I have to say that I am pleased to see the back of 2022, but I am reluctant to say anything about 2023, because I was pleased to see the end of 2019, and 2020 and 2021 always thinking that they had been tough years and hoping that the following year would be so much better. Then we had Covid, and the Ukrainian war, global supply chain backlogs etc, and I am placing no bets on what may happen in the year to come!!
Broadly, markets were down as much as they were in the 2008 financial crisis. When we look back it is obvious what the catalysts were, but when you are living through market cycles they are much less obvious than you think. At the end of 2021, we kind-of knew that inflation was an issue. The Fed thought it was transitory, the smart people questioned how that could ever be, and the market analysts kept an eye on mostly monthly indicators to try and get some perspective. And then there was a war!! Even that seems more obvious now, but at the time nobody really thought we would still be in the middle of it a year later!
So where are we now, and what are we looking at in the months ahead? Economies move in cycles, as do the markets. You would think that they work in tandem, and to an extent they do, but quite often the market anticipates what is happening in the economy and moves ahead of the economic data. So it is difficult to keep tabs in real time on what to expect. Often we look at historical data to try and predict what the future holds – this is a key point with inflation expectations and how the Fed looks at things – and sometime we apply a generic lead or lag factor to the data based on how it has behaved in the past. I would argue that we are starting to break away from some of the older established lead/lag trends as better quality data is available in near real-time.
The economic cycle
The economic cycle refers to the fluctuations in the economy between periods of expansion and periods of contraction. Indicators are data points like GDP Growth, interest rates, consumer spending, employment, etc. Expansion is economic growth. Production increases, unemployment drops and wages increase; corporate profits increase, consumers spend and the flow of money through the economy remains healthy. The increase in money supply tends to cause inflation to pick up as more people are chasing fewer goods. The economy reaches a peak when growth is at its maximum rate. At this point (or a bit before) interest rates start to rise and with the cost of money increasing corporates put some of their capital projects on hold, production slows, consumers spend less as they allocate their income to higher mortgages, credit card debt, and so on. Corporate profits come down, and earnings are more difficult to come by. Staff are laid off as companies try to contain their costs and with that, less consumer spending. At this point there is a risk that economies will go into a recession – and we reach the bottom of the cycle again. #simplifiedview.
The big story for 2022 was inflation. It rose too quickly after decades of very little inflation, and the Fed raised interest rates at the fastest pace in decades to try and keep a lid on it. So here is the thing – inflation is a rate of change. It is the percentage change on the price a year (or month) ago. When we came out of Covid lockdowns and global supply chains were under pressure, there was huge demand for goods that had not been available due to lockdowns around the world. The demand, when measured against the same demand a year before was really high and the inflation prints showed that. To be fair to the Fed, if all else had been equal, the inflation may have been transitory as the rolling measure against the previous year would have evened out quite quickly. But when you throw a war into the mix, all else is not equal!
Interest rates are a blunt tool to curb demand for goods. If the cost of borrowing money increases, there is less money to spend on non-essential goods. As the demand for those goods wanes, the inflation numbers come down. It all seems so simple. But if interest rates are high for too long, then consumers and market participants are strangled and while inflation may be bought under control, the economic activity is under pressure and growth slows, and worse yet, stops, pushing the economy into a recession. When an economy is in recession, people lose their jobs, they can’t pay their mortgages (not to mention that interest rates went up so mortgages are even higher), they stop spending and inflation falls. The central banks pat themselves on the back because they have tamed the inflation beast, and they start to lower interest rates. The whole cycle rotates, people start spending, companies start growing, they employ more people and when people have jobs, they start to buy things. The cycle starts again.
So where are we in the cycle? There are different theories, but at the end of last year, Fidelity Investment managers did not think that we had reached the bottom of the cycle. Unemployment remains low in the United States, therefore people are still earning, and there are more jobs available than people looking for work. This is a key metric for the Fed, as typically, while unemployment is low, there is still demand in the system, and demand translates into inflation. There are a lot of different views on this – and other factors are at play. The baby boomers are retiring, and many people haven’t returned to their 9 to 5 jobs after the pandemic. But there are indicators that a recession is looming, and some (the scribe included) think that the US is already in a recession.
