Courtesy Hedley & Co. PLLC
By Kevin M. Hedley
Looking back on 2022, for much of the year inflation was a major topic.
Inflation peaked at 9.1 percent in June of 2022 which was the highest rate since 1980. Inflation is measured by the Bureau of Labor and Statistics which calculates CPI inflation by taking an average weighted cost of a basket of goods and dividing it by the same basket of goods from the previous month.
So, a lot of the inflation numbers reported are based in comparison to the previous month and not since the beginning of the year. Some of the root causes of inflation included higher commodity prices due to supply issues which was exacerbated by the war in Ukraine, higher prices due to increased demand of consumers who spent less in the pandemic while saving more and supply struggling to keep up, and tight labor markets leading to increases in employee wages.
In order to combat inflation, the Fed has tightened its monetary policy by continuing to raise interest rates at it’s most aggressive pace since the 1970s. It appears the Fed has made combatting inflation a top priority, understanding the risk of being so aggressive may cool the economy to the point of triggering a recession.
Coming into 2022 there was a lot of sentiment that the Market was “expensive” from a price to earnings perspective and a correction could be possible. If you were invested in the market in 2022 you were likely at a loss in your portfolio for the year with key indices such as the S&P 500 down over 18 percent, NASDAQ down nearly 33 percent and Dow down nearly 7 percent.
Often when the market is struggling investors move to bonds or fixed income due to an often‐inverse relationship. However, in 2022 Stocks and bonds had a positive correlation and both had negative years.
Bonds had either one of their worst years ever if not ever depending on the indicator used from a performance perspective.
As we head into a new year, there is a lot of talk about a looming mild recession. As previously discussed, the Fed is more concerned with inflation than a recession. It is expected that the Fed will continue to raise interest rates, while perhaps more slowly with the goal of getting closer to the target rate of 2 percent inflation. Even if recession is avoided in 2023, corporate earnings will largely determine the economic growth and thus outlook for 2023.
Several leading indicators of a recession include growing corporate inventories, an inverted yield curve which has preceded every recession since the 1960s. This means short term interest rates exceed long-term rates thus removing the premium for time. Other signs are the market downturn experienced over the past year, home building and home buying are falling dramatically along with all of the associated employment and materials. Also, a divided government since the midterms historically means gridlock, where reform or any decisions such as providing fiscal stimulus may be very difficult to achieve.
While recession concerns may be real, there are some aspects that may buffer a recession to an extent. Coming out of the Pandemic household balance sheets are still strong and many homeowners have financed their homes during the historically low interest rate environment of the recent past.
There is still a very tight labor market with more job openings available than employees to fill them. While it is likely layoffs will increase as corporate profit margins remain tight, there is room for layoffs to occur and stay near historical averages. This is not optimal for the average US worker but may be a positive for corporate margins and the market.
From an investment perspective, slow economic growth is the expectation by many, and therefore to an extent priced into the markets. Price to earnings ratios are more in line with historical averages compared to the high ratios coming into 2022. Investors will therefore be assessing whether actual earnings and economic data meets, exceeds, or disappoints relative to expectations coming into the year. With so much uncertainty, it may be important to focus on the quality of individual companies that have stable cash flows for the upcoming year.