Highlights:
· Security markets have historically performed well over the long-term despite numerous obstacles. We believe it is very likely that investors will look back on today’s challenges in the same vein.
· Both equity and fixed income markets had one of their worst years on record as most developed market central banks embarked on aggressive interest rate increase campaigns in an attempt to tame surging inflation.
· Our investment policy concedes we do not know what the future holds and how future economic and geopolitical events will affect security markets in the short term.
Commentary:
“All good investing comes down to surviving an inevitable chain of short-term setbacks and disappointments in order to enjoy long-term progress and compounding. A big takeaway from economic history is that the past wasn’t as good as you remember, the present isn’t as bad as you think, and the future will be better than you anticipate.”
-Morgan Housel, The Psychology of Money
If you read these commentaries regularly, you should know two things by now. First, we favor quoting investors that we respect and whose investment philosophies are generally aligned with our own with a particular fondness for Warren Buffett, John Bogle, Howard Marks, and Morgan Housel. Second, like these individuals, we are long-term investors that believe time, not market timing, is critical to investment success.
The quote above struck a particular chord because it never ceases to amaze us how people have a tendency to reminisce about the “good old days” and to extrapolate current data to forecast a dire future. Since 1926, we have lived through the Great Depression, World War II, the Korean War, the civil rights movement, the Vietnam War, an oil crisis, the Cold War, the Gulf War, the AIDS pandemic, the Dot-com bubble burst, 9-11, the Great Recession, the Covid-19 pandemic, 16 recessions, and countless other instances of geopolitical turmoil. Yet despite these persistent headwinds, the S&P 500 has had an average yearly return of over 10% during this time.
The difference between all of these historical events and the situation today – war in Ukraine, inflation, risk of a pending global recession – is that the outcome of today’s issues are unknown. It seems to be human nature to fear the worst in the face of an uncertain outcome. This is understandable, and certainly so when it applies to one’s own money. A key to successful investing is having the ability to block out the short-term noise and stay focused on the long-term growth propensity of economies and companies.
Current inflation levels and the ongoing war in Ukraine are justifiable concerns and likely to continue to drive stock market volatility in the near term, but what is going to happen with the global economy in 2023 is highly uncertain. For every “expert” that predicts a recession, we can find an equally smart and qualified “expert” who predicts a soft landing or even growth. In fact, the only thing we know is that stocks have been the best asset class in terms of outperforming inflation over the last 100 years, but only over long time horizons. Case in point – over the last seventy years, stocks have outperformed inflation 100% of the time over all twenty-year periods.
With this long-term perspective in mind, let us now discuss how things unwound in the final quarter of 2022. A turnaround that began in October was short-lived, as all major asset classes ended the year with double-digit losses. The S&P 500’s return of -18.1% was one of the worst annual returns ever, trailing only events such as the Great Depression, Great Financial Crisis, and Dot-com Crash. Making matters worse was that the bond market had its worst year ever due to the Fed’s pace of rate hikes that has been the most rapid in modern times. Outside of cash and energy stocks, pretty much all investments had a tough year in 2022. Even though the calendar now reads 2023, there is no guarantee that investor sentiment will automatically improve. We remain with our cautiously optimistic stance for the long-term, but acknowledge that things can always get worse before they get better in the short-term.
Fed guidance on the direction of interest rates will likely continue to be the primary driver of uncertainty and equity market volatility in the near term. Take for example the U.S. Federal Reserve’s (“Fed”) most recent interest rate hike of 0.5% in December, which was the seventh of 2022 and marked a step down from four consecutive 0.75% increases. This seemed to imply that the Fed was starting to see signs that inflation was slowing down. However, Fed officials were not impressed by falling prices of energy, automobiles, and houses, and made it clear they remained laser-focused on the labor market. “The labor market continues to be out of balance, with demand substantially exceeding the supply of available workers,” were Fed Chair Jerome Powell’s exact words. With this in mind, the Fed signaled plans to raise rates higher than previously expected to between 5% and 5.5% in 2023 in their attempt to return inflation to its 2% target, which led to a late year sell-off in the equity markets.
Fed officials do expect the economy to slow down next year, estimating unemployment to rise to 4.7%, compared to the current 3.5% rate. This would be welcome after a year in which U.S. employers added 4.5 million jobs, the second best year for job creation on record going back to 1940. The only year for job growth that was better than 2022 was 2021, when the labor market added 6.7 million jobs following the Covid-19 pandemic shutdown. The job market continues to be the strongest aspect of the economy right now, with the housing market stalling, consumer spending slowing down, and exports tested by a strong dollar and weak growth abroad.
A recent wave of layoffs in the tech and finance industries suggest the labor market may be starting to lose momentum. Increased unemployment would be a first step in cooling the economy. There is a direct connection between unemployment and wage growth because when companies are hiring they have to pay more to compete for workers. Fed Chair Powell has made it clear that limiting wage increases is a key factor in bringing inflation under control. Powell noted at the December Federal Open Market Committee (FOMC) meeting that pay is rising at a rate “well above what would be consistent with 2% inflation.” The December jobs report showed wage growth moderated, continuing a pattern seen in recent months. This would appear to be a sign that employers have started to become more successful in restraining wage growth, but the Fed will likely need to see more concrete and longer-lasting evidence before they provide explicit guidance that they are prepared to ease further interest-rate increases.
