Economic & Market Commentary | January 19, 2023
Quarterly Commentary | January 19, 2023
We offer the following economic and market commentary for the fourth quarter of 2022.
As 2022 drew to a close, the year-over-year consumer price index (CPI) in the United States will have averaged about 8%, the highest annual average rate of CPI inflation since 1982. Inflation has remained broad-based and continued to carry momentum. At the same time, the labor market remained extraordinarily tight, with the unemployment rate lingering below 4% for most of the year. The 40-year high in inflation alongside the red-hot jobs market made clear the need to tighten policy aggressively, and the Federal Open Market Committee (FOMC) has raised rates at the fastest pace in decades.
U.S. retail spending and manufacturing weakened in November, signs of a slowing economy as the Federal Reserve continued its battle against high inflation. The Fed raised its benchmark interest rates by 0.5 percentage points to a 15-year high and signaled plans to continue lifting rates through the spring. The economy has shown signs of slowing, and inflation has eased from a summer peak, but the labor market remained tight despite layoffs in sectors such as tech and real estate.
The elevated rate of inflation, which has eroded household real income, and the degree of monetary tightening will likely cause the U.S. economy to slip into a modest recession beginning in 2023. Policymakers will likely continue to come down on the side of bringing inflation back toward the Committee's target of 2% at the expense of allowing the unemployment rate to rise. The U.S. economy could be at risk of shedding over one million workers in 2023, with an unemployment rate that could rise by 1.5 percentage points. That would inject the needed slack in the labor market to ease concerns that wage pressures could feed into inflation.
Despite falling real incomes households have continued to spend by bringing the personal saving rate down below 3%, the lowest rate since 2005, and by running up credit card debt.
The United States is not the only economy with an inflation problem at present. Inflation has risen sharply in most foreign economies as well, and central banks in those countries have faced the same dilemma as the Federal Reserve. Like their counterparts at the Fed, policymakers at many foreign central banks could choose to bring inflation down at the expense of the labor market. Consequently, many foreign economies will likely also experience contractions in net of inflation GDP in 2023. Moreover, the downturns in the Eurozone and the United Kingdom could be especially pronounced.
The U.S. dollar has strengthened against most foreign currencies throughout 2022, and this trend of appreciation should continue through the early part of 2023. But as the FOMC brings its tightening cycle to an end and as market participants begin to anticipate eventual policy easing in the United States, the dollar should trend lower against many foreign currencies starting in mid-2023.
Looking back into the fourth quarter of 2022, the U.S. economy should show some resilience expanding by around 2.0-2.5%. Consumer spending and business investment appeared to be holding up reasonably well. However, it would be a stretch to assume that the rapid adjustment in interest rates will not soon start to weigh on broader economic activity. A more meaningful downward demand adjustment could begin in early 2023, with growth expected to fall to a near-stall speed in 2023. Many underlying fundamentals remain sound. Household and business balance sheets are in good shape, and the banking system is well-capitalized. Consequently, the downturn is not expected to be especially deep or prolonged. This next recession may well be like the downturn of 1990-1991. That recession lasted for two quarters with a peak-to-trough decline in real GDP of 1.4%.
U.S. GDP in 2023 is likely to show further signs of weakness as the full impact of the most rapid rate hiking cycle in history by the Federal reserve registers in reduced economic activity. It normally takes 6-12 months for a rate hike to flow through the economy and the seven hikes in 2022 that began in March have likely still not had their full desired effect on slowing the economy and demand for goods and services. With more rate hikes expected in early 2023, the U.S. economy should enter a shallow and likely short-lived recession by the middle of 2023.
The course of inflation appears to be in the early stages of a downtrend following multi-decade inflation highs. Key to this continued downward pressure will be lower wage growth and lower shelter costs which have been key drivers of inflation. In order for wage growth to slow further, the unemployment rate will need to increase to reduce the historic tightness in the labor market. It is expected that as demand drops from higher interest rates, businesses will at some point need to cut their expenses which should result in layoffs and increased unemployment. It is expected that the unemployment rate may go as high at 5%. A big question for 2023 is how long the labor market’s strength can last.
The U.S. dollar, which has been on an historically strong run, should continue to be favored against foreign currencies at least through the end of the Fed’s rate hiking cycle in 2023. But, as the economy tips into recession or a period of very slow growth, the Fed may well feel the need to reduce interest rates to help increase economic activity. It is expected when the markets sense that rates will start coming down, that dollar strength will likely weaken and especially so because foreign central banks are likely to need to continue raising rates to squash their own inflationary pressures. Those currencies’ strength will benefit from those interest rate increases.
There are downside risks that that could worsen the outlook for U.S. and global economy. Those downsides include the Fed overshooting and taking rates too high, a fall back to past lockdown policies in China (the world’s second largest economy) if their more relaxed COVID policy produces a large perceived national health risk, and of course the war in Ukraine remains a wild card.
