The Economy Turns the Page on COVID

Equity markets hit their 2022 lows during the fourth quarter (down 25 percent). Not coincidentally, the low point was October 12, the day before the release of the October Consumer Price Index (CPI) report that showed goods inflation easing and core inflation peaking. This report, and a subsequent weaker than expected CPI reading in November, helped stoke a 14 percent rally in equities that lasted until December 1, the day before another (seemingly) hot jobs report sent stocks lower on fears that the labor market remained extremely tight. The Federal Reserve views a strained labor market as contrary to its goal of taming inflation. Despite another weaker than expected CPI report on December 13, the Fed drove the final nail in the coffin of the fourth quarter equity market rally at its December meeting by penciling in forecasts of even higher rates in 2023 than it previously signaled at its September meeting.  

The above recap highlights the push and pull the markets faced throughout the latter half of 2022, which is likely to remain as we head into 2023. A growing chorus of market participants have begun to forecast easing inflationary pressures based on economic data, which shows signs that the overall economy is lurching unevenly toward a recession despite a labor market that appears to be strong. The market’s view is in stark contrast to the Fed, which appears to be refusing to acknowledge falling inflationary pressures. Instead, it remains committed to the inflation fight at all costs. As such, Fed board members continue to talk tough on rates, likely for fear that any signs of a softened tone could prematurely cause financial conditions to ease and may cause inflationary pressures to become embedded.

While we continue to expect a recession, we believe it will be uneven and mild and, most importantly, will serve to put the final nail in the inflation coffin.

For much of 2022, tough talk from the Fed caused bond yields to rise, but as the fourth quarter drew to a close, investors appeared to be less swayed by the Fed’s insistence that rates needed to be higher. The result was yields that stopped rising as bond markets rallied modestly for the first time in 2022. Increasingly, the market appears to be suggesting to the Fed that continued rate hikes are almost certain to cause a recession.  

The change in reaction to Fed rhetoric leads us to believe that investors’ fears are shifting away from inflation and toward recession, which we expect will cause ongoing volatility in early 2023. While we continue to expect a recession, we believe it will be uneven and mild and, most importantly, will serve to put the final nail in the inflation coffin. Given this reality and the fact that inflation expectations remain anchored, we believe the Fed will pause raising rates when the labor market finally shows weakness. We also believe the Fed will have room to pivot to rate cuts, if needed, to keep a potential recession from deepening. 

In our view, investors are placing too much attention on the Fed’s current “promise” of keeping rates high for the foreseeable future. This is a very reactionary Fed whose forecasts over the past couple years have proven less than flawless. Keep in mind that at this time last year the Fed expected it would raise rates by 75 basis points for all of 2022. In reality, it raised rates by 425 basis points, including four consecutive 75-basis-point hikes. This is less a critique of the Fed than a comment about how odd and unpredictable this post-pandemic economic normalization has been.  

Economic and inflationary normalization continues 

In our quarterly market commentary at the end of 2021, we expressed our outlook that 2022 would see the U.S. economy continuing its slow return to pre-COVID levels, even though at the time the omicron variant was temporarily disrupting that normalization. We forecasted that 2022 would see consumer spending shift back toward services (think gathering in public) from excessive goods spending. The shift in demand would allow slowed supply chains to heal, lead to the rebuilding of goods inventories and, most importantly, push goods inflation (which made up the bulk of elevated CPI reading in 2021) lower.  

Broadly speaking, this is what occurred in 2022 and what we expect to continue into 2023. Gone are the headlines of clogged U.S. ports; shipping container costs have fallen more than 80 percent from their highs, used car prices have fallen 14 percent, and overall “goods” inventories are now largely rebuilt. The result has been a rapid decline in goods inflation. The previously mentioned September CPI report showed goods inflation at 0 percent month over month, with October and November showing declines of 0.4 and 0.5 percent month over month, respectively. During the last nine months (since February 2022) goods inflation rose a meager 1.0 percent, and the year-over-year level has fallen from a peak of 12.3 percent in February to now 3.7 percent. Simply put, goods inflation was a byproduct of COVID and has faded into the past.  

Unfortunately, as spending shifted in 2022 to services, so did inflationary pressures. Services inflation began the year at 3.7 percent year over year and climbed throughout the past 12 months to its current rate of 6.8 percent. It’s worth noting that a large part of this is simply due to how the CPI number for services is calculated. The vast majority — 33 percent of the 56 percent of CPI that falls in the services category — is based on shelter and rent costs. Importantly, current market rents and home price data take more than 12 months to show up in the CPI reading. While housing and rents were strong in early 2022, they weakened substantially throughout the year. For example, existing home sales fell 37 percent from their January 2022 levels. A sentiment survey of new-home builders fell from a near-record 84 to start the year (above 50 signals expansion and below indicates contraction) to just 31 to end the year. 

