2023 Market Outlook

Tighten Your Belt or Risk Losing Your Pants

From the economic height of the post-pandemic reopening spending spree, the global economy is now struggling to find a balance amid a multitude of challenges. Persistently high inflation has pushed central banks to raise interest rates rapidly, with rates projected to climb higher in 2023. Globally, governments continue to struggle to maintain fiscal discipline. Robust labor markets propel consumers forward despite diminished net worth. China is reluctantly confronting COVID-19 with a largely unvaccinated and under-exposed population. The IMF and World Bank lowered their growth forecast for 2023. Corporate earnings are under threat and market volatility has risen. Critical supply and demand imbalances persist. Thus, the key question remains: can inflation be tamed without inducing a deep, global recession?

Inflation May Have Peaked But Is Not Yet Under Control

Central governments’ consternation with inflation represents an existential crisis.  Inflation is entirely within the central government’s control (i.e. money supply and fiscal spending) and yet threatens their own political stability.  Global rates of inflation continue to run well above pre-pandemic levels and far from stated policy goals. Though, as a positive indication for the years ahead, the latter half of 2022 showed signs that inflation may have peaked with key indicators heading lower in November.  While there are some signs of lowering inflation, the Federal Reserve (Fed) has repeatedly stated that Monetary Policy will remain restrictive until consistent evidence has shown that inflation is headed towards their long-term goal of 2%.

Perhaps counterintuitive, the challenge the Fed faces in sustainably bringing down inflation is the U.S. economy's own resiliency. Real (i.e., inflation adjusted) Growth Domestic Product (GDP) for the third quarter of 2022 grew at a 3.2% annualized rate - a distinct reversion from shrinking in the first half of the year. In previous tightening cycles, the terminal Fed Funds Rate has surpassed nominal GDP before inflation was deemed under control. With current levels of inflation and economic growth, that would require short-term interest rates to more than double.

At the December Federal Open Market Committee (FOMC) meeting, the Fed raised the short-term interest rate for a seventh consecutive time. Not since the early 1980’s has such drastic tightening policy been utilized to break the fever of rampant inflation. And yet, in Fed Chairman Powell’s own words, “we have more work to do.”

Stubbornly Robust Labor Market Provides Consumers With Confidence

The key area of focus for the Fed is a stubbornly strong labor market. The quantity of available workers, known as the participation rate, continues to fall and companies are left to compete fiercely for talent. This translates into an incredibly tight labor market with 1.7 job openings for every available worker. Consequently, Year-over-Year (YoY) wage growth is running at over 5%.  For context, a rate below 4% has historically been more consistent with the Fed’s longer run inflation target.

A recent survey by the Federal Reserve Bank of New York showed that the average reservation wage — the lowest wage respondents would be willing to accept for a new job — increased from $72,873 in July to $73,667 in November. Indeed, this favorable labor backdrop led to the Consumer Confidence Index unexpectedly rebounding in December.

Reliant on the perception of job stability and future wage growth, higher consumer confidence leads to more consumption even in the face of high inflation levels. Fed Chairman Powell acknowledged the challenge of contending with an overheated labor market remarking, “[i]t’s too great, in a way, because it’s going to be adding to inflation.”

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Households Maintain Cash Reserves While Net Worth Declines

Yet this uptick in confidence is not without reason. Despite spending more on goods and services, households have been able to maintain excess cash reserves through 2022. To make up the difference between maintaining cash reserves and increased prices for goods and services, credit usage has picked up the slack. In the third quarter, home mortgage debt increased 6.6%, while non-mortgage consumer credit jumped by 7.0%. In line with the Fed’s objective to remove excess liquidity from the financial system, as interest rates continue to rise, servicing this debt will slow spending and impede economic growth.

