January Investment Comments
No year is without surprises. As we look back at 2022, probably the two most disruptive surprises were Russia’s war in Ukraine and the persistence of Covid lockdowns in China. Both caused complicated knock-on effects for the global economy. Embargoes on Russian imports stressed European energy markets and briefly caused oil and gas prices to spike worldwide. That Russian energy did not disappear, it just got rerouted, and energy commodities have pulled back significantly, although regional prices can vary compared to global averages.
Chinese demand for imports has dropped, while its export machine continues to hum despite the lockdowns. China’s balance of trade (exports minus imports) has risen to new highs. Chinese companies reselling cheap Russian energy at a markup may exaggerate this statistic.
Taking three quarters of U.S. GDP data and extrapolating consensus Q4 estimates, it appears that real growth for 2022 will be just under 2%, modestly below forecasts coming into the year. The U.S. has luckily been insulated from the disruptions mentioned above thanks to our own energy independence and the fact that only about 6% of U.S. exports go to China, a country which represents about 18% of measured global GDP. For context, about 16% of U.S. imports come from China.
Another disruptive, but less surprising, occurrence in 2022 was continued consumer price inflation. This was a global phenomenon. According to Trading Economics, eight of the world’s ten largest economies recently experienced 12-month consumer price inflation of 6% or more, led by Italy (12%), the U.K. (11%) and Germany (10%). The two that registered lower inflation were lockdown-affected China and often- deflationary Japan, which is currently experiencing 3.7% inflation, its highest rate in 30 years.
In the U.S., 12-month consumer price inflation through November was 7.1%. Energy is not currently an inflation driver, as gas prices have returned close to pre-pandemic levels. It is not abundantly clear whether China’s lockdowns were net inflationary due to renewed stress on supply chains or net deflationary due to falling Chinese demand. The rising balance of trade referenced above would seem to favor the deflationary explanation. In any event, the main driver of inflation has been monetary expansion, which central banks are now attempting to reverse.
After ignoring rising inflation in 2021, in 2022 the U.S. Federal Reserve raised interest rates sharply and started reducing its balance sheet. Overnight interest rates, which had been pinned at zero since the beginning of the pandemic, started rising in March. They will end the year in the vicinity of 4.25%. That is a big increase in one year, made necessary because the Fed waited too long to start. Balance sheet reduction has not been similarly aggressive yet. The Fed’s total assets will end the year around $8.5 trillion, about where the balance sheet stood in the fall of 2021. The M2 money supply peaked at $21.7 trillion in March of 2022 and has come down 2% since then. It needs to fall something like another 25% to return to its pre-pandemic trajectory, which is probably unrealistic to expect. Don’t expect the inflation of 2021 and 2022 to be reversed by future deflation. Prices are permanently higher.
To its credit, the U.S. Fed acted first among major central banks. Japanese rates remain pegged at zero. The U.S. dollar rose approximately 20% against the yen in 2022 and was up 30% at the October peak. The dollar rose 18% against the euro at peak and briefly became more valuable for the first time in twenty years, before the European Central Bank regained initiative with a 0.75% rate hike in September. Despite giving up some gains, the dollar is still poised to end the year at the very high end of its 20-year trading range against major foreign currencies.
It is hard to predict what inflation, interest rates, or the U.S. economy will do going into 2023. The essential question is whether inflation can be tamed without a painful recession or whether the Fed will have to break the economy to save the economy?
The early inflation drivers have calmed down, with energy and used vehicles showing recent declines. Shelter (housing), which works its way into the CPI data with a long lag, appears to be decelerating. That is good news, but there is a risk that the inflation baton could be handed off to the services sector. Services including medical care only represent about 20% of the measured CPI basket, but the other 80% has a substantial services component baked in. The wages of truck drivers and grocery employees flow through to the cost of food. For context, nearly two-thirds of GDP is labelled as services, versus goods.
Real (inflation-adjusted) median wages appeared to spike during the pandemic because job losses were higher in lower-paid sectors. After a long decline associated with the gradual reopening, inflation-adjusted wages recently bottomed about flat with their pre-pandemic level and have now started rising again. With measured unemployment a low 3.7%, there should be room for wage growth from here. More or less by definition, rising real wages create upward pressure on inflation.
It is a bit ghoulish to think of the Federal Reserve as a giant government institution committed to preventing wage growth for working people, but one way or another, the Fed needs to stop real wages from rising too quickly in 2023. If commodity costs, especially energy, are flat or down, this will leave some breathing room for further wage appreciation. However, the opposite could happen as well, especially if China finally reopens. The least bad path forward might be to let inflation run a little higher than the Fed’s ostensible 2% target, say 4%. The Fed permitting 4% annual inflation for the foreseeable future might be preferable compared to crushing the economy with even higher rates.
Rising interest rates make existing bonds less valuable while also putting downward pressure on stock valuations. Combined with the possibility of a looming recession and associated lower corporate profits, financial markets are a lot less exuberant now compared to twelve months ago. As of this writing, the S&P 500 was down 12% for 2022. The Nasdaq 100 was down 25%. The Vanguard Total Bond Market Index Fund was down 11%.
Looking ahead, the stock market would hate a severe recession. The bond market would hate an inflation-tolerant Fed. There may not be much middle ground between those two paths. We are always in favor of leaning toward the stock market and searching for companies who can succeed in any environment. Investors should pay especially close attention to valuations and beware of low multiples based on earnings that are likely to contract in a recession.
Miles Putnam, CFA