“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.