A New Year and a Crystal Ball
• The S&P closed 2022 with a loss of 18.1%, the worst year since 2008. Returns year-to-date , have however, provided some temporary investor relief.
• Consumer inflation levels continue trending downward following December’s CPI 6.5% inflation report.
• Job markets remain tight despite recent layoff headlines with unemployment levels in December falling to 3.5%.
• December retail sales decreased -1.1%, more negative than expected. Meanwhile, the Producer Price Index decreased -0.5% in December, also more negative than expected.
• Continuing bad news on the economic front has investors now betting on better news from the Federal Reserve in terms of future rate hikes.
• Estimates for the upcoming Fed meeting at month’s end will be for the next rate hike to fall between 25 and 50 basis points.
Wrapping up 2022, it was another entry for the records. At December’s close, the S&P 500 had posted a loss of -18.1%; since 1930, double-digit losses have occurred only 11 other times, including market crashes, wars or economic calamities. Two of those periods were during the Great Depression, one during the Great Financial Crisis and one other noteworthy period during the ”Great” Dot-Com crash.
To put 2022 in context, last year’s Russell large-cap index fell by a market capitalization of $10.9 trillion, led primarily by the technology sector losses of $4.35 trillion. This fact was not lost on investors with concentrated investments in the tech-centric QQQs, off by over 32% for the year. Outside of the energy sector (XLE up 64%) and the utility sector (XLU up 1.42%), few places remained to hide, no surprise to more conservative bond investors. Despite a slightly positive fourth quarter, the Bloomberg U.S. Aggregate Bond Index, usually a safe haven, still lost 13% by the year’s close. 2022 was the only year that investors in U.S. stocks and investors in core bonds both lost more than 10%.
Interestingly though, as the economic news continued to worsen throughout the year (corresponding with seven rate hikes in 2022), market watchers began talking about a possible Fed “pivot” in 2023. The prospect of the central bank reversing course and potentially beginning to lower rates was enough to provide some traction early into the fourth quarter. Although this “traction” wasn’t enough to turn the market tide by year’s end, early positive sentiment carried over into January. Certainly, a still positive labor market supported the sentiment as did some hopeful postulating that the Fed would soon lower the magnitude of past rate hikes. Although the Fed has avoided any market signals, investors have been trying to read between blurred lines.
After a somewhat sporadic rally that began in October, by mid-January the global markets had rallied positively off the interim lows set early in the fourth quarter. The U.S. equity markets were close to breaking out of their bear market downtrend, and the overseas markets had traded to their highest levels since last April. Over a three-month period ending January 17, the broader global markets (MSCI-EAFE) were up 24% while the emerging markets (MSCI-EEM) were a close second, up over 19%. In last place, but still up over 11%, was the S&P 500. Just how sticky those returns are will become more evident following the next Fed meeting on January 31-February 1 and Fed board members’ commentaries leading up to the meeting.
One Bright Spot
Without doubt, the anomaly in this recent economic downturn is the labor markets. As economic data has trended downward so have unemployment levels. The recurring theme is jobless claims falling below consensus estimates, despite headline layoffs and the Fed’s historic tightening efforts. Initial jobless claims posted another new low (despite layoffs) while the participation rate jumped to a three-month high. And of note, while the manufacturing economic data has been steadily ticking downward as well, manufacturing employment has been on the rise. In 2021, the manufacturing sector added 30,000 jobs a month, then in 2022, the monthly add jumped to 32,000.
The service industry was a different story. While the sector grew by 14,000 new jobs a month in 2022, the average in 2021 was 24,000 jobs added each month. Today’s service industry shortage still remains obvious, however, given visible “help-wanted” signs in restaurant and service shop windows. In short, the tight labor markets have continued to stymie Fed efforts to dampen job and wage growth.
On the other hand, industries are still working to rebuild following the economic and manufacturing losses during the pandemic shutdown. The intermediate risk though is that some companies may have “over-hired” and need to reverse their payroll sooner than later.
Other aspects of the consumer markets are not as positive. Retail sales for December were off -1.1%, more negative than expected with the downturn across a broad spectrum of businesses, including department stores (-6.6%), gasoline stations (-4.6%), and nonstore retailers (-1.1%). Meanwhile, the Producer Price Index (PPI), a key metric measuring wholesale prices paid by businesses, reported a year-over-year increase of 6.2%. While high, it’s well off the annual 7.3% increase reported in November, and it is the ninth consecutive monthly decrease since its 11.7% peak in March. The Fed will most certainly consider this data for its upcoming monetary policy meeting, and it appears that Fed efforts to slow the “transitional” inflation levels might be working.
The impact to the housing markets is also obvious with current mortgage rates sitting at 6.3%. While rates are down from 7% last fall, they are still well above last year’s low of 3.45%. Meanwhile, rates have pushed many buyers out of the housing markets (mortgage applications are at their lowest level in over 25 years, according to the Mortgage Bankers Association), but low housing inventories have supported home prices (currently 3.3 month inventory levels).
In this backdrop of higher rates, dwindling home inventories, and the two-year lows in housing starts, optimism is increasing for the return of the housing markets. This month the National Association of Home Builders reported improving sentiment levels for the first time since December 2021. Again, this bad news may have a silver lining for market participants.
Rates, Inflation and Business
The seven rate hikes of 2022 raised short-term Fed funds rates up to their current target range of 4.25%-4.50% and is now impacting several economic growth engines. Unfortunately, the prospect of another two to three rate increases, further hiking Fed funds rate up to a target 5% range, has yet to work its way through the economic channels. But the higher rate impact so far has been to lower December’s Consumer Price Index (CPI) to an annualized 6.5% from November’s 7.1%. While still high, the index is well off the 9.1% peak in June last year. In terms of the more important Core CPI (excludes temporary factors such as food and fuel), the inflation rate was 5.7%, a slowdown from the earlier month’s 6% inflation rate, off a July high of 6.7%.