More specifically, Fed officials are attempting to determine whether recent wage increases represent a readjustment in the labor market or are a sign of a troubling long-term trend that could feed inflation far into the future. The answer to that question might not be known for some time, with the Fed acknowledging at its November FOMC meeting that there is a lag between the action of raising interest rates and how quickly those higher rates impact the economy. In the interim, Powell believes if the Fed overtightens, they can always reverse quickly, but they cannot quickly reverse entrenched inflation expectations if they do too little. While recent interest rate increases are extraordinary relative to the past decade, they are not when measured against the past 40 years. The U.S. 10-year yield, along with most other major government debt securities, has been in a gradual decline since its peak in 1984 at 13.8%, reaching as low as 50 basis points at the outset of the Covid-19 pandemic.
While U.S. inflation is being driven by excess demand, Europe has a supply-driven inflation problem. Specifically, household energy prices in Europe skyrocketed in the final quarter of 2022 largely as they began to heat their homes as the weather turned colder in the face of a war in which Russia has determined to weaponize its vast stores of energy in an attempt to undermine European support for Ukraine. Russia was the biggest energy supplier to the European Union before their invasion of Ukraine. In response to rising energy prices, European consumers started to cut back spending on other goods. In fact, household demand for goods appears to be weakening across the globe. In response, factories are cutting production, which has taken pressure off supply chains and led to a slowdown in price increases.
The U.K. had to deal with a political firestorm during the quarter in addition to a sharp rise in energy prices and a general surge in inflation. U.K. Prime Minister Liz Truss became the shortest-serving prime minister in the country’s history after she resigned after just 45 days in office. Truss’s resignation was triggered by losing the support of her Conservative Party. Truss’s economic agenda called for cutting taxes across the board, particularly benefiting Britain’s highest income tax payer, and she resisted calls for new revenue or spending reductions to make up for the cost of the tax cuts. This is a common Conservative Party economic agenda, but inflation flips the traditional political playbook on the economy, from fueling growth to slowing it.
New U.K. Prime Minister Rishi Sunak has vowed not to cut taxes and to work with the Bank of England in their fight against inflation. Shortly after Sunak took office, the U.K. announced around $66 billion in spending cuts and tax increases over the next five years in an attempt to lower the size of government debt relative to the economy. “We cannot have long-term, sustainable growth with high inflation,” said Jeremy Hunt, the U.K.’s Treasury chief. “It is our duty to help the Bank of England in their mission to return inflation to target.”
To this point, Japan has generally avoided the inflation issues that are plaguing most of the rest of the developed world, but that may be ending. Japan’s core inflation rose at the fastest pace in nearly 40 years in November, fueling speculation that the Bank of Japan would tighten monetary policy in 2023. In Japan’s case though, this is not necessarily a bad thing after multiple decades of a deflationary mind-set that made its citizens hesitant to spend when prices rise, which consequently made it difficult for companies to raise prices. Whereas U.S. central bank officials are looking for signs of slowing wage growth before they stop raising interest rates, the Bank of Japan will likely be looking to confirm that wages are rising solidly, and that the U.S. is able to avoid a deep recession, before embarking on a rate rising campaign.
So far, inflation in emerging economies remains relatively stable despite the U.S. dollar’s rally. However, China has been on the short end of slowing global demand in response to central banks’ aggressive moves to tame inflation. The sharp pullback in demand for its goods abroad could not come at a much worse time as it removes a key growth prop at a time when its economy is already under pressure from the government’s aggressive approach to Covid-19 and a severe real estate slump.
China’s government did back off its zero-tolerance approach to Covid-19 during the quarter by relaxing mobility restrictions. Likewise, the People’s Bank of China and banking regulator recently issued a wide-ranging series of measures aimed at supporting the troubled property market, signaling a shift in tone from crackdown to support. In response to these decisive moves to support its battered economy and shift back to growth mode, investors seem to have become more bullish on Chinese equities recently, after a two year period of underperformance. A rebound in China would bode well for other emerging markets who rely on the country for a large percentage of their exports.
In conclusion, 2022 was a challenging year and we simply do not know if 2023 may present similar or new challenges. Although these challenges can appear insurmountable at times, governments, central banks and consumers have proven adept at reacting and responding to these challenges over time. It is always a messy, imperfect process due to the scale of these problems and the institutions dealing with them, but the intended result of actions is always improvement. This is cause for at least some semblance of optimism moving forward. As we are apt to do, we will end with a quote, this one from Howard Marks of Oaktree:
Investing in the current environment requires a lot of humility and an acceptance of the fact that we know very little of what the future holds. I’d want the person who manages my money to have some discomfort with his or her economic crystal ball and to construct my portfolio for the “I don’t know” world.
“It’s unwise to be too sure of one’s own wisdom,” Gandhi said. “It is healthy to be reminded that the strongest might weaken and the wisest might err.” Einstein took the idea a step further: “A true genius admits that he/she knows nothing.” Smarter and humbler people than me were willing to say, “I don’t know,” and it is ok for us mortals to say it too.
The investment policy we espouse concedes that we cannot time markets or interest rates. We are not geniuses, but firmly believe we do not need to be, as the odds of consistently predicting economic and geopolitical events, and the impact those events will have on the security markets, are not very good. Over time, we expect fixed income returns to maintain purchasing power and the model growth component to deliver substantial gains, albeit with highly irregular timing. It is our mandate to assemble portfolios that will perform well over the long run and adherence to our policy will likely achieve that result.
Urban Financial Advisory Corporation – January 2023