2022 was a year that focused on inflation’s potential impact on financial markets and asset prices. It was twice as bad as the global financial crisis in 2008; nearly $40 trillion in stock and bond value disappeared.
2023 will be a year in which the second-round effects of that inflation and subsequent rate hikes actually materialize.
This will come at a time when central banks around the world are raising interest rates to slow their economies to tame inflation, and shrinking their balance sheets from having over-stimulated economic activity for the past 14 years. The global money printing press stopped in 2022; we should now expect growth and inflation to fall.
To fight inflation, the US Fed raised interest rates last year more quickly than foreign central banks. As a result, the US dollar appreciated by 8% relative to all other world currencies last year. A strong dollar muted the impact of inflation in the US, as imported raw materials and goods cost less. In 2023, we shall now see underperformance of the USD, as foreign central banks raise rates in a “catching up” process, and money flows toward those currencies.
Market expectations are now poised for a quick fall in inflation. But a falling dollar makes high inflation a bit “stickier”, as does upward pressure on wages, which grew at a historically strong rate last year, but still failed to keep pace with inflation:
Source: Atlanta Fed
Short term interest rates as predicted by the futures market, to peak in mid-2023 at around 5.00%. The Fed itself expects a range somewhere between 4.875% and 5.625%. Most FOMC members expect Fed Funds to end the year somewhere between 5.125% to 5.375%.
The US Central Bank is now withdrawing liquidity at a level of $95 billion per month from the financial system, or roughly $1.1 trillion per year. Globally, central banks worldwide have reduced their balance sheets by $3.1 trillion in the last seven months. To put it simplistically, when the Fed prints money and buys assets (as they have done since 2008), asset prices go up. When the Fed withdraws money from the economy, asset prices fall. This is only one piece of the puzzle concerning 2022’s selloff in stocks, bonds, and real estate, but an important one. Since the 1960’s, there has never been a year when the US money supply didn’t grow until last year.
Rather than trying to predict peak inflation, let’s focus on the real economy and examine what might be store for the coming year:
The US unemployment rate is still very low at 3.5%, which, in this inflationary economy, could actually be bad for stocks. As we hover near half-century unemployment lows, any upside pressure on unemployment is likely to come from job losses, which in turn impacts consumption and revenue growth at US companies. While wages grew at a fast pace in 2022, they did not keep track with inflation which still remains at an elevated 7.1%. The Fed forecasts that unemployment will rise to 4.6% this year, while private economists see that number somewhat higher at year’s end. The tightening of US financial conditions in 2022 certainly has set the stage for a much weaker labor market in 2023. Tighter financial conditions tend to lead hiring trends by three quarters. Recent examples might include Amazon, which shed 18,000 employees this week, Meta/Facebook (11,000 employee layoff announced), Wells Fargo (10,226 in 2022), Google/Alphabet (10,000 in November), Microsoft, Twitter, Salesforce, etc.
“Global Credit Impulse”, which measures the pace of money creation in the world’s top five economies, has been sharply declining since mid-2021. It measures whether the real spending power of households and businesses are accelerating or decelerating. This indicator tends to lead the stock market by 4-5 quarters, and earnings growth by 4-6 quarters. It suggests a hard landing ahead. The less inflation adjusted money creation is available for households and businesses to spend, the less likely they are to boost consumption and spending.
Consumer demand is waning. Pent-up Covid related demand and savings kept spending healthy in 2022, but higher interest rates are starting to bite. Household debt as a percentage of disposable income has increased from 12.5% two years ago to 14.5% today. Recent comments from Target, Walmart, and others point to a stressed consumer.
The corporate earnings outlook is being slashed by Wall Street analysts, and could be lowered further as pressures pointing to a slowing economy are intensifying due to the lagged effect of the fastest Fed rate tightening cycle in decades. Wall Street consensus estimates predict a 2.8% year-over-year drop in earnings and just 4% revenue growth for S&P 500 companies in the fourth quarter. Corporate earnings season begins in mid-January for Q4 2022, and will be important for the 2023 outlook for stocks.
High inflation impacts corporate margins because raw material input prices increase. While companies were able to largely pass on costs in 2022, will they be able to do the same in 2023? Will they be able to sell enough to offset margin compression? If the US dollar falls in anticipation of “peak” interest rates, input costs for imported goods will go up, exacerbating margin compression. Lower margins translate to lower earnings.
US Leading Economic Indicators are offering recession signals:
A new corporate tax on stock buybacks is taking effect now, in January, for publicly traded companies. This was anticipated by a flurry of stock buybacks in the fourth quarter of last year. Stock buybacks have been supporting the stock market ever since zero interest rate policies were enacted under Former Fed Chairman Bernanke. Companies would borrow at low rates and use the proceeds to buy back their own stock. Now with higher rates, higher uncertainty, and now a 1% tax on these activities, expect stock buybacks to decline.
