With the first month of 2023 behind us, we believe signs are now pointing more clearly to a new economic status quo marked by higher rates, the return of price discovery, and central bank policies focused on issues beyond inflation. The turbulence and volatility of 2022—which brought negative returns for both bonds and equity—left investors with few places to take refuge. As January draws to a close, however, it marks the end of what is likely the seventh consecutive month of declining inflation. While inflation—down to 6.5% in December—may not have cooled as quickly as markets had hoped, we appear to be on track to reach the Fed’s 3% goal by the end of 2023. Having digested most of the risk from last year, markets are starting off at a more realistic level, and expectations are constrained and reasonable.
As a headwind, inflation is unique in its capacity to weigh on all financial asset classes and areas of the economy. It negatively impacts consumers across the socioeconomic spectrum, squeezes margins for businesses, and often leaves investors without any clear footholds. As inflation accelerated in 2022, portfolios that seemed safely diversified into sovereign debt suddenly were not. Previously negative correlations quickly began showing their highest betas in decades: US 30 Year Treasury bonds lost 44% peak to trough, while German bonds of similar maturity lost 50% due to their lower yields at the outset of the sell-off. Among asset classes, only real assets managed to buck this trend—and even then, only for a time, ending the year up 7%, with US property gaining 10%. (Both areas experienced 30% swings over the course of the year.)
While the market tightened dramatically in response to these pressures during the 3rd and 4th quarters of 2022, the worst of the rate hikes are behind us. We believe this will lead us into a world where investing will be based on reasonable earnings expectations, subdued growth forecasts and an allocation cycle that rewards dispersion and diversified sources of returns. We anticipate that economies will need to struggle for growth but will likely manage to stave off a deep recession.
While the impact of the initial stimulus has largely dissipated, a solid investing environment remains in the US, as indicated by three key factors: first, corporate balance sheets are healthy, and debt remains at low levels. Second, the American consumer also has a strong balance sheet and remains cash rich, with over $1.5 trillion in deposits. Third, US banks are in good shape and are continuing to lend, albeit more carefully and with tighter constraints.
In the months and years to come, the primary legacy of this inflationary period will prove to be enduring higher rates as central banks remain reluctant to ease too early, hoping to avoid a second bought of inflation. The Federal Reserve has delivered 425 points of hikes since the start of 2022 and has signaled that it will deliver another 25 at the upcoming Fed meeting on February 1. The ECB has acted in kind, raising rates by 250 bps over the course of last year, and they are far from done.
As the central banks tightened monetary conditions at the fastest pace since the 1980s, mortgage rates soared. Despite this, the banks will likely keep markets on a shorter leash than expected after the Bank of England was forced into an emergency intervention to restore confidence. It seems a new era of austerity has replaced the central bank excess of the years leading up to and immediately following the start of the pandemic, but markets have largely adjusted.
Fortunately, we believe this approach will succeed in preventing inflation from gaining heat again, and many of the other factors that contributed to the widespread price increases are unlikely to recur as well: last year, energy costs increased by 60% as supply chains were constrained by the war in Ukraine. Economies have since adjusted, however, and global governments have begun taking actions to compensate for the decades-long under-investment in energy infrastructure that exacerbated the impact of these disruptions.
Supply chains for all economic sectors are still healing from Covid shocks, the effects of the war, and general trends toward deglobalization, but while inventories are leaner, this process is a year further along the road to recovery. Similarly, housing rent inflation is no longer accelerating, and has slowly begun to decelerate. Overall, global economies have shown a remarkable ability to adapt quickly and effectively to the countless risks and disruptions that emerged last year, including the decline in fossil fuel usage, the immediate shifts to alternative supply chains, and (in most cases) the nimble adjustments to Covid’s fluctuations. The legacy of these disruptions has placed power in the hands of labor over capital and left us with a keen awareness of the fragility of our systems and the urgent need to address this. Additionally, real estate markets will need to digest a re-rating of the value of our living and office spaces as hybrid models become the norm.
As we look ahead, most of the excesses that were enabled by the permissive fiscal policy of ’20 and ’21 (speculative cryptocurrencies, SPACs, excessive valuations) have been wrung out of the market. As liquidity is removed from markets, investors must place an increased emphasis on the quality and durability of assets, in contrast to the specious nature of asset types favored when portfolios are more liquid, and money is cheaper.
Though some volatility will persist in 2023 as investors struggle to time the market’s bottom, we think this year will be markedly less volatile and more productive in its gyrations. While equities appear set to tread water, corporate profits should hold up better as companies have rapidly adjusted inventory expectations and many still retain pricing power. Consumers in both the US and Europe are also maintaining job growth, showing low unemployment and higher savings.
The slow return of China and its consumers to global trade represents an additional engine of growth in 2023. While it will take time for China’s economy to recover from the onerous Covid restrictions maintained for too long by Beijing, we anticipate that the region will become significantly additive to global growth over the course of the year.
Overall, our outlook for the future of many areas of investment remains positive. The world has experienced an exhausting and tumultuous three years, but we’re now left with a group of nations that are, broadly speaking, more aware: aware of vulnerability of the globalist economic status quo we have depended on for decades; aware of the need for greater social justice; aware of the need to ensure a sustainable future for the inheritors of the planet. Measures to protect biodiversity were widely endorsed by participants of the UN COP summit in December 2022. Widespread adoption—by virtually all industries—of practices that facilitate these missions will be necessary to achieve the 2030 goals set forth at the summit. This pressure will act as a significant market catalyst in a variety of ways and will underly many of the theses that we and other investors implement in our portfolios in the years ahead.
Additionally, we see the expansion of AI and edge computing, carried forth primarily by OpenAI, as a fundamentally transformative technology that will impact virtually every industry in ways we can’t yet fully anticipate. However, we see opportunity particularly in areas like the auto sector (specifically with respect to autonomous vehicles), in the healthcare industry (through dramatically accelerated drug discovery and as a diagnostic tool for healthcare workers), and more broadly in the info tech space, where tools like ChatGPT can act as a “translator” and provide a medium through which laypeople can build and develop programs and algorithms without an intricate understanding of programming languages.
As the era of ‘money for nothing’ comes to an end, we herald a future that is just as promising and exciting but more thoughtful about the deployment of its resources, thanks to a better understanding and acceptance of their limits.
As always, we thank you for your continued support and for the opportunity to work in collaboration with you to achieve your long-term financial goals. We look forward to a promising 2023.