Investor Insights: Q1 2023

Executive Summary:

• Persistent inflation raises the odds of a U.S. recession in 2023
• Recession NOT a foregone conclusion as the U.S. economy has unusual resiliency
• While labor shortages will pressure inflation, most other forces driving inflation are receding
• Equity investors should remain cautious in the very near term. Longer-term returns likely revert to historical mid-single digit averages after an initial surge higher
• TINA is dead to the benefit of Fixed Income investors

Economic Base Case for 2023

Investors and participants in the U.S. Economy were battered in 2022 by a surge of inflation and the subsequent response of the Federal Reserve (Fed). Domestic central bankers embarked on a rapid pace of rate hikes to slow growth and tame inflation. Tightening cycles always raise the risk of recessions, but the rapidity and magnitude of the increases to the Fed Funds Rate have been unsettling. The central bank has made explicit their belief that they cannot relax their tightening until inflation breaks.

As we enter 2023, we believe that most of the conditions that fostered inflation are diminished or even reversed. Money supply growth has fallen to pre-pandemic levels, federal relief programs that stoked excess demand have passed, supply chains are healing, high mortgage rates with subsequent declines in affordability are containing home price gains, and many commodity prices are falling, leading credence to the view.

However, we are less sanguine on inflation resulting from tightness in the labor market diminishing quickly. The most recent U.S. jobs report showed that average hourly earnings rose 0.6% month over month in November, its highest since January 2022, and increased 5.1% year over year, pointing to a mismatch between the supply and demand for workers. On balance, we believe that a tight labor market will result in continued wage increases that will pressure profit margins. Businesses will respond by passing on some of these higher compensation costs to their customers in the form of higher prices for goods and services, which will result in overall inflation that will be sticky. Higher for longer interest rates and the resultant tighter financial conditions will be necessary to reduce overall inflation which will lead to lower economic growth in calendar year 2023. The business community is adjusting to a world where labor is in short supply, but these adjustments are happening too slowly. The inability to grow our labor supply or control compensation costs is pointing to a Fed that will keep raising rates in the near term, and likely keep rates at a higher terminal rate for the entirety of 2023.

While we see room for a broad array of plausible economic outcomes in 2023, given the persistence of wage inflation, the case for a soft landing in 2023 is eroding. Qualitatively, we assign a 60% probability of a mild recession and a 40% probability of a soft landing in the U.S. in the next 12 months. Our base case for a mild recession in 2023 is predicated on the notion that the U.S. economy is structurally more resilient than in typical cycles.

The Case for a Mild Recession: Economic Resiliency

We differ little from consensus expectations that the Fed will continue to increase interest rates in 2023. Typically, the Fed starts aggressively hiking in environments characterized by low remaining economic capacity (particularly in labor) and high indebtedness. Perhaps because the inflationary spike was driven more by changes in fiscal policy rather than monetary policy, the Fed is tightening at an earlier stage of the business cycle. With roughly 6 million job seekers and over 10 million job openings, each month we have witnessed hundreds of thousands of workers being added to the payrolls. Although some layoffs are coming, the historically unprecedented labor gap suggests payroll gains will continue to be positive, adding economic buoyancy despite higher wages and the stress of Fed rate hikes.

Households and corporations are also far less vulnerable to higher interest rates, compared to previous tightening cycles. For example, relatively few households have adjustable-rate mortgages, a sharp contrast to 2007. Although credit card debt has been rising, the total burden of debt payments as a percent of disposable income is near multi-decade lows. Financial institutions are in strong shape as are most corporate balance sheets. The Fed can tighten, but outside of interest-rate sensitive segments like housing, the sting of higher rates is muted, arguing for a mild recession.

The K Expansion

While a mild recession is our base case for 2023, a new growth cycle is likely to commence in the not-too-distant future, and the nature of the next phase of economic expansion will prove a challenge for investors. We believe that the structural damage of the Pandemic will at long last have a reckoning. Because of the flood of federal cash, the much-ballyhooed "K Recovery" (with distinct economic winners and losers, represented by the upward and downward pointing arms of the letter K) never occurred as gains were widely distributed if not universal. But the upheavals of recent years cannot be ignored. Work-from-home opportunities that spur the migration of workers from cities to suburbs as well as interstate moves, the partial abandonment of public transit and central business districts, the need for more localized and resilient supply chains, the accelerated departure of older workers from the labor force, and the resultant tilt of negotiating power toward workers all have widespread implications for investors, creating both winners and losers.

Such a K-expansion offers opportunities, but aggregate returns are likely to be more modest. In a similar vein, the shrinking of our workforce points to long-term annual economic growth potential below 2%. Adding to investor challenges, even if the Fed successfully contains today’s inflation, labor tightness and lessened supply chain efficiency will create an environment of higher embedded inflation and interest rates.

The Expected Path and Level of the Fed Funds Rate

The impact inflation will have on Fed policy remains high on the mind of investors as we enter 2023. The Fed is targeting inflation that averages 2.0% over time. The Fed’s preferred measure of inflation is core Personal Consumption Expenditures (PCE), which was 4.7% year-over-year in November 2022. Forecasts from the December Fed meeting suggest a continued hawkish, but likely moderating, path of rate hikes ahead. Following December’s 50 basis point Fed Funds increase (target range is now 4.25% - 4.50%), investors (as measured by Fed Funds futures markets) are expecting an additional 50-75 basis points of interest rate increases in the first half of 2023 and a terminal target rate of roughly 5.00% to happen in May 2023. Further, investors are now expecting interest rate cuts in the second half of 2023 with the Fed Funds implied futures rate ending 2023 at approximately 4.40%.