As a result of decreasing demand and mortgage rates that more than doubled in 2022, home prices spent the latter half of the year falling and will likely continue on a downward trajectory in early 2023. Likewise, rent indices peaked early in the year and rolled over by year-end. These numbers will begin to enter the calculation and should pull services inflation lower in 2023. As for the remaining 23 percent of the services CPI, it began to falter at year-end with a 0 percent month over month reading in November after a 0.1 percent decline in October. 

Given the lagging effects of the Fed’s aggressive rate tightening, as well as a combination of easing services price pressures, continued goods disinflation and steady to falling commodity prices, we remain convinced that inflation is set to continue its descent as the economy continues to normalize and slow down. Frustratingly, the easing of inflation has taken longer than anticipated, with disruptions from the Russian invasion of Ukraine hampering progress early in 2022. However, we believe the easing of price pressures is set to accelerate in 2023. Recent inflation readings suggest progress is already happening. Importantly, after stripping out lagging shelter readings (i.e., the 67 percent that doesn’t have a lag), the all-in “current” CPI inflation is actually down 0.8 percent since June. We believe the bulk of the data continues to point to falling inflation in 2023.  

The last inflationary frontier – labor and wages  

In our year-end 2021 market commentary, we noted that we were positive on the economy and markets in the first half of the year but expressed our concern that the second half of 2022 would find investors contemplating a tight labor market and potential end to an economic/market cycle (think recession). While we expressed optimism that workers could return early in 2022 as COVID eased, we expressed our concern that simple math raised the prospect that as we pushed into 2023, we could find ourselves in a labor shortage, which typically leads to wage pressures and signals the beginning of the end of an economic cycle.

The Fed is waiting for confirmation that its actions are finally breaking the labor market.

Initially workers returned early in 2022, but as the year progressed the flow dried up, and workers remained in short supply against seemingly never-ending demand that has kept wages elevated. Elevated wage pressure is an area of acute focus for the Fed, as it is the one inflationary input stemming from demand still exceeding supply. The Fed is waiting for confirmation that its actions are finally breaking the labor market. Accordingly, we believe once jobs data show signs of weakness, the Fed will be compelled to pause its aggressive rate hike campaign.  

Current data suggest that we are still some ways from seeing labor demand subside. Indeed, the December jobs report released in early January showed a still strong 223,000 jobs added, according to the non-farm payroll report from the Bureau of Labor Statistics (BLS). The reading was largely consistent with the average pace of 270,000 new positions that had occurred since August 2022. However, although this is a more pronounced step down in demand for workers compared to the average of 396,000 new hires made monthly from March through July, it remains well above the natural rate of expansion of the workforce, which is approximately 60,000-90,000 per month. We believe the Fed remains firmly focused on this discrepancy and believes it is too large … but is it?  

We have previously noted that other “jobs reports” and indicators of the labor market point to a potentially weakening jobs market and the possibility for significant revisions to the non-farm report. Another report from the BLS, known as the household report, is calculated differently. It shows significantly fewer jobs being added than the non-farm payrolls report over the past nine months (916,000 vs. 2.9 million). Historically, the household report has been more accurate at turning points in the economy and is perhaps painting a picture of a slowing jobs market. The strong counter to this is that weekly initial jobless claims have remained low, but we note that continuing claims (i.e., those who don’t find a job after their initial jobless claims expire) are up by nearly 400,000 from lows registered in early May. Simply put, it appears to be harder for those workers who are getting laid off or terminated to find new employment. 

We note that it is hard to count the large U.S. economy in real time and that data is often revised multiple times. Indeed, each non-farm payroll number gets revised in subsequent months, and then there is an annual revision. The Philadelphia Federal Reserve recently released its forecast for what those revisions may look like for the non-farm payroll report for the second quarter of 2022. The analysis adds credence to our hypothesis. It shows that the current report’s estimate of 1,047,000 workers being added in the second quarter (April through June) could be revised to meager 10,500 additional jobs. 

We continue to believe that a potential contraction will be shallow as long as the Fed has room to unwind its overly aggressive rate actions of 2022.

Much as economic spending has shifted, we believe the jobs market is doing the same. While early COVID beneficiaries (such as goods and technology companies) are now laying off people after over-hiring, service sector employers, such as leisure and hospitality, are still adding workers in an attempt to get back to pre-COVID levels as they scramble to meet shifting demand.  

Taken in total, the reality is that the labor market remains too strong for the Fed’s disinflationary goals, and until data shows weakness, the Fed will likely continue raising rates and talking tough. With the labor market poised to crack in the not-too-distant future, along with downward pressure on inflation gaining momentum, we believe a pause in Fed rate hikes is inching nearer. Given that inflation expectations remain well anchored, the Fed should be able to pivot and cut rates later in the year if needed to limit the depth of any potential economic downturn. We continue to believe that a potential contraction will be shallow as long as the Fed has room to unwind its overly aggressive rate actions of 2022.  

