ECONOMIC AND MARKET REVIEW AND OUTLOOK, April 2023
“When my information changes, I alter my conclusions. What do you do, sir?” — John Maynard Keynes, British Economist (1883-1946)
First Quarter Recap
Financial markets rose in the first three months of 2023 with equities and fixed income improving despite a volatile environment. Most global indices joined the rally although commodities were mixed. Copper rose higher while oil fell for the period. Similarly, gold rose while the U.S. dollar drifted lowe
The first quarter was confronted with shifting narratives.
Early January featured a continuation of a soft economy consensus from the old year, with reports showing general weakness. Bond and stock prices rallied, hoping for an imminent Fed pivot where rate hikes would soon end, and the US central bank would begin cutting interest rates.
By February, stronger employment and inflation reports changed that narrative to a “no landing” or reheating story, which lasted for another month.
In March, fears of a banking crisis were sparked by the sudden failures of SVB Financial (the parent of Silicon Valley Bank) and the closure of Signature Bank. The FDIC had to quell the predicament by promising to insure all depositors of the failed institutions with accounts over the $250,000 limit.
In Europe, long-ailing Credit Suisse was taken over by UBS in a merger engineered by the SNB, the Swiss central bank.
Implications of the Regional Banking Crisis
Fortunately, the systemically important money center banks were not involved in this event compared to the Great Financial Crisis of 2008.
However, regional banks do account for 30% of all loans in the US, with their presence in mortgage lending and commercial real estate even larger. By quarter’s end, it is likely that regional banks will begin restricting credit by tightening lending standards for borrowers. It is still too early to quantify the impact of reduced lending to the economy, though most estimate the hit to be around 0.5-1.0% of real GDP (Gross Domestic Product).
The Effect on Fed Policy
The economy is still growing at a moderate rate but slowing pace. Inflation continues to normalize although service inflation, as well as housing costs and wages, remains sticky. Recently, the Fed has shown a slow tightening bias, citing an ongoing shortage of workers. The effects of regional banking problems may also lead the Federal Open Market Committee (FOMC) to pause or even halt the interest rate hiking process.
At this point, it is our belief that a pivot — or the beginning of a rate lowering cycle — is possible sometime in 2024 and not this year. Having lost a lot of public credibility by staying with the theme of “transitory” inflation in 2021, Fed Chair Jerome Powell is determined to bring down inflation much closer to 2%. Perhaps haunting him is the memory of the late 1970s, when then Fed Chair Paul Volcker stopped restrictive monetary policy too soon and had to raise rates sharply after just a few months, causing a deep recession.
Differing Messages from the Stock and Bond Markets
Fixed income markets have displayed unusual volatility this year. Overall, yields have moved lower, with the curve (difference between short and longer maturities) deeply inverted, with three-month and two-year Treasury yields considerably higher than the ten-year yields. This normally indicates a recession or at least a significant slowdown in the economy to a stall-speed pace. Another predictor of future economic growth, the index of Leading Economic Indicators (LEI) has been in negative territory for some time.
On the other hand, equities have rallied on the prospect of an imminent Fed pivot but seem to ignore the main reason for a pivot – significant economic weakness. A steep falloff in GDP growth would also impact corporate earnings, causing stock prices to swoon. The only way to avoid this is a soft-landing scenario. Although possible, we view it as an outside chance at best.
Investment Implications Going Forward
In our view, the Fed is close to ending its interest rate increases. If that occurs, stock market leadership will migrate back to growth after favoring value strategies over the last 18 months. As a result:
We have started to add to higher growth equities, especially those that are not too dependent on the economic cycle
Our bond market strategy will gradually rotate to longer fixed income bonds from short-term maturities
We have added to international equities, focusing on emerging markets which feature positive demographics due to our belief that the US dollar has peaked, at least for the for next year or two
Numerous cross currents due to the pandemic and its aftermath still reverberate throughout the economy manifesting a great deal of the market uncertainty and volatility being experienced. We think that a well-diversified portfolio featuring quality and liquidity will offer the best opportunity to build and preserve wealth over time, especially when the situation improves.
“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 theequity 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.
“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:
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.