What are the indicators that we are looking at? Inflation is the big data point as it is pretty much what will drive the monetary policy of the Fed. If we break down the inflation numbers in America, the two broad components are goods and service inflation. Goods inflation is already falling. Food prices are falling and cost of transportation has decelerated rapidly. Car prices have fallen too and the peak in car prices last year was around April, which means that when we start measuring the rate of change, it is going decelerate even faster from the second quarter of this year. Services inflation is still quite high though – and the main component of this section of the inflation calculation is in “household rents”. There is quite a large delay in calculating the rate of change in household rents, because leases don’t change immediately with the increase in interest rates, and the methodology of calculating the level is based on a survey of respondents. Looking at more real time indicators such as the Zillow Observed Rent Index, it seems that household rents are already moving down. The other component of service inflation is the wage growth – which is still rising. Wage growth tends to follow job openings and what we have seen is that the number of jobs available in the economy are falling, which should lead wage growth down. This is a very simplified analysis, but it seems to me that inflation is falling, and will probably fall faster in the next three months. Unless we have some unexpected shocks to the system, it is probable that the inflation rate will be within the band that is acceptable to the Fed by May or June and then we may see interest rates stabilising and then started to fall.
This doesn’t mean that we have an all-out positive expectation for the markets for this year. Corporate earnings will probably be weaker in the first and second quarters of this year, and slower earnings of companies usually translates into falling share prices. But because markets are forward looking, they will look through the earnings cycle and when they anticipate that the worst is behind us and that corporates will be able to benefit from a falling interest rate cycle, the market should pick up again. I think we will have more of the same volatility in the first half of this year, but it is my expectation that we will see markets pick up in the second half of the year.
What we do need to get used to is the increased volatility of share prices as they react to good and bad data points. With the proliferation of real-time, high quality market data share prices and bond yields react violently as new data is released. If the data points are out of the range of expectations, the moves are more violent. The trick is to work out what we think is realistic and position ourselves for that outcome and then hold onto our seats as we navigate our way through the typical ups and downs of market cycles!
I would love to say that 2023 will be an easy and prosperous year. I think that market performance will be more positive than 2022, but I can’t say that I think it will be easier! I hope that the year is happy, healthy and full of all good things (whatever that is for you!).
Could bad news be good news?
I have to say that I am pleased to see the back of 2022, but I am reluctant to say anything about 2023, because I was pleased to see the end of 2019, and 2020 and 2021 always thinking that they had been tough years and hoping that the following year would be so much better. Then we had Covid, and the Ukrainian war, global supply chain backlogs etc, and I am placing no bets on what may happen in the year to come!!
Broadly, markets were down as much as they were in the 2008 financial crisis. When we look back it is obvious what the catalysts were, but when you are living through market cycles they are much less obvious than you think. At the end of 2021, we kind-of knew that inflation was an issue. The Fed thought it was transitory, the smart people questioned how that could ever be, and the market analysts kept an eye on mostly monthly indicators to try and get some perspective. And then there was a war!! Even that seems more obvious now, but at the time nobody really thought we would still be in the middle of it a year later!
So where are we now, and what are we looking at in the months ahead? Economies move in cycles, as do the markets. You would think that they work in tandem, and to an extent they do, but quite often the market anticipates what is happening in the economy and moves ahead of the economic data. So it is difficult to keep tabs in real time on what to expect. Often we look at historical data to try and predict what the future holds – this is a key point with inflation expectations and how the Fed looks at things – and sometime we apply a generic lead or lag factor to the data based on how it has behaved in the past. I would argue that we are starting to break away from some of the older established lead/lag trends as better quality data is available in near real-time.
The economic cycle
The economic cycle refers to the fluctuations in the economy between periods of expansion and periods of contraction. Indicators are data points like GDP Growth, interest rates, consumer spending, employment, etc. Expansion is economic growth. Production increases, unemployment drops and wages increase; corporate profits increase, consumers spend and the flow of money through the economy remains healthy. The increase in money supply tends to cause inflation to pick up as more people are chasing fewer goods. The economy reaches a peak when growth is at its maximum rate. At this point (or a bit before) interest rates start to rise and with the cost of money increasing corporates put some of their capital projects on hold, production slows, consumers spend less as they allocate their income to higher mortgages, credit card debt, and so on. Corporate profits come down, and earnings are more difficult to come by. Staff are laid off as companies try to contain their costs and with that, less consumer spending. At this point there is a risk that economies will go into a recession – and we reach the bottom of the cycle again. #simplifiedview.
