Bryan Dooley
With the Federal Reserve implementing an almost unprecedented barrage of restrictive monetary policies during the course of 2022, stock and bond prices plummeted throughout the year. These policy initiatives included seven large interest rate hikes, relentless quantitative tightening and an historic shrinking of the money supply as defined by M2.
For 2022, the S&P 500 declined by 19.44%, the MSCI World Stock Index fell 19.46%, the technology-heavy Nasdaq dropped 33.1% and the Bloomberg Aggregate Bond Index was down by 13.01%. Historically, 2022 was a very unusual year when both stocks and bonds posted meaningful declines at the same time. For most investors, 2022 will be a forgettable year.
Monetary policy mistakes
Fed Reserve chairman, Jerome Powell has clearly pivoted from being overly dovish to being overly hawkish. Now operating in damage control mode, he is attempting to rescue his reputation following one of the worst monetary policy errors in central banking history.
The Fed’s uber easy money policies which began the depths of the 2020 pandemic eventually caused the highest inflation in forty years. Meanwhile, Washington continued to toss dry logs on the inflationary fire with extreme deficit spending.
And now, from full speed ahead, Powell and his colleagues have thrown the monetary gears sharply in reverse thereby spiking financial market volatility. The Fed’s near-term goal is to engineer a recession and thereby break the back of the inflation they caused.
Recession imminent
Currently, a recession appears imminent as key economic indicators continue to head south. For example, the leading economic indicators (LEI’s) in the US have been heading lower since March of this year. In fact, with the exception of February, month-over-month LEI’s have been running negative all year long.
The LEI index is comprised of ten economic components whose changes tend to precede changes in the overall economy. Components of the LEI include manufacturer’s orders for consumer goods and materials, building permits, money supply (M2) and the spread between long and short-term interest rates. The LEI index tends to lead economic growth by about seven months.
While increasingly restrictive central bank monetary policies have been the major pain point for last year’s sloppy markets, other factors also played a part. Russia’s unprovoked war in Ukraine, China’s heavy-handed zero-COVID policy, global supply chain disruptions and cryptocurrency blow-ups added to volatility and downward pressure on higher risk assets.
Back to basics
Importantly, investors returned to basics in 2022. During the central bank “free money” era, which was taken to extremes in 2020 and 2021, several atypical asset classes reached various states of irrational exuberance. Crypto coins, non-fungible tokens, special purpose acquisition vehicles and meme stocks were all the rage when the monetary spigots were flowing.
However, last year marked a serious reversal in overhyped and perhaps overvalued assets as investors returned to focusing on fundamentals such as earnings, cashflow, dividends and valuations. Many of the more speculative assets have declined as much as 80-90%, while value and dividend paying stocks have held up relatively well.
As the economy continues to downshift, equity markets have been exhibiting classic signs of defensiveness below the surface. For example, the best performing sectors on a year-to-date basis have been energy, electric utilities, healthcare and consumer staples. Demand in these sectors tends to be resilient against economic weakness. Consumers need healthcare and food regardless of economic conditions.
Looking ahead, investors can expect further volatility as central banks around the world continue to raise interest rates in their efforts to cap inflation. From this point forward, the larger rate increases should now occur in non-US markets which are just now beginning to catch up with the US’s over tightening programme.
For example, in December, Japan announced an increase in the allowable trading range of its 10-year bonds, effectively relaxing its historic yield curve control policy. The Japanese two-year yield rose above zero for the first time in 15 years. Meanwhile, over in Europe, the ECB is echoing Powell’s refrain to do whatever it takes to curb inflation.
The good news for the markets is that much of the recession scenario may already be baked into asset prices. Indeed, the recession expected early next year will be one of the most widely anticipated ones in modern history.
In my experience, asset prices tend to react more dramatically to unexpected rather than expected events. While markets have the potential to retest their June and October lows, buyers will likely emerge at those more distressed levels. Remember, the markets often tend to climb the proverbial “wall of worry.”
Stock picking
More important than the overall direction of the equity markets, is which securities investors need to own. Heading into 2023, investors will want to be positioned in higher quality companies trading at reasonable valuations.
We like select companies in the industrial, information technology, healthcare, national defence and energy sectors. Dividend-paying companies had spectacular outperformance in 2022 compared to their non-dividend-paying counterparts and I expect this to remain a trend as free money continues to evapourate and an ageing population craves income.
We also see opportunity in the bond markets. Throughout the year, the US Treasury yield curve became increasingly inverted as investors forecast that interest rates must eventually peak. In the last months of the year, short-term Treasury yields rose, while longer term rates were little changed.
During Q4, the Federal Open Market Committee increased its policy rate by 0.75 percentage points in the November meeting, then 0.5 percentage points in the December meeting. In December, Fed chairman Jerome Powell indicated that the Fed Funds terminal rate will likely be around 5.1%, up from the 4.6% estimate back in September. According to the FOMC dot plot, which is a survey of FOMC members’ projections, rates will keep moving higher this year, but will shift lower in 2024.
In this environment, we continue to like the front end of the interest rate curve where 4-5% low-risk yields are easily available. However, we are beginning to warm up to longer duration securities. Indeed, many longer-dated investment grade bonds and preferred issues, yielding 6% or more are offering equity-like returns with the benefit of high current income and lower volatility.
Bryan Dooley, CFA, is the chief investment officer at LOM Asset Management Ltd in Bermuda.
Please contact LOM at +1 345 233-0100 or visit www.lom.com for further information.
This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.
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