Market Data for year-end 2022:
- S&P 500 Stock Index: 3840, down 19.4%
- Ten-year Treasury Note Yield: 3.88%, up 2.37%
- Gold: $1,824 per ounce, down 0.3%
- Oil: $80 per barrel, up 6.7%
Both stocks and bonds suffered significant losses in 2022, as persistent inflationary pressure forced the US Federal Reserve to raise their benchmark overnight interest rate much more than investors expected at the end of 2021 (4.25% actual vs .75% expected). This outperformance of expectations by the Fed dealt a particularly severe blow to speculative assets, such as previously high flying “growth” stocks and crypto “currencies.” These assets were inflated to extreme, if not outright ludicrous, valuations by the Federal Reserve’s previous wildly over-stimulative post-Covid monetary policy in conjunction with massive “emergency” fiscal stimulus from the Federal government.
Unfortunately, these excesses in policy created an excess of consumer demand that helped push price inflation to four-decade highs. While Covid-related supply chain disruptions and Russia’s war in Ukraine also contributed to inflation, the primary culprit was an over-stimulated US economy. There are only two ways to deal with such a demand-driven inflation: (1) tightening monetary policy and/or (2) fiscal (taxation and spending) policy. Fiscal policy tightened in 2022 by virtue of Covid-related spending rolling off, while the Fed increased interest rates and slowed growth in the overall money supply.
As the huge run up in the price of risk assets in 2020-21 was aided heavily by inflationary governmental policies, it was almost axiomatic that the withdrawal of said policies would result in a retrenchment with the most speculative assets suffering the worst losses. The corollary to this phenomenon is that those assets which were not heavily assisted by government stimulus experienced relatively muted losses. As you will see in your rates of return, this proved to be the case with our high-quality, dividend growth strategy.
Moving forward, the single biggest driver of market performance will continue to be the evolution of Federal Reserve monetary policy. We do expect that the Fed will refrain from further policy tightening at some point in 2023. The uncertainty, however, is not only when, but also at what level of price inflation. This depends on the ongoing strength of the economy versus the Fed’s tolerance for an increase in unemployment, which is necessary to drive inflation down toward their professed 2% target. We have always felt that the Fed would likely settle for an inflation rate above 2% to avoid significant levels of unemployment. This being the case, the real question in our mind is when will the core rate of inflation settle into an “acceptable range of three to four percent versus today’s 5%?
The sooner this happens, the better it will be for asset markets. Over the longer-term, however, the Fed accepting a higher level of inflation implies higher long-term interest rates and lower valuations for stocks, particularly “growth” stocks that pay a marginal to non-existent dividend. With corporate bonds yielding five to six percent, as opposed to the three to four percent of the past decade, investors will be much less interested in owning stocks that do not provide a competitive income stream. Accordingly, our dividend growth-centric strategy is particularly well positioned for the years ahead.
Beyond Federal Reserve policy, there are other factors that could significantly impact asset prices in 2023. These include the path of the pandemic, the war in Ukraine, and the possibility of a debt ceiling “crisis” in Washington. Concerning Covid, China’s rapid emergence from their “zero-Covid” strategy has the potential to upend activity in their own economy, while potentially unleashing a new wave of infections upon the rest of the world. We will not handicap this further other than to say we are following the situation. Regarding the ongoing war in Ukraine, a significant escalation in hostilities between NATO and Russia would almost certainly send a wave of fear through markets. Once again, we are not making any specific predictions, but will continue to follow developments closely.
We do have a relatively higher degree of certainty that there will be some sort of brinksmanship involving the raising of the Federal government’s “debt ceiling” sometime in the fall. It is no secret that the incoming Republican controlled House of Representatives is looking to make mischief for the Biden administration, and threatening to cause a default on the US national debt is certainly the most powerful weapon in their arsenal. Such a default would be catastrophic for financial markets as US Treasuries are the bedrock of global finance. These showdowns were common during the Obama administration and never led to an actual default, so perhaps investors aren’t taking the current threat seriously. Be that as it may, we’ll see how they feel about it when they come face-to-face with the prospect of a global financial calamity. Our guess is that they aren’t going to like it.
For 2023, we see US stocks, as represented by the S&P 500 stock index, trading in a range of 3300 to 4300. (It ended 2022 at 3840.) We think a realization by investors that the Fed may settle for an inflation rate above 2% will keep the benchmark ten-year Treasury note yielding comfortably above 3% (currently 3.88%), while slower overall global economic growth will likely lead to stable to declining commodity prices.
As always, we appreciate your business and the continued confidence you have placed in us. Please do not hesitate to contact us with any questions or concerns you may have. We wish you a healthy and prosperous 2023.