Blood, Sweat & Tears famously sang “What goes up must come down.” What was true then remains so now.
Reflecting on 2022
Volatility in the equity markets is to be expected at times. Anyone who studies the stock market will tell you that “Corrections" and "Bear" markets are common, especially after a period of extraordinary returns which we experienced through 2020 and 2021. They will also tell you that a "bear" market in fixed income is rare and even more so when combined with a significant decline in the stock markets. In fact, we must go back more than 75 years to find a time when there was as big a decline in both markets simultaneously. The old "60/40" balanced model favored by investors for decades as a tradeoff between risk and return was down 15-17% in 2022 depending on their specific holdings. This magnitude of loss from traditional balanced portfolios hasn't been seen since the 1930's.
At first blush, it seems the primary culprit was the higher interest rates engineered by the Federal Reserve. It was the second fastest increase in interest rates in history, only eclipsed by the infamous Paul Volcker shock of 1980.
The real culprits though were/is sky-high inflation caused by a myriad of factors including:
- The Federal Reserve’s tardiness in recognizing and addressing an obvious inflation problem and keeping rates too low for too long.
- The US gov't largesse (massive pandemic-era entitlements and transfer payments.)
- Election and political turmoil in the United States.
- The tight job market caused many to ask where did all the employees go?
- China lockdowns impacting constrained supply chains.
- Finally, the war in Ukraine... All of this created a witch’s brew of inflationary pressure.
Where we are today
Inflation remains stubborn and continues due to consumer spending fueled by accumulated savings and a strong job market. Consumers, especially the top 20% are now proliferate spenders on services-eating out, travel, entertainment etc. This type of spending supplanted the previous chapter when everyone was buying homes, remodeling, cars, and other durable goods financed in part by extremely cheap interest rates. Consumers have spent tremendous amounts of money, much of it borrowed.
House sales and building has fallen to a trickle, and commercial real estate projects are mostly dead in the water. Many tech/communications/financial/retail companies are actively trimming employees in anticipation of a recession mid-2023. The driver behind this trend is higher-interest rates that doubled or tripled the cost of borrowing money. Like body blows to a boxer, higher interest rates and less Federal money supply are slowly affecting the consumer and the economy. Money isn't free anymore and investors, business leaders, and everyday consumers have taken note. This is exactly the reaction the Fed wants. It MUST slow the systemic transfer of wage increases to inflation. If not checked, these increases will become embedded in the economy. History has shown wage-price inflation is difficult to eradicate, even after the economy cools.
We believe we are close to an inflection point where the rise of interest rates by the Fed, a more constrained money supply and slightly higher unemployment will start slowing the overall economy. Certain key industries are already there, and the sales of durable goods has decreased along with prices. Consumer spending, while still strong for services is starting to slow. This could be the beginning of a new slower economic cycle and signal the end of the Fed tightening.
We think the most likely economic and financial scenario is that we will dip into a slight recession from mid to late 2023 which could last into 2024. According to most of our sources of information, the consensus is that any recession will be relatively shallow but will lack the "V" shaped recovery of most recent versions. This means that we might just sort of bump along for a while until certain key questions are resolved such as:
- What will be the real inflation rate?
- What will be the ultimate "real" unemployment rate?
- What level are adjusted interest rates?
- When and how will the war in Ukraine end? Impacts?
- What happens to the second biggest economy in the world, China? -will they truly reopen? Will they emerge more trade-friendly again, or will they and the US continue their unofficial trade war?
Until these issues are clarified, the fix fixed-income markets will likely trade at higher yields and more volatility than normal. The stock markets will not be able to find a truly sustained footing until the fixed-income markets find stability. While not an end-of-the-world situation, it does, warrant caution and patience for the time being.
Investing too aggressively in the equity markets with the rationale that stocks are "now much cheaper" could be a fool's errand at this juncture. There must be a more substantial catalyst behind it all. Earnings must be solid and growing before a sustained rally can take hold and endure. Between now and then, there will likely be many feints and head fakes by the markets.
What can or should be done now?
At this juncture, we feel there are now competing opportunities adjusted for risk/reward in fixed income. As for the stock markets, history has always rewarded long-term patience, a steady hand, and a strong stomach to overcome can stand periods of volatility, stay invested, and the market will be your friend s of volatility, stay invested and the market will be your friend once again further down the road.
Our team is here to help you and your employees with the big questions during these tumultuous times, so please reach out and engage with us, we are here to help you.
Founder and CEO
Deschutes Investment Consulting
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