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2022 Review & 2023 Outlook: The Bill Came Due

2022 is now in the history books and market observers in the future will likely view this past year as a period of ‘the bill came due’. What bill you ask? It could be several, but the main one would be 12 years of central bank quantitative easing that saw the value of assets on the U.S. Federal Reserve skyrocket from around $800 billion in 2008 to a stunning ~$9 trillion. Accompanying this rise in central bank assets was a substantial inflation in financial assets that favored risk taking versus saving for over a decade.

The COVID pandemic twisted and contorted supply chains and balance sheets which evolved asset inflation into a more insidious form of inflation in goods and services. The Fed, and other central banks around the world, were too slow out of the starting blocks into 2021 to fight inflation (remember the word transitory spilled a lot of ink in financial publications and government reports that year) and 2021 in arrears looks like a blow off top in risk assets valuations.

2022 saw central banks, led by the Federal Reserve, play catch up on staving off inflation by dramatically increasing interest rates. The Fed Funds rate went from 0% to 4.5% in a historically short time accompanied by a decreasing of the Fed balance sheet at twice the pace of the post 2008 financial crisis period. This led to negative returns in nearly every risk asset class, with the S&P 500 Index finishing the year down 18.2% and the Barclays Aggregate Bond Index -12.9%. It is not very often that stocks and bonds have meaningful drawdowns in the same year, in fact it’s been over 40 years since we’ve seen these type contractions in both indexes simultaneously.


[S&P 500 Index by quarter, 2022]

So what does 2023 have in store for investors? Well, at least at first, is likely more of the same. In past interest rate cycles the Fed stopped raising interest rates once the rate exceeded the Consumer Price Index (CPI). As we move through this year, we are very likely to see one or two more interest rate increases (albeit smaller at .25% each versus .50% or .75%) as rates are nudged up. Inflation looks to be rolling over very quickly in recent data, with prices on goods falling as well as housing prices, rents, and oil prices. The stubborn parts of inflation are food stuffs and wages, with wages being the chief concern of policy makers.


[Previous Federal Reserve hiking cycles upper bound rate with accompanying CPI (Consumer Price Index) rate]

The silver lining in the equity markets in 2022 was that the decrease was chiefly valuation compression (the P/E ratio). S&P 500 earnings appear to have grown about 5% last year, so any major structural damage to the average S&P 500 company’s ability to operate was limited to non-existent. However, with much tighter financial conditions in place for 2023 and a rather dramatically slowing economy worldwide, the ‘R’ word Recession is creeping into the collective minds of investors. This worry is warranted, given the Federal Reserve and other central banks open willingness to sacrifice growth to bring inflation under control. A reminder, historically though, that once we are declared to be in a recession the lion’s share of the losses in the stock market have been realized. Another benefit to the change in interest rates is investors for the first time in a long time can earn more than a de minimis interest rate on their cash and bond investments. Since the financial crisis, low interest rates have nudged investors into riskier assets, such as real estate and stocks, in search of return. There were many long periods of time in the past 15 years where the dividend yield on the S&P 500 exceeded the interest you could earn in either a savings account or even a 10-year Treasury bond. This was known in the investment industry as T.I.N.A. – There Is No Alternative (to equities). There is reason to hope that with a sustained period of higher interest rates, investors can achieve a reasonable return on their cash and bonds investments, and not have to over commit to risk assets to achieve their desired return.

As the Federal Reserve and other central bank policy makers likely reign in or even conclude their inflation fighting policies later in 2023, investors will breathe a collective sigh of relief. Keep in mind, however, that this ‘all clear’ sign will likely have been met with an already increasing equity market as historically markets often anticipate these types of events and price the consequences ahead of time.


[S&P earnings (EPS) were rather steady in 2022, while Price of the S&P decreased thus contracting the Price/ Earnings ratio (P/E]
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