A Two-Faced God
The month of January takes its name from the ancient Roman god Janus, the god of gates, transitions and beginnings. He was normally depicted as having two faces, one looking forward and one looking backward, an appropriate image for a month in which memories of the past coalesce with hopes for the future. Because he was a god of beginnings and transitions, he was able to see far enough into the future to know where beginnings and transitions might lead. The Roman Janus had only one face for the future, and that was subject to the interpretations of a limited number of official seers; our twenty-first century Janus — the January forecast of the markets in 2023 — has multiple forward-looking faces, each representing different visions of the future and each subject to multiple unofficial interpretations. With the future having as many faces as Hydra has heads, we will try to limit our commentary to what we consider to be the most important factors that will shape the markets’ course in 2023, or at least their course during the first quarter of 2023.
It’s no surprise that the factors that will shape the markets for at least the next several months, and probably for the entire year, will be the same factors that defined them for most of 2022: inflation and anticipation of the Fed’s response to that inflation. It’s the Fed’s understandable preoccupation with taming the highest rate of inflation in forty years that precipitated 2022’s bear market in stocks (which is still in place), created doubts about the future of the economy in 2023 and great uncertainty among market participants about how to place their “bets”. From near zero at the beginning of 2022 to a current 4.25-4.50% the Fed has ratcheted up overnight rates at the most precipitous pace in over forty years and promises more to come in 2023, though perhaps at a slower pace. In addition, the Fed has continued trimming its balance sheet, thereby effectively reducing the supply of money (inflation may be defined as too many dollars chasing a fixed or diminished supply of goods and services). The plan, of course, is to slow demand by raising the cost of credit and increasing the costs of hiring new employees. This plan can work — in fact, it’s really the only plan — but the odds don’t favor a quick and painless return to an acceptable rate of inflation, the much desired but seldom, if ever achieved, soft landing. In today’s environment, a soft landing would be something like a 2% rate of inflation accompanied by an unemployment rate below 5%. An overzealous and overlong adherence to the plan will result in a wrecked economy and a deep recession. A timid and too quickly abandoned pursuit of the plan will only postpone the reckoning with inflation and could usher in a period of “stagflation”, the depressing combination of high inflation and high unemployment. In Homeric terms, the Fed, acting as Odysseus, is trying to navigate a safe course between the Scylla of recession and the Charybdis of inflation: too much tightening of the sails to avoid inflation will land the economy on the rocks of recession; too much loosening of those sails will cast the economy into a downward spiraling whirlpool of diminishing dollar values. The safe way between these two monsters is very narrow and the Fed is steering with backward facing eyes, relying on signs and statistics that are almost always at least a month old and subject to revisions.
Some of these signs indicate that inflation may be easing. Over the last three months (ending in November), the pandemic induced interruptions in supply chains have loosened significantly: many retailers and wholesalers report well stocked inventories, with some (notably in electronics) reporting uncomfortably high inventories, suggesting that sales after Christmas might be forthcoming. The broadest measure of price increases, the trailing twelve-month Consumer Price Index (CPI), may have peaked in May at 9%: the monthly numbers for CPI, for CPI less food and energy and for Personal Consumption Expenditures (PCE) less food and energy — the Fed’s preferred inflation measure — have consecutively declined between August and November.
And some signs indicate continuing economic strength rather than weakness. GDP in the third quarter increased at an annualized rate of 2.9% and an early estimate of GDP for the fourth quarter places growth at 2.8%. The Unemployment Rate remains constant at 3.7% in November, though Continuing Jobless Claims — one of the more current statistics in the Fed’s line of sight — has ticked higher in the last few weeks, indicating some difficulty finding work among the unemployed.
So far, the Fed has engineered a few months of modest disinflation without weakening the economy. The most recent inflation numbers — those for November — are lower than earlier numbers but are still too high: a trailing twelve-month CPI of 7.12% is clearly better than 9%, but not by much and has importance only if the rate continues downward in future reports. The stock market considers this good news — the S&P 500 is up 7.1% from its October lows — based on a belief that the Fed is close to declaring victory and halting its tightening regime. But “one swallow does not a summer make” and it seems unlikely, given repeated statements from Fed Chairman Powell, that the Fed will seize upon this modest improvement as an excuse for cutting or even pausing its action on rates: as Chairman Powell stated as recently as November 30th, “History cautions strongly against prematurely loosening policy. We will stay the course until the job is done.”
As every investor knows, 2022 was not a good year for stocks or bonds. The S&P 500 was down as much as 25% during the year before recovering somewhat in the fourth quarter (+7.1%) and registering a negative 19.7% for the full year. As represented by ten-year U.S. Treasuries, bond yields saw interest rates increase from 1.496% to 3.826%, producing an almost 20% decline in market value for the year. The worst returns were in growth stocks with high P/E multiples and no dividends and long term, long duration bonds. The best returns, or more likely the least negative returns, were in high dividend yielding stocks, cash or cash equivalents, and short to intermediate term bonds.
We expect that the first quarter of 2023 will provide a great deal of excitement as new economic reports provide evidence that the economy is floundering, overheating or maintaining an “in-between” course. At least for the next three months, every statistic is likely to be viewed through the lenses of inflation: good news on the economy — accelerating GDP, declining unemployment, etc. — will confirm the Fed’s bias towards tightening and will be bad news for the markets; bad news on the economy will have the reverse effect as the markets begin to anticipate an early conclusion to the Fed’s tightening cycle. If the monthly inflation numbers continue to moderate, then, at some point, perhaps midway through 2023, the Fed will be able to declare victory and begin cutting rates. If not, then the Fed will have to continue tightening and run the risk of a deep recession.
We would like to believe that the Fed can bring inflation down to 2% or lower without driving the economy off a cliff. But the Fed’s history in curbing inflation painlessly is not encouraging. Maybe it’s different this time: the Fed might have more room than usual to accomplish both a victory over inflation and a soft landing. Since the tightening cycle began against a backdrop of near zero interest rates and historically low unemployment, there may be more flexibility in how far rates can rise before the economy begins to contract. And already, with the passage of time, the pandemic induced supply train interruptions appear to be easing, reducing the scarcity of goods and services and correcting the imbalance between consumer demand and supply. But using blunt instruments – short term interest rates and the money supply – to fine tune the economy does not usually end well.
We certainly wish the fed well, but for now, we remain skeptical. Odysseus did pass safely between Scylla and Charybdis in the Strait of Messina, but he lost much of his crew during the passage. Expect a lot of turbulence over the next three months as signs of inflation wax and wane. We could well see a positive conclusion to 2023 – the return of the bull market in stocks and a stable interest rate environment – but there will likely be rough waters between now and then.
Not Investment Advice or an Offer This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing. Argent Financial Group is the parent company of Argent Trust, Heritage Trust and AmeriTrust.