Matthew Davis presents our 2023 Economic Outlook with insights into recent economic events and thoughts on where we might be headed.
Transcription
Hannah
Hello, everyone. I’m Hannah Boundy, and I’m joined today by my colleague Matthew Davis to share some current market insights as well as our thoughts on where we might be headed next and what that means for our investment outlook. As you well know, last year was a unique year with declines in both the equity and fixed income markets though we’ve seen quite a bit of recovery in recent months. A lot of our expectations about what’s next are influenced by where we’ve been, and so we’ll begin our presentation with a look back at 2022. Matt -
Matt
Appreciate it, Hannah. Like Hannah mentioned, 2022 was a pretty unique year as we can see in this first chart. Looking at this second bar from the right, we see the S&P 500 was down 19% for the year, although at one point, it was down as much as 25%. 19% is easily the worst year the stock market has had since 2008 and one of the worst years we’ve had in the past 40 years. It was the 3rd worst year we have had since the 1980s.
But the more intriguing part of the market for 2022 was actually the bond market. Here, we’re looking at the same type of chart here, but for the bond aggregate, which is a bond index similar to the S&P 500, but for bonds. Here, we see the bond market was down 13% last year, though it had fallen as much as 17% during the year. Looking at this chart, we can see it was easily the worst bond year by a significant margin since 1976. Just to give you some context with respect to how far back this chart goes, the second worst year we see for bonds was a negative 3% in the mid 1990s.
Hannah
Obviously, this was a really bad year for fixed income and very unusual to see this kind volatility, especially to the downside. When we look at performance last year, it’s clear that one reason it was so painful was that we weren’t getting many benefits from diversification. Historically, when we get a down year in the stock market, we’re able to cushion some of those declines by pairing stocks with bonds who have historically been negatively correlated. That wasn’t the case last year. Instead, both markets declined.
Matt
Correct. And a big part of that was inflation. 2022 saw a significant surprise in inflation, as I’m sure many of you experienced in your day to day lives. You can kind of see it in this chart. There’s a big, big jump up, pushing close to 9% in price increases, which again, historically, you have to go back all the way to early 80s, late 70s to see inflation of this magnitude because inflation has really been tame for several decades now.
Hannah
I think it’s worth noting that while 9% is certainly painful, it’s not hyper-inflation either. It’s not pleasant for anyone, but it’s also not a massive crisis either. Hyper-Inflation occurs when prices increase by more than 50% month over month – something they’re experiencing in places like Sri Lanka and Venezuela which can lead to social unrest and upheaval, and fortunately, that’s not what we’re seeing.
Matt
That’s right. It was a difficult 12 months, but it was and is tamable. And the good news is we’re already seeing progress on the Federal Reserve’s efforts to tame inflation which has had a positive impact on market performance so far this year. To see more specifically what is driving inflation to finally start slowing down this, we can look at this bar chart here. To the left we can see different categories of goods and services that are driving inflation. Starting at the bottom we see shelter and restaurants, and here’s kind of a catch all - food at home, new and used vehicles, and energy. And actually, when we met last year in May, we shared that we thought we were really close to a peak inflation, and we were just a month off.
Here, we see the peak came in June. We got all the way up to 9.1 %, and then we’ve seen it trending down since then, but it did trend down slower than was expected. And that was again part of the volatility we saw in the back half of last year. There are several big components that are having the biggest impact on the drop in inflation. One is oil. The price of oil has come back down. The next area is new and used vehicles. That market has finally normalized somewhat. We’re also seeing some of the supply chain disruptions we saw during and after the pandemic are starting to go way, especially on the vehicle side, and those are pulling inflation down as well. Shelter, however, has remained very sticky. In fact, home prices and rent are still trending up slightly. Theoretically, those should come down with higher interest rates affecting mortgages and making it more expensive to afford a home, but we haven’t seen that expected correction materialize just yet.