A market that has largely normalized  

Much as we expected the economy to normalize in 2022, we similarly expressed our view that the financial markets would also revert back to historical trends as easy monetary policy gave way to tighter financial conditions and higher interest rates. We noted that a return to normal could be particularly damaging to the most expensive parts of the market – the “hopes, dreams, themes and memes” stocks that were bid up based on overly optimistic growth projections.  

Similarly, we noted other equity market oddities would revert back to normal in 2022, given our belief that investors would shift their focus from speculation and longer-term growth prospects toward a focus on cheaper stocks of companies operating in sectors producing cash flows and earnings in the here and now. We noted the large premium investors were placing on growth stocks relative to value stocks, Large Cap versus Small Caps and U.S. equity relative to businesses headquartered overseas.  

Unfortunately, this “normalization” occurred against a backdrop of broad-based weakness in the markets, with nearly all major asset classes posting negative returns. Still, the cheapest areas experienced the least pain. A basket of unprofitable tech stocks and exchange-traded funds dedicated to investing in hopes for the future and in “meme” stocks fell by more than 65 percent for the year and finished the year down as much as 90 percent from highs registered in 2021. S&P 500 value stocks outperformed S&P 500 growth stocks for the first time since 2016 (and by the largest amount since 1999), with value down 5 percent compared to a loss of nearly 30 percent for growth companies. Similarly, U.S. Small Caps (S&P 600) outperformed Large Cap for the first time since 2016. Likewise, the 50 biggest names in the S&P 500 underperformed an equally weighted version of the index for the first time since 2016 — the performance gap was more than 12.6 percent. And somewhat surprisingly to many, International Developed stocks, as represented by the MSCI EAFE index, were boosted by a strong fourth quarter and eclipsed U.S. equity market performance for the first time since 2017.  

Not only did equity markets fall, but bonds also did not play their typical hedge role against equity losses. The Bloomberg Aggregate Bond index of investment-grade bonds fell for the second year in a row, with the index — down 13.1 percent — posting its largest drawdown and negative annual return in its history. This was the first time the index recorded negative returns in consecutive years and only the fifth time since 1976 that it ended the year in negative territory.  

The one bright spot was an asset class that we have long recommended, Commodities, which provided a second strong year of performance and was the only major asset class with positive returns for the year. For those who have questioned the value of this asset class, we believe the past few years have proven its worth as an effective hedge against losses elsewhere in a portfolio. Tying these concepts together, we note that this is only the fifth time since 1926 that both stocks and bonds both produced negative returns. The other years were 1931, 1946, 1969 and 1973. Setting aside the Great Depression year of 1931, in the other four periods (inclusive of 2022) commodities provided a positive return. 

The final word  

That was then, and this is now. While uncertainty and concerns remain as we head into 2023, it is important to note that fixed income and equity markets have already done much of the heavy lifting toward re-normalizing and repricing in response to Fed actions and economic headwinds. Consider that after the Fed flooded the world with liquidity in early 2020 in response to COVID’s arrival, the onslaught of cash sent the 10-year Treasury to a record low yield of .508 percent in August 2020. It finished 2021 at a mere 1.512 percent despite rising inflation. Similarly, the yield on the Bloomberg Aggregate Bond Index of all investment-grade bonds in the U.S. fell to 1.02 percent in August 2020 and ended 2021 at a paltry 1.75 percent. Now, at the end of 2022, the 10-year Treasury yields 3.877 percent, while overall investment-grade bonds yield 4.68 percent. Put simply, we believe bonds now offer real value and have likely returned to their historical norm as a hedge against further equity downturns.

While we expect many twists and turns and a recession in 2023, we reaffirm our belief that intermediate- to long-term investors will be rewarded from these levels.

Much as the bond market has repriced, so too has the stock market. Perhaps the most beneficial for the overall health of equities has been the significant revaluation of the most speculative parts of the market. Additionally, the S&P 500 began 2021 trading at 21 times expected 2022 earnings and now trades at a more normal 16.5 times expected 2023 earnings. There is still a risk here, as earnings may falter in 2023, but this is a much more comfortable starting level for valuations. Most importantly, we repeat our 2022 message that there are still areas of the market that offer compelling valuations for longer-term investors in which to place their capital. We note that value stocks continue to trade at discounts, as do U.S. small and mid-cap equities and international developed equities.  

Investors experienced extreme volatility in 2022, and unfortunately many weak hands were washed out of the market. Pessimism remains rampant, and historically this has proven to be a strong contrarian indicator. We note that 2022 saw the highest average bear reading and lowest average bull reading for the American Association of Individual Investors Investor Sentiment Survey going back to its 1987 inception. While we expect many twists and turns and a recession in 2023, we reaffirm our belief that intermediate- to long-term investors will be rewarded from these levels.  

We believe the most important new year’s resolution an investor can make is to have a financial plan crafted by an advisor, to keep it updated and to stick with it through good times and (more importantly) tough times. The past three years have witnessed an incredible COVID-induced bust, subsequent boom (uneven as it was) and now, we believe, a return back toward more “normal” economic and market times.  

Happy new year.  

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