Between Hope and Fear

By:

CFA, Chief Investment Strategist

The best thing investors can say about 2022 is that it’s almost over. After years of ultra-low interest rates that flattered financial asset prices, rates rose rapidly in response to aggressive global central bank policies to combat soaring inflation, leaving investors few places to hide.

Ultimately, the intrinsic value of any security — stock, bond, real estate — is the present value of future cash flows discounted at the discount rate. Investors’ inability to accurately determine the discount rate created enormous market volatility in 2022.

And because the value of the security decreases as the discount rate increases, 2022’s substantial increase in the discount rate resulted in significant declines across virtually every asset class, from the most conservative to the most speculative. Typical US midterm election anxiety, China’s zero-COVID policy, and the Russia-Ukraine war magnified capital market volatility and investor losses.

As a result, the traditional 60/40 investment portfolio is on pace to record its worst calendar year performance in 85 years, since 1937.1

And yet, despite this gloomy backdrop, investors will start 2023 stuck somewhere between hope and fear.

Hope for a Soft Landing

Excitement over a potential slowdown in both the pace and magnitude of Federal Reserve (Fed) rate hikes — the so-called Fed pivot — has led to several brief but strong bear market rallies over the past six months. And several measures of inflation have begun to show signs of decelerating, fanning the Fed pivot flames. On November 10, the Consumer Price Index (CPI) rose less than expected in October, sending stock prices sharply higher and bond yields lower. Just days later, the Producer Price Index (PPI), a measure of the prices that companies get for finished goods in the marketplace, also increased less than expected.

Despite the most aggressive Fed rate hikes in history, the economy, corporate profits, and labor markets aren’t signaling a recession on the horizon just yet. In the aftermath of the 20th National Congress Communist Party, there is growing speculation that China is desperately seeking a solution to its zero-COVID policy. And, with the onset of winter, there is increasing pressure on Russia and Ukraine to pause military actions and begin to negotiate a settlement.

All this has raised investors’ hopes that the Fed will be able to engineer a soft landing in the first half of 2023.

Fear of the Fed’s Inflation Fight

But investors know that hope is not a strategy. In fact, the Fed has successfully produced a soft landing just three times in the modern era — in the mid-1960s, 1984, and 1994. Against these odds, investors fear that having waited too long to begin its battle with inflation, the Fed will tighten too much to defeat it — and finally break something somewhere in the global capital markets. A deep recession, plummeting corporate profits, and steep job losses almost always follow such a misstep. These fears consume investors as we charge toward 2023.

The Fed’s willingness to risk recession and withstand higher market volatility so that it can firmly defeat inflation suggests that, until it declares victory, risks likely will remain skewed to the downside.

Mind the Gap Between the Economy and Market

Sentiment shifting between hope and fear highlights one of the enduring investment lessons from the pandemic: the economy is not the market. In fact, the gap between the economy and the market has widened dramatically over the past few years.

Oddly, at the height of the COVID-19 health crisis in 2020–2021, markets rallied. Investors recognized that eventually a health solution to the coronavirus would be achieved, the economy would reopen, earnings would rebound, and jobs would return. Afterall, the market is a forward- looking mechanism. Easy monetary policy and massive government spending also aided the pandemic recovery.

Just as strangely, in 2022 — despite a modestly expanding economy, healthy corporate profits, and a strong labor market— financial asset prices collapsed under the weight of tighter monetary policies, fading fiscal spending, surging inflation, China’s zero-COVID policy, and the Russia-Ukraine war.

Now, as 2023 begins, investors expect the economy to falter, corporate profits to plunge, and job losses to rise due to the lag effects of aggressive Fed rate hikes. This potential recession is the most anticipated in modern history. Wildly, when it finally arrives, investors may breathe a welcome sigh of relief and begin looking ahead to the inevitable recovery. Before the economic, earnings, and job market data hit rock bottom, investors will have already begun to price in the next phase of the economic cycle. The question is, will your portfolios be ready?

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Footnotes

1 Bloomberg Finance, L.P., as of November 17, 2022. Based on the return for the MSCI ACWI IMI Index and the Bloomberg US Aggregate Bond Index of a portfolio weighted 60% to equities and 40% to bonds.

Glossary

Consumer Price Index (CPI)
A widely used measure of inflation at the consumer level that helps evaluate changes in cost of living. The CPI is composed of a basket of consumer goods and services across the economy and is calculated by the US Department of Labor by assessing price changes in the basket of goods and services and averaging them. Core CPI is the same series, but excluding more accurately.

Inflation
An overall increase in the price of an economy’s goods and services during a given period, translating to a loss in purchasing power per unit of currency. Inflation generally occurs when growth of the money supply outpaces growth of the economy. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.

Originally Posted December 5, 2022 – Between Hope and Fear

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