Hannah
And all of this really begs the question – if inflation has been so impactful last year and is such a big deal for the economy, what can be done to reign it back in? And of course, we know that the answer is the Federal Reserve Intervened. And we’ve written about this in the past. The Federal Reserve has a dual mandate which is to keep unemployment low and to keep prices stable, which is another way of saying, keep inflation stable. And they do that by moving the federal funds rate, which is the rate that banks can borrow money at, up and down. Part of the problem before is that money was cheap, and because it was cheap and plentiful, there was a lot of demand for goods. And in a simple supply and demand equation, we know that when demand increasing and supply holds steady, or in some cases decreases, price goes up, and we have inflation. So to bring demand back down, what the Federal Reserve does is they raise rates, and in doing so, they make money more expensive – it becomes most costly to borrow – and because money is hard to get, demand falls, and prices start to fall.
Matt
And that’s exactly what took place last year. So here we have a chart of the Federal Reserve raising rates, and the idea here is that they are pumping the breaks on the economy to bring inflation to back down and like Hannah said, they do that by making money expensive. And so again in this chart, what you see the sharp increase here on the right side, and that was the Fed increasing rates all the way up to 4.6%. What is remarkable about that number is not only that it’s one of the highest rates we have had in over a decade, but it that pace at which the Federal Reserve increase rates was incredibly quick. If you kind of look back between 2016 to 2020, it took us 4 years to go up about 2 and a half percent.
This past year, it took us about seven months to go up 4.6%. So, it’s not just that rates got up so high, but how quickly they went up. And while it was dramatic, we also see it’s what was necessary to bring down inflation. Here you can see some of these other lines - this dark blue line shows what the fed themselves are expecting as their trajectory for interest rates, and what that tells us is they will likely increase rates a little bit more, but then probably drop them back down. Looking at this green line, we get an idea of what the market is actually expecting them to do. And there seems to be quite a bit of consensus across the board that we are near the peak of raising rates, and then the Fed will normalize rates back down and take some of the pressure off the economy.
Hannah
Which brings us to one of the biggest questions on everyone’s mind right now, and that is, what is the likelihood of a recession – and of course, an easy definition of a recession is when we find ourselves in two back-to-back quarters of negative growth, for example, two quarters in which GDP declines.
Matt
Right. And we don’t know for certain what will happen. We don’t have any crystal balls in our new office. But our expectation is that there is still a decent chance we will enter a recession. However, if it does occur we also expect it to be pretty shallow with just a mild decline in growth. This chart offers us a forward indicator of the likelihood of a recession based on tracking against various economic data that is out there. Looking back on 2020, you can see, kind of across the board, everything was flashing red in the early stages of the pandemic, because everything was coming to a halt. And that’s a very clear sign of a recession.
Right now, we’re starting to see some red lines flash on the production side. Retail has fallen. Holiday sales were a little bit slower than history would suggest they should be. Having said that, some areas of employment; some of the payroll numbers are not looking that bad. All that to say, a recession could be coming. There are some indicators of it potentially happening already.
Of course, surprises can also happen. The news cycle is constant in this day and age, and who knows what the future holds, but the data suggests that if there is a recession, it will likely be a mild recession. And one of the big reasons for that is unemployment and wages. Unemployment remains reasonably low. Through January of this year, unemployment stayed at 3.4%, which is way below historical averages.
Hannah
And unemployment is typically inversely correlated with recessionary environments. Typically, in a recession, we would see unemployment climb as companies cut jobs and spending to weather an economic downturn. And we’ve seen a little bit of that, especially in the tech sector, which went on a hiring spree when the pandemic ended. But for the most part, we’re not seeing huge layoffs and rising unemployment. In fact, wage growth has been robust and, in some respects, is a big part of what’s contributing to higher inflation. People were getting large raises as the labor market was declining, with more individuals retiring or leaving the workforce for other reasons such as the inability to access childcare and with more discretionary income, they were able to spend more, and that competition for goods was pushing prices up.
Matt
That’s right, and now we’re seeing wage growth is finally coming back down, which again suggests inflation is coming down, but not necessarily that people are being laid off and cannot find any jobs. Unemployment is staying low, and hopefully that means the Federal Reserve is successfully threading that needle of bringing inflation down without bringing the economy to a halt. So again, a relatively positive sign, and hopefully a sign that if a recession does occur, it won’t be too deep. When we think about a recession, consumer finance is another thing we look at as an indicator. And when it comes to our individual balance sheets, on average, consumer health is still pretty good.