Our view is consistent with the consensus view on expectations for several more interest rate hikes and a terminal Fed Funds rate to be roughly 5.00% by summer of 2023. Where we differ from the current consensus view is that we do not see Fed Funds rate declines in 2023. Rather, we expect Fed officials to keep the expected 5.00% Fed Funds rate at its terminal rate through year-end 2023, at the very earliest, given the tight labor market’s impact on inflation. One of the lessons learned from the persistent inflation experienced in the 1970s was that a lengthy period of restrictive monetary policy was needed to keep inflation levels low and steady. It is our belief that the current Fed understands this lesson and will not make the same mistake that was made during the 1970s where monetary policy was intermittently restrictive, but not restrictive enough to cure inflation once and for all. Fed Chair Jerome Powell has made it very clear in public comments that he intends to remain restrictive on policies "…until the job is done."

2023 Investment Outlook

We anticipate that stocks and other risk assets will have a difficult time entering a new bull market until there is more evidence that inflation is receding, and that economic activity is bottoming. At some point there will be clarity, whether it comes in the form of a recession or a soft landing, there will be a clear sign that inflation, including wage inflation, is in retreat. Until then, we would expect a holding pattern of continued volatility, sector rotation, and range bound trading in equity markets.

For the investor, 2022’s experience is a reminder that successful investing always has periods of trial. Patience and adherence to an investment discipline, i.e., a thoughtfully structured diversified portfolio, remains the key to investment success over time. Now is the time to review investment policies with your advisor. Positively, we see an environment with many broad economic and company specific fundamental data that remains resilient, particularly domestically, driven by an empowered consumer. However, expectations remain for a continued slowdown in economic activity as we enter 2023. The full impact of higher interest rates has yet to be felt as their effect on the real economy occurs with a long and variable lag.

In the U.S., historically, durable equity market bottoms are achieved through:

1. A Fed dovish pause or pivot (i.e., when the central bank completes its interest rate increasing campaign and/or begins to outright lower interest rates).

• Following December’s 50 basis point Fed Funds increase (target range is now 4.25% - 4.50%), investors are expecting an additional 50-75 basis point of interest rate increases in the first half of 2023 and a terminal target rate of roughly 5.00% to happen in May 2023.

and/or

2. A bottoming in economic activity. Our preferred measures are a bottoming in expected prospective earnings per share (EPS) estimates (a measure of a company or a group of company’s future profits), and/or or by a trough in Purchasing Manager’s Indices (survey data which offers prospective economic trends in the manufacturing and services sectors).

• S&P 500 EPS estimates appear too high, given an expected economic slowdown, and are just beginning to deteriorate.
• Purchasing Manager’s Index data is offering mixed to deteriorating signals today.

In our estimation, neither of these two guideposts have been achieved today and it is too early to position for a new bull market in equities. If history is a guide, once the worst of these inflationary and economic slowdown fears subside, equity markets will recover. Prospective expected equity returns are likely to see a violent initial movement upward once the economy finds a floor, or the Fed pivots (from inflation subsiding), or both. However, longer-term prospective equity returns are likely to moderate from the torrid pace of recent years and settle into an annual mid-single digit range, consistent with long-term historical averages. This thesis is primarily supported by current valuation levels which are modestly above long-term averages and by a much higher cost of capital than investors have experienced over the past decade which will exert downward pressure on prospective valuation levels. As we begin 2023, we continue to favor high quality (strong profitability, stable earnings, strong balance sheets, and growing dividends), shorter-duration stocks (no speculative tech), stocks that pay dividends, with a domestic and value bias.

For the last ten years, with global sovereign and corporate interest rates at all-time lows (many yielding near 0.00% and some having negative yields), investors have characterized the investing landscape as a "TINA" market. "TINA" being an acronym for "There Is No Alternative" to equities. For Bond investors, there finally does appear to be an alternative to equities as global sovereign and corporate yields surged in 2022 given persistent inflation and hawkish central banks that entered an aggressive interest rate hiking cycle. In the U.S., the 10-year U.S. Treasury yield was at 3.67% on December 23, 2022, roughly 2.16% higher than the end of 2021. We believe that the TINA market is gone and that bond investors will now earn a more reasonable yield on their investments.

Many parts of the domestic yield curve are inverted, signaling investor’s belief of an economic slowdown, a growth scare, a recession, or perhaps that inflation might moderate quickly, and that Fed policy is too tight. As economic risks persist, there likely will be a ceiling on yields in the very near term. Economic growth is likely to resume following the current growth scare. This will put upward pressure on intermediate global sovereign and corporate bond yields over the longer-term. Much lower sovereign yields continue to exist in Europe and Japan, relative to the U.S., which may push capital into U.S. Treasuries, limiting domestic interest rate increases. We maintain that these competing factors will ultimately cause global intermediate term interest rates to grind higher longer-term, but limit runaway interest rate increases (yields much higher than 4.5%-5.0% on the 10-Year U.S. Treasury in 2023 appear unlikely today). A good proxy for expected fixed income returns will likely be an investor’s entrance yield level for most fixed income sub­categories. As economic and inflation uncertainty persist in the near term, we continue to favor high credit quality, benchmark duration domestic fixed income, with modest allocations to the Fixed Income Related category (where capital is nimbly allocated across both corporate and consumer sectors) and Treasury Inflation-Protected Security (TIPS) categories which will benefit should inflation persist. With the pickup in yields in 2022, a variety of fixed income categories are viable alternatives to equities.

Finally, allocations to Cash will help reduce portfolio volatility and preserve capital, and have become increasingly relevant, given the pickup in yield in 2022. As of December 23, 2022, money market yields are approximately 4.06%,after starting 2022 at essentially 0.00%. Given this pickup in yield and in the context of a fully diversified portfolio, cash, in addition to bonds, are a viable alternative to equities.