ slumped 22%. Foreign markets fared only slightly better with developed markets dropping 14% and emerging markets declining over 11%. Bond prices also slumped, with the yield on ten-year Treasuries rising from 2.34% to 3.01% (recall it was 1.51% at the start of the year).

Commodities were mixed, as metals rallied early in the quarter only to sell off sharply in June. Oil rose, though its gains were more subdued relative to the spike of the first quarter. Gold came off its winter highs, while the US dollar was the standout, displaying strength throughout the spring. On the other hand, crypto assets crashed with bitcoin declining 59%, almost three-quarters from its highs of last year.

An Economic Cycle and Financial Markets in Fast Motion

From an overheating economy in January, to the beginning of Fed rate hikes in March, followed by concerns of recession in June — the first half of 2022 was a whirlwind of gloomy news unlike any other economic cycle since World War II. Financial markets also reflected this dynamic. At the start of the year, there was a rotation out of highly valued stocks into inflationary beneficiaries, then in the spring, a move into defensive stocks that would perform better in a slowing economy.

The effects of the pandemic have made economic forecasting even more challenging. Although there are job openings, many people haven’t returned to the labor force. Government stimulus checks swelled consumer savings but spending patterns have changed. When Covid first struck, people stayed home for safety reasons and ordered goods online like electronics, furniture and home improvement items. Services such as restaurants, hotels and airlines suffered.

As the population became vaccinated, many began venturing out and traveling, helping services recover, while the demand for goods fell. Retailers and other businesses had a difficult time determining how much to order, especially with the persistent supply chain issues. To make matters worse, the war in Ukraine has added to uncertainty about global energy and food prices. 

The Federal Reserve and the Fight Against Inflation

To fight inflation, the Fed has steadily restricted monetary policy, sharply raising the Federal Funds rate from 0.25% in March to 1.75% currently. The logic is that by increasing rates, the overall demand in the economy will decrease, causing inflation to cool off.  Yet rising prices have persisted, with the latest Consumer Price reports revealing they may still have not yet peaked as many economists earlier predicted.

Chair Powell and other members are increasingly concerned that inflationary expectations may become imbedded, leading to price instability and further compounding problems. However, Fed rate hikes along with “jawboning” or tough policy talk have already had some effect in slowing demand, especially in the housing sector where 30-year fixed mortgage rates have spiked from 3.11% to almost 5.30%.

Soft Landing or Recession?

In a soft-landing scenario, growth moderates but does not contract, while a recession features an economic contraction with a significant rise in unemployment. There is a great debate going on about which outcome will occur.

The yield curve has inverted (displaying a negative slope) among many maturities although the most important one — the 90-day Treasury yield to the 10-year Treasury yield — remains positively sloped. While growth has slowed in manufacturing and retail areas and consumer confidence surveys indicate a more pessimistic outlook, other indicators show a moderate expansion.

As mentioned earlier, consumer spending has come off its highs, although this is largely a shift to service spending. There is still about $2 trillion in consumer savings from Covid stimulus checks sent by the government, which provides a cushion against a weakening economy. In addition, the labor market is holding firm, producing over one million jobs in the last quarter alone.

Looking Ahead

Reflecting the more difficult environment so far this year:

  • We have further trimmed our U.S. core equity tilt over bonds and other asset classes.
  • Since January, we have steadily reduced exposure to stocks where possible, with the stocks currently in portfolios having positive earnings, cash flow and good balance sheets. They will be even stronger once inflation subsides and the economy turns up again.
  • Funds have been primarily reallocated into short-term fixed income investments, although if rates continue to rise, we will be increasing our allocation to longer maturities.