The big story for 2022 was inflation. It rose too quickly after decades of very little inflation, and the Fed raised interest rates at the fastest pace in decades to try and keep a lid on it. So here is the thing – inflation is a rate of change. It is the percentage change on the price a year (or month) ago. When we came out of Covid lockdowns and global supply chains were under pressure, there was huge demand for goods that had not been available due to lockdowns around the world. The demand, when measured against the same demand a year before was really high and the inflation prints showed that. To be fair to the Fed, if all else had been equal, the inflation may have been transitory as the rolling measure against the previous year would have evened out quite quickly. But when you throw a war into the mix, all else is not equal!
Interest rates are a blunt tool to curb demand for goods. If the cost of borrowing money increases, there is less money to spend on non-essential goods. As the demand for those goods wanes, the inflation numbers come down. It all seems so simple. But if interest rates are high for too long, then consumers and market participants are strangled and while inflation may be bought under control, the economic activity is under pressure and growth slows, and worse yet, stops, pushing the economy into a recession. When an economy is in recession, people lose their jobs, they can’t pay their mortgages (not to mention that interest rates went up so mortgages are even higher), they stop spending and inflation falls. The central banks pat themselves on the back because they have tamed the inflation beast, and they start to lower interest rates. The whole cycle rotates, people start spending, companies start growing, they employ more people and when people have jobs, they start to buy things. The cycle starts again.
So where are we in the cycle? There are different theories, but at the end of last year, Fidelity Investment managers did not think that we had reached the bottom of the cycle. Unemployment remains low in the United States, therefore people are still earning, and there are more jobs available than people looking for work. This is a key metric for the Fed, as typically, while unemployment is low, there is still demand in the system, and demand translates into inflation. There are a lot of different views on this – and other factors are at play. The baby boomers are retiring, and many people haven’t returned to their 9 to 5 jobs after the pandemic. But there are indicators that a recession is looming, and some (the scribe included) think that the US is already in a recession.
What are the indicators that we are looking at? Inflation is the big data point as it is pretty much what will drive the monetary policy of the Fed. If we break down the inflation numbers in America, the two broad components are goods and service inflation. Goods inflation is already falling. Food prices are falling and cost of transportation has decelerated rapidly. Car prices have fallen too and the peak in car prices last year was around April, which means that when we start measuring the rate of change, it is going decelerate even faster from the second quarter of this year. Services inflation is still quite high though – and the main component of this section of the inflation calculation is in “household rents”. There is quite a large delay in calculating the rate of change in household rents, because leases don’t change immediately with the increase in interest rates, and the methodology of calculating the level is based on a survey of respondents. Looking at more real time indicators such as the Zillow Observed Rent Index, it seems that household rents are already moving down. The other component of service inflation is the wage growth – which is still rising. Wage growth tends to follow job openings and what we have seen is that the number of jobs available in the economy are falling, which should lead wage growth down. This is a very simplified analysis, but it seems to me that inflation is falling, and will probably fall faster in the next three months. Unless we have some unexpected shocks to the system, it is probable that the inflation rate will be within the band that is acceptable to the Fed by May or June and then we may see interest rates stabilising and then started to fall.
This doesn’t mean that we have an all-out positive expectation for the markets for this year. Corporate earnings will probably be weaker in the first and second quarters of this year, and slower earnings of companies usually translates into falling share prices. But because markets are forward looking, they will look through the earnings cycle and when they anticipate that the worst is behind us and that corporates will be able to benefit from a falling interest rate cycle, the market should pick up again. I think we will have more of the same volatility in the first half of this year, but it is my expectation that we will see markets pick up in the second half of the year.
What we do need to get used to is the increased volatility of share prices as they react to good and bad data points. With the proliferation of real-time, high quality market data share prices and bond yields react violently as new data is released. If the data points are out of the range of expectations, the moves are more violent. The trick is to work out what we think is realistic and position ourselves for that outcome and then hold onto our seats as we navigate our way through the typical ups and downs of market cycles!
I would love to say that 2023 will be an easy and prosperous year. I think that market performance will be more positive than 2022, but I can’t say that I think it will be easier! I hope that the year is happy, healthy and full of all good things (whatever that is for you!).
Asset Class Returns
The table below represents a rolling year view of the major asset class returns that we track. It offers a view of the asset classes we use to diversify your portfolio.