Investor resolve was tested in 2022 with a return to a bear market. Seismic shifts in the macroeconomic backdrop, from elevated inflation readings across the globe, to continued disruption of global supply chains, ongoing commodity price pressure and aggressive central bank monetary policy actions, to name a few, created a perfect storm that led markets lower. As of this writing, both equities and bonds have negative year-to-date returns in the double digits. For investors, it may have felt like there was no place to hide, leaving many searching for clarity and direction.
While macro headwinds swirled throughout the year, we believe the two primary culprits of dramatic moves in financial markets were inflation and Federal Reserve (Fed) monetary policy. As it relates to inflation, the U.S. Consumer Price Index (CPI) started the year at 7.0%, already a far cry from the Fed’s 2.0% target. Investors watched it climb to a peak of 9.1% in June before declining to 7.1% in November. For perspective, the last time CPI was above 9.0% was 41 years ago in 1981.
The fed funds rate, the tool the Fed uses to implement changes in monetary policy, increased this year at the most rapid pace in history. Fed funds started the year with a target range of 0.00% – 0.25% and now sits at 3.75% – 4.00%, with most of the move happening since June. We believe, given recent Fed commentary, that the central bank will continue raising rates in the near term. The Fed recently increased 0.50% at the last meeting of 2022 and we anticipate additional increases into 2023. Again, for perspective, the last time the fed funds rate was 4.00% was in 2008.
As the path of inflation and fed policy remain key drivers heading into the new year, from our perspective, it is increasingly evident that many parts of the globe, including the United States, will find themselves in a recession at some point in 2023. Over the past year, the business cycle has been in a “slowing but growing” phase as economic growth declined versus the year before but earnings growth remained strong.
By design, as the Fed increases interest rates, economic activity and consumer demand typically decrease as short-term borrowing costs rise. This affects individuals as well as businesses. The slowdown in demand eventually leads to lower profit margins for companies. With lower profit margins, companies rein in spending, which can lead to job destruction, either through fewer openings or direct layoffs. Monetary policy impacts the economy with a lagged effect, and for this reason, as the Fed is forced to increase rates to tame inflation, it is simultaneously decreasing demand and moving the U.S. economy closer to a potential recession in 2023.
The most recent recession, which lasted from March to April 2020, was purely driven by the onset of the pandemic and was the shortest on record at only two months. As such, it hardly serves as a useful guide for investors. Prior to that, investors would have to look to the Great Recession that followed the global financial crisis in 2008. While investors may be able to glean from it some useful tips to navigate the next recession, again, we do not believe it represents what we may face in the new year.
While no two recessions are identical, they do tend to have similar characteristics. For example, unemployment increases, credit tightens and profits fall. This was certainly the case for 2008. Although the same might be true should we enter a recession in 2023, we certainly do not expect it to be of the same magnitude. The primary difference is that this would be a monetary policy-induced recession instead of a recession driven by an overextended credit environment. This key distinction allows us to approach 2023 with caution, but also with a plan of action for each asset class.
In this year’s outlook, we attempt to shed light on the potential path forward for each asset class and how investors should be positioned as we venture into the uncharted territory of 2023.