More broadly, the IMF and World Bank lowered their 2023 forecasts for global GDP growth, predicting that one-third of nations will experience at least two quarters of negative growth. For the time being, high income levels are supporting nominal spending in the face of higher prices, but longer-term real wage growth cannot support the current pace of consumption. Markets are digesting the impeding slow down and household net worth is declining. Reflecting higher mortgage rates, U.S. home sales declined for the 10th consecutive month in November, falling by 7.7% from October. Home sales are at their weakest level since May 2020. While housing inventories are rising, they remain under supplied which has dampened the fall in prices to this point.

Expansive Fiscal Policy Is Hard To Quit

Old habits die hard. One challenge the global economy is facing is simply that prior methods of success may not work going forward. In the face of an economic slowdown, the policy prescription would ordinarily call for fiscal expenditures to promote economic activity. And therein lies the problem. Our current economic predicament was created entirely from too much money being injected into the financial system by the central government. The correct course of action now requires the exact opposite -- but frankly, that is not politically popular.

The recently passed $1.65 trillion Omnibus Spending Bill increases YoY Federal discretionary and military spending. Transfer payments, a redistribution of income and wealth by means of the government making a payment, remain above pre-pandemic levels. The constitutionality of the Federal student loan forgiveness is being challenged but principal & interest repayment has been delayed until no later than June 30, 2023.

However, capital injections have not been restricted to the Federal level. In fact, as of the end of the third quarter, at least twenty states have provided some form of rebates to taxpayers in efforts to ease the burden of inflation. Though, with Republicans taking control of the House in 2023, the likely resulting gridlock may provide the reluctant reduction of stimulus the economy ultimately requires to find a sustainable balance.

Growing Geopolitical Tensions Add To Inflation

President Zelensky’s December speech in front of Congress provides further evidence that the conflict in Ukraine is far from over. With a fresh allocation of $45 billion, the total contribution by U.S. taxpayers to the Ukrainian cause now exceeds $100 billion. As the conflict draws on, the potential for direct involvement of U.S. troops through the invocation of Article 5 of the NATO Treaty becomes more real. Recent offenses within Russian territory have increased the stakes for a protracted affair with ever escalating costs and human casualties. Recently, an energy export embargo was enacted, intended to weaken Russia financially, by placing a cap on the price paid for oil at $70 per barrel. In retaliation, Putin has officially blocked the transmission of Russian energy to participating countries. Experts speculate that energy prices could surge and remain high through the summer.

Separately, China’s military exercises encroaching on Taiwanese territory have increased throughout 2022. Recently, after the Chinese government objected to a U.S. defense bill that was signed into law, as many as 71 warplanes and 7 ships were sent toward Taiwan. In response, the Biden administration approved an additional $180 million arms sale to Taiwan concurrently with the announcement that Taiwan would extend its mandatory military service requirement from four months to one year. To hedge against potential market fallout from these rising geopolitical risks, we strategically deploy protective puts and raise cash balances where prudent. In our view, the implied volatility priced within protective puts is attractive and we will continue to proactively build defensive portfolio positions for the time being.

China’s COVID-19 Reckoning May Hamper Supply Chain

In an abrupt capitulation, China has significantly relaxed what was once a very strict COVID-19 quarantine and testing program (i.e., its Zero-COVID Policy). China has not committed to providing updated data for infection and deaths, but it is widely reported that hospitals are now overrun with patients seeking treatment. To support the supply side of the economy, front line workers are being told to report to work regardless of symptoms. However, the risk remains that further delays and disruptions to supply chains as a result of increased infections in China may keep inflationary pressures elevated.

Adding further complexities to the inflation situation, Chinese consumers are poised to “revenge shop” much in the same way as the rest of the world acted when their economies reopened.  Restrictions on outbound travel from China have been largely removed and international tourism is expected to resume.  However, some countries, wary of an influx of cases and lack of data from China, are imposing COVID-19 testing, and possible quarantine, on visitors from China. For our part, having been focused on the Chinese consumer for some time now, the timing of the spending resurgence represents some countercyclicality and diversification benefits to our portfolios.