Now, as rates have begun dampening business outlooks and profit margins (interest expense), the impact is showing up in a number of economic reports. This month’s New York Fed Empire Manufacturing Index fell to an index reading of -32.9 from a December low of -11.2 (business contraction). The New York Fed reading reflected the broader downturn in the Manufacturing Purchasing Manager Index (ISM PMI) as well. The broader index reading of 48.4 (below 50 is contracting) was the first contraction after 29 consecutive months of expansion. The Services ISM index also contracted with an index reading of 49.6, the first expansion-reversal since May 2020.
Also notable was that despite a number of geopolitical issues impacting the European markets, the S&P Global Eurozone Manufacturing PMI rose slightly to a still contracting economic index reading of 47.8. Overseas, business confidence also improved for the second month in a row, rising again from October’s two-and-a-half-year low, despite ongoing worries about inflation, high energy bills and recession risks. These factors were likely reflected in the rallies that helped the overseas markets outpace the indexes here at home.
Commodity Inflation Impact
Commodities are great barometers of both inflationary pressures and economic growth. The timing of both rate tightening and the ongoing Ukraine and Russia war has impacted a number of commodity prices, most notably food (grain prices) and energy (oil and natural gas). Early in the recovery from the pandemic lows, raw materials such as lumber were quickly bid up as the housing markets rallied. In March of 2022, the price of lumber (1,000 board feet) was selling for $1,460. Today, the price has fallen to $354 for the same quantity.
Oil prices have followed suit. In June 2022, both Brent oil prices and West Texas Intermediate pushed above the $120 price hurdle. Today prices have fallen to the $75 to $80 range. This top range will likely get tested given the Paris-based International Energy Agency’s recent upgrade in expected oil demand growth for 2023. With China now in a “re-opening stage,” total demand for oil is expected to increase by an additional 200,000 barrels a day. Today, there is definitely support for energy prices, but over time, we expect a further potential dampening impact on inflationary pressures as China re-emerges into the global economic mix.
Overall, rising rates have helped bring down a number of commodity prices as measured by the broad Bloomberg Commodity Index. The index is weighted approximately 30% energy, 23% grains, 16% industrial metals, 20% precious metals, and the balance is livestock and soft commodities (sugar, coffee, cotton). Since the June peak, the index has steadily declined. One exception, however, is copper. Since October, copper prices have continued to rise in anticipation of a restart in industrial demand. One possibility is the potential needs for China’s economic restart recently announced following their post-pandemic opening.
Also notable was the recent drop in the dollar to a seven-month low. Markets are now expecting a slowdown in domestic growth in tandem with what appears to be inflation trending downwards. This softening in the dollar exchange rate should help support our manufacturing exports both in China and Europe as the dollar declines and improves our relative export pricing in the foreign markets. The negative of course is that the weaker dollar raises the relative pricing of imported goods here at home.
Market Musings for 2023
Just a few weeks into the new year and investors are already trying to read the still cloudy tea leaves. There are indeed forward economic (and market) positive considerations:
• The University of Michigan’s January Consumer Sentiment survey rose to its highest reading since January 2022, up 8.2% from the December reading. Survey respondents were optimistic about the current state of the economy and were self-forecasting inflation’s decline with rates one year out of 4% and five years out of 3%.
• The January ZEW (German business sentiment survey) reported a surge in expectations by 40 index points for the second largest month/month increase on record. Improving export earnings with China’s lifting of Covid restrictions contributed to the spike in expectations.
• Investor cash continues to exit the market and sit in the sidelines; current money market rates help. This past month ICI estimated outflows from global equities amounted to $99 billion, December 1, 2022, through January 4, 2023 (representing future market buying power).
• Inflation is on the decline as evidenced by the downturn in CPI. Also consider that the recent economic reports are backward looking. Little forecasting is involved in reporting what has already happened.
• Strong labor markets and wage growth support consumer spending, while monthly job growth has remained robust with unemployment claims at still near historic lows.
• Although credit card use has increased significantly, household balance sheets can still support additional spending and borrowing.
On the negative front, considerations investors should factor in include:
• The markets have ignored Fed “rhetoric” and have been pricing in a pivot toward lower rates at some point this year—certainly not the Fed message. Fed comments have indicated that it will raise rates up to (and maintain) a 5% rate level until inflation is under control with no time frame mentioned.
• Bond yields are truly inverted with three-month and two-year Treasury yields higher than the 10-year bond (also the case for the 30-year note). In the past, this extended period where bond yields have “inverted, they have been reliable forecasts of an eventual recession.
• For many, a recession is not “if but when.” The question remains whether or not the slide into a recession now causes more economic pain. Impacts from the past rate hikes will still be working through the markets (and jobs), but at this point the underlying economy is likely in a good position to withstand a downturn.
From an investment perspective, considerations include:
• Bond yields (and short-term cash instruments) are attractive again and make sense from an asset allocation and investment perspective.
• Although analysts are currently forecasting a downturn in earnings this year, two reminders are that markets regularly underestimate corporate earnings and that the forecasts become less accurate over longer periods of time.
• Even though there are reasons for pessimism (inverted yield curves and recession watches), there are also reasons to be optimistic: Inflation has likely peaked; valuations on mid-cap and small-cap companies are attractive again (also the case for many overseas companies); investor sentiment is a poor gauge of the market’s direction; and although each market downturn is different, it is rare for the markets to have two consecutive negative years.
Not Investment Advice or an Offer -This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing. Argent Financial Group is the parent company of Argent Trust, Heritage Trust and AmeriTrust.