Goodbye 2022 – As we entered the year 2022, we dealt with old and new exogenous shocks, a pandemic becoming and endemic, and a conflict between Russia and Ukraine. But the year quickly became about inflation and its impacts on central banks that were behind the curve and forced to firmly react on growth which put recession in question, and on risky assets which struggled to overcome their low-rate obsession. This year also led to worries about systemic risk and what could break the crypto bank. Amid all that, the larger trend sure to shape the years ahead are China’s continued evolution and President Xi’s goals.
For the year, the NASDAQ finished down 33.1%, the S&P 500 was off 19.4% and Dow shed 8.8% ending the worst year since 2008 and the seventh worst year since 1928. These averages only tell part of the story. The only S&P sector that was positive for the year was Energy gaining 60% while Communications and Consumer Discretionary lost more than 40% each. That is only ½ the story. The bond market, you know, the part of the market for your ‘safe’ money, had the worst year in history…..in history, losing 13.1%.
The good news is that interest rates are up, higher than they have been in almost 20 years. The folks living on the income their portfolio can generate are being paid more interest. We’ve gone from the low-return world of 2009-21 to a full-return world, and it may become more so in the near term. Investors can now potentially get solid returns from credit instruments, meaning they no longer need to rely as heavily on riskier investments to achieve their overall return targets. Lenders and bargain hunters face much better prospects in this changed environment than they did in 2009-21. The bad news is that higher interest rates weigh heavily on companies’ cost of capital and household costs such as the interest they pay on home loans and auto loans. Importantly, if you grant that the environment is and may continue to be very different from what it was over the last 13 years – and most of the last 40 years – it should follow that the investment strategies that worked best over those periods may not be the ones that outperform in the years ahead.
If the Fed normalizes rates by 2024, it could well be in response to recession, as is currently signaled by the yield curve. But if that is the case, it is unlikely earnings will hold up, at least in real terms. It is a catch-22, and the markets are caught in the middle of it.
The bottom line is that while stocks suffered this year from higher interest rates, the greatest headwind in 2023 should be lower profits. The economy still needs to pay a price for the massive artificial stimulus of 2020-21. Part of that bill came due this year and we think the rest comes due in 2023.
The Fed is being as transparent as possible. Recently Chairman Powell was quoted as saying; “We need to be honest with ourselves that there’s inflation. 12-month core inflation is 6% CPI. That is three times our 2% target. Now it is good to see progress but let us just understand we have a long way to go to get back to price stability, I do not think anyone knows whether we are going to have a recession or not, and, if we do, whether it’s going to be a deep one or not. It is just – it is not knowable… The historical record cautions strongly against prematurely loosening policy. We will stay the course, until the job is done.”
According to Bloomberg, the S&P 500 Value Index currently yields 2.22% and the S&P 500 Growth Index only yields 1.0%. Additionally, the P/E multiple of S&P 500 Value Index is 17.3x versus 23.5x for S&P 500 Growth Index. In our opinion, in an environment of higher for longer interest rates, equity prices do not have much, if any, opportunity to grow their earnings multiples. Those higher interest rates will ultimately slow GDP growth and earnings growth rates will slow as well even if the economy avoids a recession. We expect equity returns in that environment to be more muted and simply put, dividends will make up a much larger percentage of the total return over the next several years.
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