January Update: Winning Ugly

In 2022, many negative factors were amplified as both the level and rate of change worked against us. For example, Fed Policy experienced record rate increases in terms of both speed and size. In general, we do not foresee the rate of change as a problem for certain categories (inflation, Fed policy, interest rates) though the absolute levels will likely remain problematic. However, the likely impact of higher inflation and restrictive policy on things like GDP and earnings growth are not likely to improve the odds of a winning hand in 2023.

Let’s look at each factor briefly:

1. Inflation – negative but not worsening. We see inflation as likely to decline from its incredibly elevated levels domestically, though reaching the Fed’s stated 2% target seems ambitious. Prior to this millennium, inflation almost never hit 2%. Accordingly, we see a probability of inflation gravitating towards its longer-term average near 4%, especially given its global grip. We think that this high versus recent-history level of inflation will continue to be a challenge.

2. GDP Growth – moving into the negative column. We have written about this in the past, but the inversion of the yield curve, in both magnitude and breadth, typically coincides with worsening GDP growth and/or a recession.

3. Fed Policy -negative but improving, just barely. Hard for this one to get worse, given the historic rate increases experienced in 2022. Consensus calls for a further 0.75% increase, which is paltry versus 2022’s 4.75%. Just the same, to think that Fed policy is going to be a positive as opposed to just less bad in 2023 is misguided.

Look no further than the growth in money supply, or, more specifically, the lack thereof, something we have not seen in the over 40 years the Fed has been tracking this metric:

Its balance sheet runoff has only just started as well, and the current run rate of $95 billion per month would see the Fed’s balance sheet shrink over 13% in 2023. Pundits excited about the prospects of a pivot should curb their enthusiasm at best and be careful for what they wish at worst. Pivots, i.e., changes from restrictive to accommodative policy, often mean something has structurally broken with the financial system or the economy due to overly aggressive tightening.

4. Interest rates – negative but improving. The key factor here is mortgage rates, which hit 7% but have declined somewhat. We are seeing the damage inflicted on the housing market, but the knock-on effects on profits and employment have not appeared. Yet. This is consistent with the Fed’s typical policy mistakes.

(Also, something almost no one is discussing is the effect of higher rates on the rapidly increasing pile of government debt. According to the U.S. Treasury, “As of November 2022 it costs $103 billion to maintain the debt, which is 11% of the total federal spending.” This debt is at an average 2% interest rate.)

5. Credit spreads -moving into the negative column. From our perspective, spreads do not reflect the likelihood of an economic slowdown. High-yield spreads are in-line with their long-term average. We use this as a contrarian indicator and would be more aggressive if spreads increased.

6. Stock multiples – improving to neutral. This is where a lot of investors get excited. We cannot tell you how often we hear that the market, or, more likely, stock X, is cheap because it is Y% below its all-time high. This is simply not a viable valuation framework. After entering 2022 very overvalued, the best we can say is that the S&P 500 – as a whole – has returned to an average valuation.

The caveat, and it is a big one, is that current valuations remain elevated versus prior bear market troughs. In other words, typically more damage is done. Perhaps we will get lucky this time, but you know our thoughts on luck.

7. Earnings growth – moving into the negative column. This remains the biggest disconnect we see. While estimates have been reduced, they remain aggressive in our opinion, with only three sectors (energy, health care, and materials) forecast to see a decline earnings in 2023, while four (communications, financials, technology, and consumer discretionary) are forecast to have double-digit growth: