2022 was a year marked by tumult, uncertainty, and fundamental shifts in the geopolitical, social, and investing landscape. Amid the fallout of the pandemic, the world continues working to establish a new status quo. Investors, consumers, businesses, and the international community have had to continually rethink the way they engage with one another. The world has had to digest the first major act of aggression by a global superpower since WWII, and the most legitimate threat of nuclear war in nearly as long. Europe was divorced from its primary source of oil and gas. China’s unrelenting Covid protocols led to further disruptions in global supply chains and the most salient political unrest the country has seen in decades. The second-order effects of these events prompted tremendous fiscal response from global central banks, leading to the highest levels of inflation in nearly half a century and necessitating further fiscal intervention that has left much of the world at risk of recession.
Central banks like the Fed pivoted into aggressive tightening cycles just as economies had begun to stabilize, leading to slowed growth in the US and China and negative growth in Europe. The world has been forced to accept and respond to the vulnerability of its international supply chains and other systems linked to the proliferation of globalism.
Faced with disruption on this scale, markets corrected their Covid booms across the board. Both bond and equity markets are positioned to end the year near pre-pandemic levels, with some market intersections down as much as 50%. For the first time in over 30 years, bond and equity markets were highly correlated, leaving investors with no real long term safe havens. (The commodities/energy sectors may be the sole exception, a direct result of the war in Ukraine and efforts to account for a consistent lack of investment in infrastructure over the last ten years.) In our portfolios, the other major source of returns has been volatility strategies that have capitalized on the consistent uncertainty and change.
As we look toward the new year, the outlook for inflation and central bank monetary policy remains at the forefront of investors’ minds. Currently, central banks appear ready to slow the pace of their rate hikes, and interest rate differentials have begun to narrow in most parts of the world. While the dollar has begun to depreciate, our research suggests this is mostly the result of the short-term removal of speculative positions. (Growth differentials inevitably impact currency rates, and the US continues to dominate, relatively speaking.) Investors must now rethink how to capture returns in a world of low growth and persistent inflation, where governments and central banks have largely exhausted their arsenals.
Led by the US Federal Reserve, the regime changes instituted by global central banks have predominantly driven the narrative of global markets for the last 8 months, and understanding their actions is essential to preparing for the investing landscape in 2023. Though inflation seems to have peaked—as indicated by recent prints from both the CPI and PPI—will the Fed continue to tighten above the 4.5% current level? And will they continue with additional hikes, even while the real rate currently stands at 1.5%? Nothing if not transparent, Jerome Powell remains committed to containing inflation and bringing it back down to a 2% target at all costs. Market expectations are that the Fed will continue hiking to 5.5% over the next year. This over-tightening will lead to a shallow recession and weigh down equities through 2023 and possibly 2024.
We anticipate that the Fed will stop hiking by the end of Q1 and settle at 4.75-5% once it processes two key data points: (1) a rapid decline in inflation as the impact of high rates on housing and manufacturing is rolled into data, and (2) household surveys, which imply there has been no meaningful job creation for the past 9 months. As the unemployment level jumps to reflect this reality, we believe the Fed will cease hiking and address its dual mandate.
Despite the fastest rate hike up from a trough since the Fed’s inception, the US consumer has remained resilient. Over 196.7 million shoppers went out shopping on Thanksgiving weekend as excess savings and a solid employment market continue to buttress the consumer. Online sales, on both Cyber Monday and Black Friday, increased by 5.8% and 2.3% YoY, respectively. However, housing markets are showing clear slowdowns as the increase in mortgage rates (which have doubled to 6.7%) led to a drop in housing starts from 1.8 to 1.4 million units over the last 6 months.
Outside the US, Europe and the UK have proven firmly committed to hiking rates at a similar pace as the Fed. Because inflation driven by energy supply chain disruption has been so much more severe in Europe than in the US, central banks in the region may be forced to continue hiking long after J