Quarterly Commentary

4Q 2022

Looking back at 2022

Turbulent from the start, 2022 will be remembered as the year when inflation surged to levels not seen in forty years. Suddenly aware of the need to quell inflationary pressures, the Federal Reserve and other central banks changed gears and began jacking up interest rates. Investors were clearly surprised by the policy shift and are still absorbing the implications of the apparent end of the “easy money” regime that had supported asset prices over the previous decade.

Most types of investments fared poorly. It was the first year on record that both US stocks and longer-term bonds fell by more than 10%. The invasion of Ukraine led to alarming price spikes in global energy, food and other raw materials markets. As the year progressed it became evident that the Fed and other central banks were resolved to keep raising rates until inflation is contained. That brought a new concern to the table – the risk of a central bank overshoot – where higher interest rates trigger a recession.

Strategies that had produced outstanding returns over the previous decade failed in the face of higher rates and heightened uncertainty. The Nasdaq 100 index (large technology stocks) fell 33% and small unprofitable tech stocks fared far worse. Foreign stocks, many commodities, real estate, and digital assets saw declines similar to the 19% drop in US stocks by the end of the year. The “everything selloff” meant that conventional balanced portfolios did not provide their usual protection.

In retrospect, it is abundantly clear that bonds were vulnerable as we entered 2022. The Consumer Price Index was breaking higher, having risen 6.7% over the previous twelve months. The interest paid on one-year Treasury bonds had also begun to rise – from 0.1% all the way to 0.4%. If inflation were to continue rising at that pace (it did), anyone buying a bond at that time stood to lose more than 6% as the meager yield was overwhelmed by the loss of purchasing power. Similarly, ten-year Treasuries were priced to yield 1.5% despite a markets-based measure of expected ten-year inflation that stood at 2.6%. A buyer of those bonds was expected to lose 1.1% each year for ten years due to inflation.

While this seems irrational, negative real returns for bonds had become the norm in the easy money era. Investors came to expect low inflation and even lower interest rates. Inflation was checked by abundant cheap labor (especially overseas), increasing fossil fuel production (particularly in the US), cheap and safe transportation and complex just-in-time supply chains that facilitated procurement at the lowest possible cost. These disinflationary forces offset government spending that saw US money supply (currency, bank deposits and money market funds, known as M2) increase from $10 trillion in 2012 to $15 trillion at the end of 2019. Then came the pandemic, with even more rate suppression accompanied by massive government spending. Money supply grew from $15T to $21.5T in a little more than two years. The economic recovery that sharply accelerated with the introduction of vaccines in late 2020 saw a sharp rise in demand as the previously disinflationary offsets were in total disarray. What was hard to see in advance was how these many factors contributed to the inflation shock, and how, after dithering around, the Fed would forcefully respond.

Where do we stand now?

The year-over-year change for the CPI peaked at 9.1% in June and has receded slowly since then – December’s reading was 6.5%. The trend is now down rather than up (less inflation, not deflation, to be clear). The household expenses that drove CPI inflation in 2022 were shelter, food, new and used cars, gasoline, utility bills, and health care. Underlying each category is a mix of pandemic-related demand spikes, short-term supply chain issues (computer chips, building materials), higher wages paid, and higher energy prices (fuel, fertilizer, chemicals). Each should stabilize and many could decline as the year progresses (some already have, such as Natural Gas), which would allow the Fed to slow down and then pause its interest rate increases.

The bond market looks safer now. The yield on a one-year bond moved up to 4.7% – investors will realize a positive return if year-over-year inflation recedes to that level. The comparison between the ten-year yield and the ten-year inflation breakeven rate has turned positive with the current reading of 1.6% last being seen in 2010.

Equity investors are busy trying to predict when the Fed will pivot, first to neutral (a pause), and then to a rate cut. The goldilocks scenario for stocks is a so-called soft landing in the US and Europe. That would be year-over-year inflation returning toward 2-3% with no more than a short and shallow economic slowdown that rebalances job markets without high unemployment levels. Should this come to pass, Fed chief Jerome Powell would deserve a ticker tape parade down Broadway. But the outcomes are not binary – soft landing or hard landing – and while we fear the Fed may go a bit too far, they will eventually get it right.

Our outlook

The path to last year’s results included three rallies of 10% or more. Each fizzled out. Commentators are constantly speculating on the timing of the Fed pivot, and investors want to be sufficiently invested when the turn eventually arrives. History shows that stocks do well in the year following (choose one): the peak in inflation, the bottom in business expectations (PMI), or the last in a series of Fed interest rate increases. Given today’s circumstances, we are not sure these examples can provide much of a guide. Moreover, the Fed is advising everyone to chill, and an exuberant stock market is not what it wants to see. It’s likely we are much closer to the end than the beginning of this tightening cycle but that’s not to say the coast is clear.

As fundamental investors focused on individual company financials, we try to purchase a stock when the price is sufficiently low to account for the risks we can see, and hopefully a few we can’t. Said another way, we look for overly pessimistic expectations to be priced in before we buy. We do our best to trim or exit positions when the tables have turned, and other investors are more sanguine. It doesn’t always work as planned, yet it is a process that has worked over time. Our goal is to take advantage of the fear of loss when the stock market is weak and the fear of missing out when the market is moving up. 

As we enter 2023, we are hoping for a pivot and we are hoping for a soft landing but we are not betting the proverbial house on either. Geopolitical risks remain elevated, the path to lower inflation could be erratic – and those are just the known unknowns. We expect another year with ample volatility to test our discipline and resolve.