As this is our last written communication for the year, we wish first to express our sincere gratitude for each and every PIM client. We are honored to be entrusted with the responsibility of managing your investment and retirement assets and providing planning and general financial counsel across a wide range of important topics. As you know, PIM is a fiduciary investment advisor firm, with an exclusive duty of loyalty to you. We strive to fulfill this duty through diligent service, study, and practice. Our only goal is to help each and every PIM client achieve financial peace of mind.
Maintaining peace of mind this year may not have been as easy as in recent years. Inflation soared, capital markets tanked and international conflict dominated the headlines. During this period, our goal has been to deliver acceptable risk-adjusted return for each PIM client, that outperforms our internal blended benchmark portfolios. What follows is a review of 2022 and our views on 2023.
The Year That Was
This is the time of year when Wall Street strategists begin rolling out their 2023 forecasts. In general, they will be wildly wrong. To prove the point, here is a list of last year’s predictions:
Market Strategists’ Estimates
2022 S&P 500 Target
BANK OF AMERICA MERRILL LYNCH
WELLS FARGO INVESTMENT INSTITUTE
The average year-end 2022 estimate for the S&P 500 was 4984, roughly a 17% gain. The S&P 500 closed November at 4080, or 18% below year-end consensus.
PIM was not immune to the guarded optimism that prevailed in December of 2021. We thought the S&P 500 would finish the year with a small gain.
Most analysts focus primarily on corporate earnings when making their forecasts. Unfortunately, there is a growing mountain of research suggesting that one-year earnings forecasts only explain about 25% of actual stock price changes. The other 75% is explained by things like inflation, interest rates, economic growth, currency values, and geopolitics.
This point was proven in 2022, as earnings didn’t drive the market down as much as everything else did. Inflation was significantly above expectations. Interest rates increased by two times the Fed’s initial annual guidance. The US saw two consecutive quarters of negative GDP growth. The US dollar strengthened by the most in 40 years. And a land war began in Europe. Predicting these variables is challenging. Ignoring them, as is convention for most analysts, is dangerous.
PIM does incorporate these macro variables into our framework. Our most useful capital market forecasting tool focuses on key macro variables to build fair value models for various assets. From the tool, we expected to see falling economic growth, higher interest rates and increased inflationary pressures in 2022. We expected the direction, but not the magnitude of change that developed over the course of the year. This allowed us to allocate portfolios to areas that would perform better than the benchmarks.
The Year Ahead
Rather than publish an S&P 500 return forecast, which is about as useful as guessing the number of jelly beans in a jar, we will discuss the key factors that we think will drive returns in the coming year.
Interest rates were the most important driver of financial markets in 2022. We do not expect short-term interest rates to increase significantly above 5.25% (currently between 3.75-4%). We’re finally seeing the transitory piece of the inflation puzzle (core goods) fall in price due to cooling consumer demand, high inventories and improved global logistics. The impact of the rapid interest rate increases experienced this year should be acutely felt in the economy in 2023. It’s not unreasonable to forecast that short-term interest rates may be above the core inflation rate by the second half of 2023. Historically, inflationary periods begin to end when interest rates are above the rate of inflation. The figure below shows core inflation (red) and the Fed’s short-term interest rate (blue). The Fed will be pleased when the blue line is above the red line, which we anticipate will happen at 5.25% in the second half of 2023.
Unemployment will rise, but the process will be uneven. The beginning of this trend is already evident in the technology sector. However, workers remain in demand as wage growth is above 6% and job openings are still far above pre-pandemic averages. The labor market needs to soften considerably before the Fed begins to think about cutting interest rates to stimulate the economy. The labor market is currently weaker than earlier in the year, but still healthy overall. The jobs report for November showed 260k new jobs, beating expectations of 200k.
The figure presented below shows the four week moving average of initial jobless claims (green) and the unemployement rate (red). Jobless claims data is released on a weekly basis, making it more timely than the monthly unemployement numbers and a good indicator of the direction of unemployment rates. Using the four week average helps smooth out some of the weekly noise. Unemployment above 4% for three months would trigger the “Sahm rule” and indicate recession. We appear to be under no imminent threat of this particular trigger.
Growth Matters More than Inflation in 2023
Inflation, and the change in interest rates needed to bring inflation under control, was the main story of 2022. In 2023, we will see a greater focus on growth measures, which are disappointingly weak.
