A Not-So-Happy Last Year
The just-concluded year was an unproductive one for investors of nearly all persuasions. Both stocks and bonds lost value in 2022, the result of sharp interest rate hikes from the Federal Reserve. The Fed was (and is) responding to a surge of inflation brought on by pandemic-related circumstances—namely, supply chain dislocations, excessive government relief spending, and interest rates that stayed too low, for too long. These factors, taken together, threatened to overheat the economy, and pushed the Fed, along with other central banks, into inflation fighting mode.
Starting in March 2022, the Fed raised rates by 4.25% from a starting point of zero, increasing borrowing rates throughout the economy. More rate hikes are all but certain. Indeed, the Fed has maintained a hard line in its inflation fight, telling investors that it won’t stop its tight money policy until the inflation battle is finished. For perspective, the Fed has a 2% annual inflation target, and the most recent inflation data show the Consumer Price Index (CPI) running at a 6% core rate over the last twelve months. Recent trends in the inflation data are encouraging, but it will take several more months for the “hottest” inflation prints to roll off the twelve-month lookback. Regardless, we are headed in the right direction.
With only a limited interruption since the global financial crisis of 2008-09, the Fed has furnished cheap money to the US economy. Interest rates throughout this period were unusually low by historical standards, justified in part by the low inflation data and the modest growth that accompanied the era. Over time, cheap borrowing costs helped to bid up values across financial assets, in real estate, and encouraged speculation in new investment trends including SPACs, “meme” stocks, and cryptocurrencies. 2022 was the payback year for these excesses. Our view is that, going forward, common sense will return to investing practice, and the opportunity set for investors is more attractive than commonly believed.
Strategizing for 2023
As we consider the investment landscape for 2023 and the opportunities it presents, we first want to glean the tempo of the economy. As we emphasized in prior messages, we believed the economy to be in a strong spot to sustain the impact of rate hikes, and our view has largely been confirmed. Ultimately, a sound economy provides the foundation for positive investing outcomes.
While it is true that higher interest rates are beginning to affect the economy, in the main the economy continues to perform. For the year’s third quarter, Gross Domestic Product (GDP) increased at an annualized rate of 3.2%. Numbers for the fourth quarter are not yet available, but the Atlanta Fed’s GDPNow tracker is forecasting the quarter at 3.8% growth. We see some indications that the economy is slowing at the margin, but consumer activity remains solid and the economy continues to add jobs. The December payrolls report, released today, indicated the economy added 223,000 jobs last month. Workers continue to enjoy wage gains, albeit at a moderating rate, consistent with an improving outlook for inflation. Elsewhere, natural gas prices are at an 18-month low, and gasoline has surrendered its price increases and is flat with year-ago levels.
The full impact of the Fed’s rate hikes has yet to be felt, however. Despite the economy’s present strength, surveys of purchasing managers indicate slowing business conditions in the broader economy. Additionally, offsetting the positive payroll news, corporate layoffs are increasing, especially in the technology sector. These are not surprising developments, especially when woven into the overall cycle of corporate planning and budgeting. Having just completed their planning for 2023, we expect corporate managements to be conservative in their plans and in their expectations for business in the new year.
We are optimistic on what 2023 might offer us as investors. Despite a difficult last year, most of stock market’s decline took place in the year’s first half. For the most part, we moved sideways in the second half of the year, and we might remain somewhat rangebound in the early part of 2023, until the final pieces of the inflation and interest rates puzzle reveal themselves.
Following a year when stock prices declined and earnings expanded (yes, corporate profits improved in 2022 over 2021), the valuation on the S&P 500 has improved. The forward P/E ratio on the market is 16.5 times, below both its 5- and 10-year averages. We should note, as well, that expected profit levels for 2023 have come down over the last several weeks, so forward valuations are already reflecting a degree of forecasting conservatism. In short, stocks are a better bargain these days.
Likewise, although higher interest rates were the root cause of last year’s negative returns, we are in a good spot to take advantage of the Fed’s tight money. Riskless Treasury bonds are yielding north of 4% for maturities up to three years. Government Agency bonds and investment grade corporates of similar maturities improve on these yields further. With the Fed more or less locked in to higher rates for longer, until the inflation bogeyman returns to his hiding spot, we have a solid opportunity for low-risk investments among several fixed income types.
On balance, we expect an economic slowdown of soft-landing variety, with some industries and sectors affected more than others. As we have noted previously, rate-sensitive sectors such as housing and autos should see some impact from higher rates, as their products are typically purchased with borrowed money. Likewise, the technology sector, broadly speaking, has been weak, primarily on valuation contraction. Throughout the easy money era, the tech sector enjoyed strong valuations, but those are reversing, and we expect some continuation of that trend.
In the presence of higher interest rates, we think investors will have a renewed focus on valuation, cash flow generation, profits, and dividends. We believe our portfolio strategies, as well as our overall investing style, are well-positioned for these factors, and we continue to research new investment ideas. For some investors, this will be new religion. At Ascent, it has been our DNA from our founding.
As we turn the page to 2023, we offer you, our clients and friends, our best wishes for a healthy and happy New Year. We thank you for your continued confidence.