By: Jeff Bullock
As we turn the page to 2023 and away from one of the worst years in both equity and credit markets in decades, we examine what happened, the policymaker response, and what that means for 2023 and beyond.
What Happened & The Response
After nearly a decade of money printing and central bank balance sheet expansion, inflation finally reared its ugly head. The decision to shut down the economy in 2020 due to Covid-19 led to the passing of unprecedented rescue packages by lawmakers, as well as direct central bank intervention in markets which had never happened before at this level. With a zero-interest rate policy (i.e., free money), a buyer of last resort (i.e., the Fed), and forgivable loans available to many businesses (i.e., PPP loans, etc), global markets and the economy seemingly went into extreme expansion mode. This all lasted for about 18 months before the inflation boogeyman came to life.
The Fed made many missteps along the way. First, they were very late to the game – one example is that they were still fueling inflation by directly buying bonds in the market as late as March 2022, when inflation was already at 8.5%. They then pivoted from a multi-decade policy of “easy money”, to extreme hawkishness, in a matter of days.
Jay Powell, the Fed Chair, went from saying, “We’re not even thinking about thinking about raising rates,” to one of the most aggressive rate-raising endeavors in decades. A pivot like this is nothing short of a massive misstep in their policy. As reported inflation hit 9.1% in June, the restrictive nature of their policy increased. The latter part of the year consisted of 0.75% rate rises every month to try and slow the economy down. The current Fed Rate went from 0.25% to 4.75% by year-end. Truly unprecedented.
Make no mistake, the Fed is trying to cause a recession. That’s the only true way to slow down inflation. All the discussion about a “soft landing” is simply a different way of saying they are trying to slow the economy down without causing a recession, or perhaps only causing a mild recession. If they overshoot and cause a “hard landing”, then we can expect more than a mild recession.
Why did the stock market have so much volatility in 2022? Very simply, it’s trying to figure out if the economy will have a hard or soft landing. The big daily, weekly, and monthly moves were all driven by news that either made investors react in extreme ways.
2023 Outlook
Despite the bad year in the stock market, most companies actually grew in 2022. Yes, you heard me correctly. Bottom-line earnings for the stock market increased in 2022 compared to 2021. Then why did the market fall nearly 20%?
Valuations/Multiples. The price of any company, or the stock market as a whole, is a function of two inputs: (1) Earnings and (2) the Multiple that investors are willing to pay for those earnings.
In 2022, despite companies delivering strong earnings, valuations dropped due to all of the uncertainties surrounding the economy. In other words, investors were not willing to pay as high of a multiple for their equity exposure in 2022 that they were willing to do in years past.
If 2022 was the year of the multiple revaluation, then 2023 will be the year of earnings.
It’s important to remember that nearly three-quarters of GDP is Consumer Consumption; i.e., you and me spending money. This drives company growth. If consumers (you and me) keep spending at the rate we have, despite the added price inflation, then company earnings will continue to stay strong. However, if consumers decide to cut back, delay a vacation, or substitute higher quality goods with lower ones, then we probably see a slowdown in the economy.
The market is currently in a “wait and see” mode. It’s not pricing in a deep or even mild recession, but at the same time, it’s not pricing in a strong economic outlook. Will inflation continue to come down? Will 4th Quarter earnings beat expectations? Will the Fed be able to hit the breaks on raising interest rates?
These are all the questions that will drive the earnings narrative for 2023.
Portfolio Positioning
With all of that said, how do we position portfolios in an environment like this for those who have exposure?
- On the equity side, we continue to tilt toward the value style of equities with an emphasis on strong dividend-paying companies. We have been positioned this way since early 2022, which has been good, and continue to like this area to start the year.
- On the fixed income side, we continue to focus on short-to-mid duration and high quality credit. We have been positioned on the short-end of the duration spectrum for over a year now, which has been a good place to be. We continue to favor short-duration over long.
- On the alternative side, we continue to like 1st lien private credit where it makes sense in a portfolio.
Summary
We expect the first part of 2023 to continue to be choppy in equity markets with elevated volatility still playing a role in portfolios. As inflation, unemployment, and earnings data role in, markets will adjust and re-price expectations.
- Bull Case: The bull case is a “soft landing” from the Fed and lower inflation. This will allow interest rates to stabilize, modest growth, and even the small potential for multiple expansion.
- Bear Case: The bear case is a “hard landing” from the Fed and sticky inflation. This will cause interest rates to stay elevated which will mute growth and potentially cause multiples to fall even more.
- Base Case: Somewhere in-between the “soft” and “hard” landing. Unemployment will then take center stage as the economy will look toward a recovery in 2024.
Without using too many superlatives, 2022 was truly an unprecedented year in markets. We are confident in our approach and watch market each day looking for opportunities.
As always, feel free to give us a call to discuss.
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