The Conference Board of Leading Economic Indicators (LEI) consists of ten components and is highly correlated with GDP growth, typically leading the real economy by seven months. Current data suggests a recession beginning shortly.
Further evidence of an economic slowdown comes from the yield curve. Here we show the difference in yield between the two-year Treasury and the ten-year Treasury. In normal times, one should expect a higher yield from longer-term Treasuries than from their shorter-term counterparts. The two-year Treasury is often thought of as a leading indicator of where the Fed will take short-term interest rates. The ten-year Treasury is thought of as the market’s view of economic health; higher rates portend higher economic growth.
When the difference in yield between the ten- and two-year Treasury becomes negative, the market is suggesting that the Fed is pushing too hard on short-term rates to cool the economy and the result will be a recession. At a high level, most economic activity is based on the idea of borrowing at short-term rates and investing for the long-term. When long-term return expectations are below the cost of borrowing short-term, firms do not expect new investments to be profitable, so they don’t invest in their own growth. In a nutshell, this is why an inverted yield curve matters to the market.
At -0.71%, the difference between the two- and ten-year Treasury is as negative as it has been since 1981. The lag between a deeply inverted yield curve and an actual recession varies by up to a year and a half. Also, the impact of inflation on bond yields makes this signal less useful than in “normal” times. There are enough caveats in our current situation to suggest that a deeply inverted yield curve is a bad sign, but actual interest rate cuts from the Fed will be a better indicator of an impending recession. Signs of this occuring will come from a fall in the two-year Treasury yield, which still appears a few quarters away.
In 2022, China experienced the weakest level of economic growth since the Great Financial Crisis. The Chinese economy is the second largest on the planet, and their zero-COVID policies and slowing economy have put welcomed downward pressure on commodity prices such as oil and industrial metals. This has served to ease inflationary pressures globally.
We are skeptical of any Western forecast of the Chinese economy. Analysts’ opinions today range from continued lockdowns to stimulus-fueled economic re-opening in 2023. There are reports now of political unrest in China, as well as all-time high COVID case counts with a renewed emphasis on state-run vaccination programs. The Chinese Communist Party is at a crossroads. Either a crackdown on dissent or a painful re-opening may be in the future. In other words, China could act either as a much-needed driver or painful anchor to global growth in 2023.
The data we have today strongly suggests cooling inflation and slowing economic growth.
In our view, the appropriate investment strategy for these conditions is an emphasis on the most unloved asset class of 2022, fixed income. Apart from economically sensitive high-yield bonds, the fixed income market looks attractive across the board, offering yields and total return profiles that rival anything seen in the past decade. Traditionally, bonds are the least exciting portion of a diversified investment portfolio. For next year, they may be the best option for a challenging economic environment and actually generate positive total return.
Equities, even after this year’s decline, still appear expensive relative to the earnings outlook. One of the most interesting dynamics of the equity markets in 2022 was the performance of “old economy” firms. The energy, industrial equipment, and materials sectors all performed well this year. New economy technology firms, even the best (Microsoft, Apple, Amazon) underperformed the overall market for the first time in many years. The bleeding edge of the new economy narrative (cryptocurrencies, biotech, innovation) have been destroyed in 2022 and are down 60-80%. This type of performance shift from one area of the economy to another is natural in capital markets and has been a long time coming. We expect this trend away from technology and towards more value-oriented sectors to continue.
While the data and consensus opinion point to recession, it’s important to stress that the future is not yet written. We were fortunate enough to hear the legendary Bob Farrell speak this year. Bob was the Chief Strategist at Merrill Lynch for 45 years. At 88, his intellect remains sharp and impressive. One of Bob’s rules of Wall Street is “When all the experts and forecasts agree, something else is going to happen”. Despite the downbeat consensus for recession, realize no one has a crystal ball and there remains a path for a soft landing in the economy. Unfortunately, the data does not indicate high odds of such an outcome, which is why we will remain conservatively positioned.
As we fast approach the holidays, it is time to pause and consider the many ways in which we are truly blessed. So again, please accept our sincere appreciation for the opportunity to serve you and for the trust you place in us.
From our families to yours, very best wishes for a happy and peaceful holiday season.