Waiting for Godot

Key Trends and Observations

1. The economy is weakening and will probably experience a mild recession in 2023.

2. Inflation is still too high even though it will probably come down during 2023.

3. The Fed is not done raising rates and those rates may stay higher for longer.

4. Earnings estimates are too high regardless of the economy’s direction.

5. Stocks and bonds are no longer expensive, but they are not cheap either.

6. Stocks have never bottomed before a recession started.

7. Volatility is likely to continue, and the bottoming process and recovery may be elongated.

8.  Don’t lose sight of the bull market opportunity which will occur on the other side of the current weak trend. Equities will bottom well ahead of the economy and corporate earnings.

9.  A flexible, rules-based investment approach works best in this type of environment.

Economic Update

The global economy continued to deteriorate through the end of 2022, but not to the extent previously feared. In fact, some parts of the U.S. and European economies showed resilience despite the high inflationary environment, rising interest rates, and war in Ukraine. In the U.S., the labor market is still tight, and household balance sheets remain strong. Europe has managed its energy disruption by cutting back consumption and doling out fiscal support to households to help address high energy and food costs. China is currently facing a swell of Covid cases, but it has taken a momentous step by easing tough pandemic policies, setting the stage for a reopening rebound.

Still, rising interest rates and slowing economic growth are heightening recession fears around the world. In the past year, the Federal Reserve (Fed) embarked on an aggressive campaign to hike interest rates to tame the most rapid inflation seen in decades, and the Fed’s actions reverberated across the world. Other central banks hiked rates, both to fight inflation in their economies and to stabilize their currencies against the U.S. dollar.

In the U.S., headline inflation slowed to 6.5% in December. This is an encouraging sign that, after a year and a half of swift, consistent price increases, inflation in the U.S. is beginning to abate. The Fed hiked interest rates to 4.5% at year end and, after months of hiking rates rapidly, the Fed is entering a phase in which it expects to adjust policy more cautiously. However, this does not mean the Fed is letting up.

Farewell to a very challenging year

Given all these factors, 2022 wasn’t the easiest of years for investors to handle.  With rising inflation, higher interest rates, and a war raging in Europe, it should come as no surprise it was a very poor year for equities.  Large company U.S. stock were down about 20%, small company stocks lost 22% and the NASDAQ lost 33%.

Adding insult to injury, bonds, a typically conservative asset class used to help cushion the blow of stock market volatility, lost 13.7% (as measured by the Vanguard Total Bond Index) and long-term U.S. government treasury bonds lost 30%.

Outlook

The global economic outlook remains highly uncertain. Higher interest rates slow inflation by cooling business investment and consumer demand for goods and services, paving the way for more moderate price increases. But, in the process, higher rates also curtail employment, weaken wage growth, and ripple through financial markets in disruptive ways. Just how much pain these moves will ultimately cause remains unclear. So many countries are raising rates so quickly, and doing so in a synchronized manner, that it is difficult to determine how intense any slowdown will be once it takes full effect. Monetary policy is a blunt tool, and often acts with a long lag.

The big question is how quickly inflation comes down.  The Fed plans to hike rates higher than previously expected, to over 5% by this spring, and to keep rates elevated for longer. This will give the Fed time to see how inflation and the labor market react to policy changes it has already put in place.

The Fed expects it will take several years for inflation to return to its 2% target and that inflation risks remain to the upside. In particular, the job market is still very strong, and wages are growing rapidly, so a sharper economic deceleration may be needed for inflation to fully fade. The Fed has projected economic growth of just 0.5% in 2023, which would be consistent with a short and shallow recession during the year.

On Recession Watch

This may be the most anticipated recession in history. Economists have been forecasting contraction for the US economy since at least April, shortly after the Federal Reserve began raising interest rates. But a bit like Godot, it has yet to show up. Credit the cash cushion American consumers and corporations built during the pandemic. But that will eventually disappear, and then the economy may suffer. In 2020 and 2021, generous unemployment insurance benefits, stimulus checks and child tax credit payments helped households squirrel away roughly $2.3 trillion in excess savings. This powered a surge in demand as the economy reopened, but also helped fuel upward pressure on inflation.  As stimulus programs ended last year and the economy reopened — increasing opportunities to spend money — Americans’ cash war chest began to dwindle. JPMorgan recently warned excess savings could be completely depleted by the second half of 2023.  This, along with the delayed impacts of higher interest rates, could finally bring about the much-anticipated recession.

Portfolio Positioning

In times like these, it is important to have an investment process that removes emotion from the equation. Maintaining analytical independence from pre-written market narratives, removing preconceived biases, deferring to an analytical framework, and managing investments in a systematic manner are important pillars in managing dynamic investment portfolios.

The baseline of this approach uses data and price history to position portfolios for the current and impending market environment by using a mix of long-term indicators to signal broad market trends and short-term indicators to position portfolios to move nimbly and benefit from short term market opportunities and volatility.

Our portfolios shifted to a more defensive standing in March, and a max defensive positioning was attained in early April; equity allocations were lowered significantly across portfolios, with moderate risk portfolios seeing equity allocations reduced to a 25% weighting.  These defensive moves helped buffer portfolios from a large portion of the declines markets experienced during the second and third quarters.  In late October, signals turned positive, and portfolios were opportunistically positioned for growth and benefitted from the ensuing late year rally.

A result of this dynamic, quantitative investment management approach is reflected in portfolio performance during the second half of the year:  whereas the Nasdaq fell 5%, bonds dropped 6% and the S&P 500 was flat during the period, our moderately balanced portfolios saw results in the 7-8% range during the period.  Taking a pro-active, rules based stance has it’s benefits.

As we begin the new year, signals remain positive and short term opportunities present themselves to take advantage of the daily noise and churn occurring in the markets.  Portfolios will remain dynamically managed, and adjustments will be made if and when greater volatility returns, and signals turn negative again. 

Here’s to hoping for the best but being positioned and ready for all possible outcomes.