The best predictor of recession comes from the bond market. When the spread between the 2 year bond yield and the ten year bond yield goes negative, there are many examples of a recession that follows. This has occurred 4 times since 1980. The current 2 year-10 year bond spread is nearly at negative 1 percent, the lowest it’s ever been.
Stock valuations are still expensive, even after the 2022 selloff. The forward P/E of the S&P 500 currently stands at 18.82 times. Since 1980 the average valuation for that index was 16.44 times. The average drop in profits during a recession, from peak-to-trough, is 20%. Wall Street consensus is for this year’s S&P 500 earnings to come in at $234 per share, which represents only a 3% drop. There is ample room for downward earnings revisions by Wall Street analysts given the likelihood of a recession. Let’s assume $205 per share after analysts do this. Without a recession, the market’s P/E could fall to 17 times that number, or roughly 3,500 on the S&P index, 8.4% lower from current levels. With a mild recession, or “soft landing”, the market’s P/E could fall to 15 times per share earnings, or roughly 3,100 on the S&P index, some 19% lower than current levels. And with a severe recession, things get much worse, which we won’t speculate on here.
The market is bracing for an increase in credit downgrades and defaults, which means that investors may be forced to reduce their exposure to the $1.4 trillion junk bond market this year. Many institutional investors are bound by rules concerning a minimum quality of credit in their bond portfolios. When credit ratings are downgraded, those investors are forced to liquidate exposures that fall below a certain threshold. This could prove to be unsettling for markets, and make it harder for lower credit quality companies to obtain financing.
The December Services PMI (Purchasing Manufacturer’s Index) just dropped into contraction territory at 49.6 from 56.5 the prior month. Anything under 50 is a contraction, and we haven’t seen that since May of 2020. From the same research group, the New Orders index is also in contraction at 45.2
A disturbing trend worth noting is that American consumer debt just hit a record $16.5 trillion (a new record, with $1.27 trillion added in the last 12 months), at a time when savings rates are hitting a 50 year low:
Source: St. Louis FedCredit Card debt is reaching all-time highs as well, totaling close to a trillion at year’s end. The chart below shows outstanding credit card debt (top line) vs. US credit card interest rates. Consumers are borrowing record amounts even as interest rates hit their highest levels in decades. The American consumer is on perilous ground:
Source: Bloomberg
An imminent danger to markets is the political theater building over the Federal debt ceiling. The government now has permission to borrow up to $31.4 trillion. When it hits that level (which should happen in the coming month), the US Treasury can no longer issue any more debt to pay its bills without congressional approval. The Treasury may decide to use “extraordinary” measures to keep the government solvent, but that will only last until mid-2023. Beyond that, the credit rating of the US is vulnerable, as it was in 2011 when the same scenario played out and the United States lost its AAA credit rating.Stock market lows come after recessions begin, usually about two-thirds of the way through the recession, and the recession has not yet begun. A recession will not begin in the U.S. until unemployment ticks up. Given a mid-2023 convergence between spending slowdown, increased unemployment, and debt ceiling standoffs, it is increasingly likely that a recession could arrive in late Q2 or Q3 of this year
Newly appointed House Speaker McCarthy has already indicated that the GOP will demand spending cuts in exchange for lifting the debt ceiling. It’s worth noting that the 2011 Congressional brinksmanship caused a selloff of around 15% in the US stock market.
Manufacturing conditions in the U.S. are deteriorating. The New York Fed said its general business conditions plunged to a negative 32.9 in January from a negative 11.2 in December, with a negative reading indicating a contraction. Economists had expected the index to climb to a negative 4.5. Stripping out the Covid period in 2000, it's the worst print this economic indicator has had since March 2009.
Stock market lows come after recessions begin, usually about two-thirds of the way through the recession, and the recession has not yet begun. A recession will not begin in the U.S. until unemployment ticks up. Given a mid-2023 convergence between spending slowdown, increased unemployment, and debt ceiling standoffs, it is increasingly likely that a recession could arrive in late Q2 or Q3 of this year.
Stocks and Bonds aren’t the only asset class which have been hit hard. The housing market is extremely weak due to rising mortgage rates. Accounting firm KPMG expects home prices to drop by 20% in 2023, while banks preview a drop of 5-7.5%, on average. Housing is a leading indicator of unemployment, with a lag of around ten months. The following chart demonstrates that unemployment may rise given the drop in housing over the past year:
Bonds seem to be a better path for the first half of 2023 given that they are now inexpensive and offer a yield of 5.5%(S&P500 bond index) vs a 1.7% dividend yield for the S&P 500 Index, which is still overvalued.
For the first half of 2023, do not be surprised to see the Fed continue its hawkish path of rate rises. It is signaling a “higher rates for longer” message and is unlikely to cut interest rates until well into 2024.
The Nasdaq fell 33.1% in 2022, the S&P 500 was down 19.4%, and the Dow fell 8.8%.
Wishing a Happy and Prosperous New Year!
Grant Rogers
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