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Three Questions for the Bear


Richard Barnett, CFA

The fourth quarter of 2022 was a grind from a market and asset management perspective, and in some ways a continuation of the theme of our last letter.  Investors are still adjusting to a new interest rate regime, while at the same time dealing with high inflation, slowing growth, lingering COVID effects, supply chain disruptions, and war in Europe.  

For the full year of 2022 – a bear market year – the major market indices are shown below:

Ycharts US Consumer Price index MoM, YCharts, 12/16/22

As the bear slogged through the mud, we may have seen the first hints of economic and macro-environmental change.  Let's take a look at Q4 in the context of three important questions we are addressing with clients during this bear market. 

Is inflation peaking?

The end of COVID lockdowns triggered a strong global demand stimulus which, combined with massive liquidity from world central banks, led to a rapid economic growth surge accompanied by a surprising spike in inflation. The Fed threw in the towel on the “transitory” inflation narrative in late 2021 and started raising interest rates to combat inflation.  It's hard to believe that it was just March last year when the Fed first hiked interest rates by .25%, the first hike since 2018.  Since then, the central bank has executed one of the fastest rate hike regimes in history.  According to a recent study by the World Economic Forum, the 2022 rate hikes were twice as fast as the March 1988 - May 1989 cycle1.  After the December 14 rate hike, the target range is now 4.25% to 5%, up from .25 to .5% last March. 

While inflation spiked along with interest rates, it may have peaked over the last few months of the year. The November month-over-month CPI was just +.2%, compared to +.27% in October and +.58% in September4.  For core PCE, the Personal Consumption Expenditure index, which the Fed closely watches, was +.2% in October, from +.5% in October and August. Economic researcher 42 Macro shows a seasonally adjusted annual inflation decline from 5.3% to 1.2% for CPI and 5.6% to 2.6% for PCE2.

Longer term, 42 Macro’s inflation model suggests that core PCE, the Fed’s key inflation measure, is likely to trend .7 - 1.3% higher throughout the decade3.  Moving forward, it’s hard to see the U.S. hitting the Fed’s 2% inflation target anytime soon.  The Fed may have to increase its inflation target to reflect current market realities.  We agree that inflation has peaked but will continue to be high relative to the last few years for the foreseeable future. 

Why are stocks and bonds both down?

The main reason to hold stocks and bonds in a portfolio is diversification, and in most years the prices of stocks and bonds have a very low correlation.  Rapidly rising rates caused bond values to decline, since bond yields and bond prices move in opposite directions, and drove equities lower, especially for rate-sensitive sectors like tech stocks.  Spiking inflation as the global economy continued to recover from COVID-induced economic slowdowns exacerbated the decline for both stocks and bonds.  Just how often do stocks and bonds decline in the same year?

According to a recent study by Callan3, looking back to 1926, there were 37 quarters when both stock and bond returns were negative, which is just under 10% of all quarters.  More recently, the last time this happened was the first quarter of 2018, and before that, the second and third quarters of 2008, in the midst of the Global Financial Crisis. The data shows these instances are more rare since 1990 than in the sixty years before. 

Moving to annual returns, there were only two calendar years when stocks and bonds were both down, which were 1931 and 1969, although it almost happened in 2018.  2022’s stock and bond performance will mark only the third “double negative” year of the last 96 years.  So the case for stock and bond diversification hasn’t changed3.  Here’s to hoping for a reversion to the mean in 2023. 

Are we headed for a recession?

Reading the financial press, it seems like conventional wisdom right now that the Fed will keep hiking rates until they trigger a recession, or until they “break something”.  “Soft landing” was the watchword early in 2022.  Over the summer and fall, opinions have narrowed, with hopes for a soft landing fading.  In December, Fed Chairman Powell said the landing might be “softish”.  In a Reuters poll5 from early December, economists surveyed raised the probability of a recession in the next two years to 70%.  

That seems pretty high, but economists are bad at predicting recessions. A working paper4 from the International Monetary Fund looked at forecasts across 63 countries from 1994 - 2014. To quote the summary, “The main finding is that, while forecasters are generally aware that recession years will be different from other years, they miss the magnitude of the recession by a wide margin until the year is almost over”.  Economists from both the public and private sectors had equally dismal forecasting records4

The Federal Reserve Bank of Atlanta's “GDPNow” real-time forecast model is 3.8% annualized growth for the fourth quarter of 20222.  This is above the September quarterly annualized actual GDP of 2.9%, and these growth rates are close to the long-term average GDP of about 3%.  Growth will have to decelerate dramatically from its long-term average for two consecutive quarters to trigger an actual recession.

While this is certainly possible, many factors will impact the probability of a recession, including rates, inflation, the labor market, asset prices, credit, and liquidity.  China’s abrupt reversal of most COVID zero lockdowns in December, following rare public protests across the country, shows how quickly things can change.  This will either be a tailwind to the global economy if it revives China’s growth, or a headwind if COVID cases continue to rise, as they seem to be at the moment 

Looking ahead, we see a challenging market for risk assets heading into 2023, the possibility but not the inevitability of a recession late in the year, and a strong chance of the Federal Reserve reducing or stopping rate hikes when the Fed funds rates reach the terminal rate target in the 5% range.   

We have been quite busy watching the capital markets this year, and we made three rounds of portfolio realignments in 2022–early in the first quarter, in late summer, and near the end of the year, to make our portfolios more resilient.  This has helped mitigate the worst of the bear market that slogged along all year.  

We will continue to manage portfolios to support the long-term financial aspirations of our clients through whatever comes in 2023.

References and footnotes
1 “The pace of US interest rate hikes is faster than at any time in recent history. Is this creating a risk of recession?” World Economic Forum, 10/12/22. 
2 “Mission Accomplished On Core Inflation?” and “Secular Inflation Model,” December Macro Scouting Report, 42 Macro, 12/8/22
3 “Unprecedented Territory—and the Inherent Limits of Diversification”, Callan, 5/13/22.
4 How Well Do Economists Forecast Recessions?, International Monetary Fund working paper, Zidong An, Joao Tovar Jasses, Prakash Loungani, March 5, 2018
5 “U.S. heading into shallow recession, no respite from rate hikes yet: Reuters poll”, Indradip Ghosh, Reuters, 12/8/22

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