What happened? What's going to happen?
2022 was tough. 2023 will have its challenges but be perched for opportunities.
Published January 12 2023
[Editor’s Note: This a special look back/ look ahead piece to start the new year. Linda’s regular weekly will return next week.]
Lots of oddities in the markets and economy in 2022. It was the first calendar year that total returns for both the S&P 500 and 10-year Treasuries were down by more than -10%. It was the worst annual performance for the conventional 60/40 portfolio (-16.8%) since 1937’s 20.6% decline, and the fourth worst year since the Dutton family set out in covered wagons for Montana (that’s courtesy of Leuthold Group). And the 236 basis-point jump in the 10-year yield was the most since 1788. History suggests yields are far more likely to fall after a big rise the previous year, but the inflationary 1970s’ proved to be an exception. Just an observation. The past year also saw the end of negative-yielding global debt, remarkable considering two years ago, there was $18.4 trillion of such debt globally and more than 4,000 bonds with a negative yield. Also unusual last year: as PMIs fell, bond yields rose, marking their largest decoupling since ISM data started (the global MSCI fell by 20% and the 10-year Treasury yield more than doubled). Similarly, yields soared even though foreigners snapped up Treasury, agency and corporate bonds at a record annual pace of $1.2 trillion through October. This suggests the balance of supply and demand matters far less for yields than expectations for Fed policy, an observation worth remembering as the new year gets underway with the bond market much less hawkish than the Fed. A 10-year Treasury that peaked at 4.25% in late October was, at this writing, trading at 3.53%, and fed futures are pricing a rate cut as early as fall. The Fed’s dot plot, and rhetoric, offer no such relief.
Consensus on Wall Street is for a recession—the latest Bank of America Global Fund Manager Survey shows 68% of fund managers expect one. Wouldn’t it be odd if it doesn’t show up this year? Clearly, no one asked the consumer. Sure, their real incomes and savings have been hit as they’ve dealt with 40-year high inflation, much of it in gas, utilities, food and rents. But those key inputs have started to roll over in earnest, and employment conditions (outside of Big Tech) remain quite favorable, with far more openings than unemployed. A far cry from an imminent recession. Wages—while moderating—are still elevated, and real incomes could turn positive by midyear as inflation cools, helping boost confidence and keeping consumer spending resilient. The savings rate may be at two-decade lows but there’s still an estimated $1.2 trillion to $1.4 trillion of excess Covid relief savings in people’s pockets. Arguing this money won’t be spent means arguing the savings rate will jump despite easing financial conditions. On what planet? Households don’t lift their saving rates when they are feeling more confident. Housing is hurting, and manufacturing and services had a weak close to 2022. But the consumer, who accounts for 70% of economic activity, is still going. Recession risks could emerge in the back half, particularly if inflation reemerges too, when the very positive CPI base effects in this year’s first half start wearing off. A Fed U-turn on first-half numbers also could raise the likelihood inflation remains structurally higher. Do you take the Fed at its word?
If the economy does fall into recession, it will be the most telegraphed in history. