Vigilare Wealth Management 2022 Q4 Commentary
The year 2022 ended up being one of nowhere to hide. The historical market pattern of the ominous second year in the first term of a Presidential cycle prevailed yet again. Every attempt at a market rally fizzled due to a looming U.S. Federal Reserve (the Fed) hellbent on breaking the back of the post-covid era inflation monster. There was no refuge in the traditionally defensive bond market either. Most folks are likely eager to put 2022 in the rear-view mirror. However, this tug-of-war battle between inflation and the Fed rages on into 2023.
The market sell-off of last year was more widespread than even the Financial Crisis of 2008 or the Dot Com wreck of 2000. This was the first “inflation” triggered turmoil in the markets since the early 80s. This is because inflation driven panics affect both stocks and bonds. The hottest market during the pandemic (NASDAQ) had an overnight reversal and went from the best performer to being clobbered in 2022, losing 33%. The “conservative” bond market was down over 13%, which was the worst year dating back to the 1930s (5-standard deviation event for those data geeks out there). Another example of the depth of the rout; the Vanguard balanced fund, a conservatively run 60/40 balanced fund, was down 17% in 2022. Compare this to the 2008 financial crisis year when the fund lost only slightly more (down 22%). Another balanced behemoth fund, Fidelity Balanced, was down over 18% in 2022.
What is causing this market turmoil and when does it end? We have written extensively about the root causes largely stemming from the historical and unprecedented fiscal and monetary policy responses to the 2020 Pandemic, and the effect this had on pushing all markets to record levels. The unintended consequence of these policy actions led to a wave of inflationary pressures. This eventually propelled the Fed to respond (in a panic in our opinion) by raising rates as aggressively as they ever have in their 100-year history.
What is the Fed trying to accomplish? Are they trying to drive the U.S. economy into a proverbial ditch? Short answer, yes. The Fed wants to, first and foremost, squash inflation. They are less concerned about the collateral damage as they have been in past rate hike cycles. This stems from the underlying fear of repeating past Fed policy mistakes which still echo in the halls of the Fed buildings. History is not kind to the likes of the affable Fed Chair Arthur Burns and his reluctance to aggressively raise rates against the inflation flare ups of the 70s. Ambivalent Mr. Burns juxtaposed against the legendary and larger than life cigar-smoking inflation slayer Paul Volker, who “bravely” took the economy to recession by raising rates and finally landing the death blow to the uncontrollable 70s inflation. Current Fed chair Powell has referred to Volker (not to be confused with Voldemort) as an inspiration for recent policy actions in several recent speeches and Q&As.
Our view however is that inflation is peaking. This can be witnessed in many areas such as goods inflation, primarily due to the normalizing of supply chains and softening of demand. Still, the Fed has made it very clear to us (and to all who are listening) that their focus will be to bring down the “services” side of inflation, which can be stickier and more persistent than goods and commodities inflation. Fed Chair Powell’s exact words were that he wants to see “considerably more slack in the labor market”. Our view is that this softening goal will require the unemployment rate to move higher and for labor demand to weaken. Therefore, the Fed may have to induce a recession to accomplish their more acutely targeted goal. And although they may slow the pace of increases moving forward, the Fed has stated that they want to keep rates at a high level for a longer period to address the service component of inflation.
None of this is lost on the leading economists. Two-thirds of wall street economists at the largest financial institutions are predicting a recession in 2023, although most are forecasting a very shallow one. If a shallow recession were to occur, this would be one of the most predicted recessions in modern memory. Bloomberg’s 13-data point recession model is predicting a 100% chance of recession! We are skeptical that when there is such large consensus about something specific occurring, that it usually doesn’t materialize the way everyone was forecasted.
What we do know is that this year will be a much better time to invest than the start of 2022. We are also closer to an end of this bear market than we were at the start of last year. Compared to last year when rates were at zero, current higher rates make the bond market as attractive as it has been in over a decade. If we do have a very shallow recession or no recession at all, markets will have likely bottomed already. However, if there is a recession in 2023, and it is sharper than anticipated (by the “experts”), then the market will continue to struggle. In our last writing, we made some back-of-the-napkin estimates of where the stock market may decline in a deeper recession scenario, and at the current levels, markets aren’t remotely close to a bottom. Astonishingly, after the 2022 drop in market values, the U.S. stock market is overvalued relative to the 25-year average using most conventional valuation methods.
Our view is that 2023 is going to be a year that could bring surprises (positive or negative) and especially for those more risk-averse individuals, adjustments will need to be made quickly and decisively. Success in this environment will depend on the ability to adapt and adjust to the evolving conditions, probably much more than at any point in recent memory. Flexibility and nimbleness will prevail over a strong conviction of a singular outcome. Nobody knows the exact path of inflation, or how the Fed stance will evolve (believe us that the Fed doesn’t even know itself). How resilient will the economy be against the backdrop of these historically aggressive rate hikes? To add, there is still a Hot-War in Ukraine and a Cold-War brewing between the U.S. and China. In politics, the newly sworn in 118th Congress might want to make a splash in its debut. This is a market environment where confident forecasting should take a back seat to adapting and evolving to changing conditions.
The good news is that the defensive bond market looks attractive (I.E., defensive strategy is earning a return) and bear markets eventually lead to new bull markets, which are full of wonderful new opportunities. We are in the stage of the bear market where with every failed rally the attrition starts to set in. That is that hopeless feeling by investors that the market will never ever come back. This human emotion of giving up is most convincing, but in hindsight these times usually mark the beginnings of the most fruitful times in market history. If we can summarize the strategy for early 2023 in one word, it would be “Patience”. Those for which will be rewarded.
Thank you for your trust.
The Vigilare Wealth Management Team
IMPORTANT DISCLOSURES Vigilare Wealth Management is an SEC registered investment adviser. The information presented here is not specific to any individual’s personal circumstances. This is not an offer to buy or sell securities. No investment process is free of risk and there is no guarantee that the investment process described herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.