I want to point out this top right chart here which shows our debt payments as a percent of our income. What it’s getting at is how much of our income are we spending on debt servicing – things like interest payments? And we see that debt payments remain at historically lows levels: a little bit less than 10 %. You can see back in 2007 and the beginning of 2008, that number was around 13%. And what this tells is that households were in a leveraged place and had to cut back on other spending to pay down debt, and when that happens, that can send the economy into the recession. We are not seeing that right now. People's balance sheets are still relatively robust. Looking at that bottom right chart, this shows household’s excess savings. And again, what this shows is an excess of money and part of what was driving inflation last year – there was so much money being injected into the economy.
JP. Morgan, who puts out these charts, estimates that over $2 trillion of excess savings was being added to the economy. And as we talked about earlier, too much money chasing too few goods causes the price of those goods to rise. However, as those prices rise, people start dipping into and spending down their savings and at this point we would there’s a little bit less than a trillion left in excess savings. What this means is that people still have some savings built up, but it’s coming back down, and as excess savings dry up, inflation should also slow.
Hannah
Matt, we’ve talked a lot about the economy. You’ve shared about inflation, and interest rates, and the possibility of a recession. But economics is kind of the here and now. What does that mean for markets that are forward looking?
Matt
Yes. That’s a great point. The financial markets are always forward looking, which is why they sold off last year – in anticipation of a potential recession. But that expectation of a recession is now baked in. So the question to ask when it comes to the markets is what do we expect happens next? What kind of opportunities are on the horizon?
This chart looks at valuations in the stock market, specifically the S&P 500. It is a way of looking at valuations and trying to understand if stocks are expensive or cheap based on historical standards. And here the answer is that they’re not that cheap. They have definitely come down. But part of that is that they were trending expensive for a while. They had become overpriced. There is still a little bit of above average pricing, at least when it comes to the forward PE ratio. So even though that they have sold off, we are not necessarily jumping up and down saying, hey, there’s a great opportunity on the stock side.
What we are seeing is opportunity over on the bond side. This chart shows us yield to worst.
Hannah
And you can kind of think of yield to worst as a measure of the worst possible yield a bond can receive based on the earliest date it can redeemed without defaulting. So you can kind of think of it as the worst possible annual return that bond is expected to generate based on where rates are at this current juncture in time.
Matt
Or put another way, how much am I getting income-wise from my bonds, especially if I hold them all to maturity, which could be even better than the yield to worst. Looking at this graph, these blue diamonds show what bonds are currently yielding versus the purple. That has been their median yield over the past 10 years. And you can see across the board, current yields are significantly above the 10 year medium. Even looking at something as secure as a US treasury, we are starting to see yield rising to about 4.1 % again versus a historical ten year median of 1.5%. That is a significant increase for, especially for conservative portfolios like many of our clients are in. This offers a significant opportunity for income at a very low level of risk.
And we’re seeing that with investment grade corporates also with yields well over 5%. Mortgages are offering four and a half to 5 %. And then when you go out to the right, a little bit more aggressive in the fixed income space, whether it is emerging markets, high yield or even leveraged loans, we are seeing yields in the 8 to 10 % range, which I would still argue come with less risk than the stock market. And this is, for us, the first real intriguing opportunity we have seen, especially on the fixed income side, in almost over a decade. Certainly, we have not seen opportunity like this for a conservative investor to actually earn potentially significantly more than they have been going forward.
So at this point, what we’re currently exploring in our portfolios on the stocks side is not being overly aggressive there. Still being opportunistic and waiting for either a bigger sell off or just greater opportunity as the business environment shifts. However, on the bond side, we’re really exploring what kind of opportunity there is and what that means for how we approach portfolio construction. Many of our managers have already begun to make some shifts to their strategies to take advantage of some of these opportunities. And we’ll have more on that for our clients in the months to come.
Hannah
So, in conclusion, it was a very bumpy 2022. As we lean in to 2023, we are still working through a lot of data, and there may still be some surprises yet to come. But there are also some opportunities showing up that we want to be selective about exploring and potentially implementing on the bond side. We will continue to monitor the equity markets and be patient when it comes to opportunity there. Obviously, at the end of the day, for our clients, preservation always remains the most important thing to us. We want to be cautious and plan-driven, but are also excited to finally be seeing some opportunity after such a volatile 2022.
Matthew
Absolutely. Well, that is our 2023 outlook. Thank you all for joining us, and always feel free to reach out if you have any questions or if there’s anything else we can be doing for you.