2022 was a historic year with both stock and bond markets suffering unique double-digit losses. The largest factors negatively impacting markets included multi-decade high inflation, the Fed’s persistent fight to contain it with eye-popping rate increases, and the promise of more increases to come. The war in Ukraine, divisive partisan politics, a weakening housing market, falling consumer sentiment, talk of recession, and the prospects of declining corporate profits and margins also combined for a toxic brew of negative inputs concerning investors. And the news around the world was gloomy as well with Europe and the U.K. headed for recession and China, the world's second-largest economy, headed for much slower annual growth than it is accustomed to.
Though the fourth quarter provided positive return momentum going into 2023 with both stocks and bonds gaining ground on earlier losses during the year. These gains were not nearly enough to offset the large declines from earlier in the year. U.S. equities finished the year with a positive fourth quarter as the large-cap S&P 500 posted a 7.6% return, the Russell Midcap was up 9.2%, and the small-cap Russell 2000 gained 6.2%. For the full year of 2022 however the S&P 500 was down 18.1%, the Russell Mid Cap was down 17.3%, and the Russell 2000 was down 20.4%.
Stylistically Value stocks resumed their performance dominance over Growth stocks in the fourth quarter. For all of 2022 large, mid, and small-cap Value stocks dramatically outpaced their Growth counterparts continuing a performance trend reversal that began in 2021 following years of lagging the performance of growth stocks.
International equities also posted positive returns for the fourth quarter but delivered negative returns for the full year just like domestic stocks. That said, the fourth quarter gains were stronger in overseas markets contributing to international developed market equities outpacing U.S. stocks. For all of 2022, the MSCI All Country World Index ex-U.S. declined 16% while the MSCI Emerging Markets Index declined 20.1%.
The bond market turned into a sea of red ink in 2022 as bond price declines mounted while interest rates rose during the year. There was no escaping the downward price pressure on bonds from rapidly rising interest rates. The bond market, sensing the worst was over for the rate hiking cycle began clawing back some earlier year losses in the fourth quarter with fixed income around the globe posting positive returns. The Bloomberg U.S. Aggregate Index was up 1.9% in the fourth quarter, the High Yield Index gained 4.2% and the Global Aggregate ex-U.S. was up 6.8% in the fourth quarter. However, for the year these same three gauges of bond performance were down 13.0%, 11.2%, and 18.7% respectively. The strong U.S. dollar made non-U.S. bonds less attractive and added to the downward pressure on those bond prices.
The outlook for stocks and bonds has brightened somewhat since last quarter largely due to the likelihood that the Fed is closer to the end of its rate hiking cycle than they were at the end of last quarter. That said, however, it takes time for a Fed rate hike to flow through the economy and show up in changes to corporate revenues, profits, margins, and employment trends. With all the hikes of 2022 behind us but at least a few more on the way, there is still a time lag yet to experience, probably until the end of this year, for the impact of the Fed’s tightening cycle to fully impact the economy. Until there is greater clarity on the actual impact on the performance of the economy stocks may well be moving sideways with no clear direction.
There continue to be downside risks to the capital markets, which should be kept in mind as 2023 gets underway. Those risks include the Fed overshooting their rate increases, a deeper-than-expected recession, contagion which could emerge from an increase in credit defaults as rates continue to rise, and of course, a possible escalation in the conflict in Ukraine and its potential impact on the prices of oil and commodities. The impending US Government debt ceiling deadline is also fast approaching. Treasury Secretary Yellen warned Congress last week that a decision will need to be reached by mid-summer about whether to increase the debt ceiling. While debt ceiling increases are common – 90 in the 20th century alone – this is something we will be monitoring closely given the current gridlock in Congress. Please be on the lookout for an additional GW & Wade blog post this week discussing the debt ceiling. These types of events could well lead to elevated market volatility in comparison to recent years – this volatility, however, may create new investment opportunities.
A longer-term view of markets suggests the tailwinds stock and bond investors enjoyed for the past decade or more including massive fiscal stimulus as well as declining and ultra-low interest rates will not resurface any time soon. Securities values are more likely to be driven by the organic operational successes of businesses. That will likely result in market returns being lower than in the recent past.
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Based on the S&P 500 trailing twelve-month Price-to-Earnings ratio, our gauge of U.S. equity valuation registers a December reading at the 34th percentile (data series from January 1957 to December 2022.
Based on the Federal Reserve Bank of Philadelphia’s U.S. Coincident Index, our gauge of U.S. economic activity in November registers at the 53rd percentile (data series from April 1979 to November 2022).
The equity valuation and economic activity gauges have been reviewed by GW & Wade and are consistent with the firm’s near-term outlook.
This economic and market commentary was prepared by Capital Market Consultants, Inc. (CMC), an independent investment management consulting firm, and has been approved for distribution by GW & Wade, LLC. Data used to prepare this report by CMC are derived from a variety of sources believed to be reliable including well-established information and data software providers and governmental sources. CMC is not affiliated with any of these sources.
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About the indices presented above:
Standard & Poor's 500 (S&P 500®) Index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the Nasdaq.
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