There also is a risk that inflation is more structurally entrenched than to which we have grown accustomed to over the last several decades. In the wake of COVID-19 disruptions, companies are broadly evaluating ways to mitigate risks to their supply chains. Across the U.S., terms like nearshoring and reshoring have entered the common vernacular of supply chain professionals. In contrast, the last several decades of globalization and offshoring provided benefits to manufacturing through proximity to raw materials and low labor costs. As emphasis was placed on efficiency and global competition, the net effect was stubbornly low inflation figures. The latest switch in approach prefers more closely located supply hubs which ensures quicker transit from manufacturers to customers but likely requires greater costs.  

Corporate Refinancing Presents Opportunities For The Patient Investor

Turning our attention to financial markets, despite the potential for a recession, credit spreads remain within relatively normal bounds. The yield curve is fully inverted (i.e., longer dated maturities have lower rates than shorter dated maturities) driven by the Fed’s action on the front end of the curve. Higher interest rates have looming implications for the corporate debt markets. Several trillion dollars’ worth of corporate debt is set to mature in the next few years.

New debt issuances as well as refinancing existing debt in a higher interest rate environment offers the potential for patient investors to lock in fixed income investments at higher rates of return than we have seen in decades. For now, however, the more attractive risk-reward tradeoff remains in more secure, shorter dated bonds. Additionally, in the not-too-distance future, we expect opportunities in the distressed debt market that offer investors asymmetric upside.

Cost Cutting In Order To Defend Profit Margins

Known as the Santa Claus Rally, it is not uncommon for stocks to perform well on the last week of each year. However, 2022 had no such good fortune. It is quite evident that equity markets are struggling to contend with restrictive monetary policy and likely economic slowdown.  While at present the economic weakness is primarily restricted to housing and core goods, investors are starting to price in the likelihood that weakness spreads into the rest of the economy. For example, short-term interest rate futures imply expectations that the Fed will start cutting rates in the second half of next year. We, however, are not completely convinced. While prices and inflation have moderated at the end of the year, equity valuations remain elevated and do not yet reflect the challenging time ahead for corporate earnings.

Early expansion in profit margins typically follow growth in revenues. With inflation at the highest level in decades and consumers’ pocketbooks flush with cash, companies were more than able to grow revenues and profits.  However, as interest rates continue to rise, the opportunity cost to save money will overtake desire to spend causing unit sales volume to begin to slow.  As sales volume decreases and revenues drop, the current outsized demand for workers will eventually be eliminated. The decreased demand for workers will help hamper surging wage growth. As future wage expectations normalize, consumers will be more cost conscious. Likewise, to maintain corporate profitability, corporations will need to deploy cost cutting strategies. Related, we expect unemployment to increase in 2023 and along with it, a rise in the likelihood of a recession. The timeline, duration, and depth of the next recession will very likely be determined by how much longer it takes for labor markets to find equilibrium and how high the Fed is willing to push interest rates to get us there.  It should be noted that historically, equity markets begin to recover two to six months before the end of a recession.

Buckle Up

2022 was an extremely challenging year for financial markets, seeing the worst performance in both equity and fixed income markets in a very long time. In our view, restrictive Monetary Policy is here to stay for the foreseeable future and market volatility will continue well into the new year. As the labor market continues to be a key sticking point to the Fed’s ability to curb inflation, we’ll be watching wage growth carefully as an indicator of labor market tightness and precursor for future Fed action.

Further related to the efficacy of central bank policy, a deadlocked Congress may provide the necessary reprieve in fiscal stimulus needed to help combat inflation, but political fortitude will be tested early and often. While geopolitical gamesmanship is mostly beyond our speculation, we are wary of the downside implications and continue to pursue investment methods to hedge this risk.

In general, we are constantly searching for attractive investment opportunities that provide asymmetric upside versus downside but further declines in asset valuations in the new year are quite possible.  Perhaps in an abundance of caution, we would rather tighten our belts than risk losing our pants.

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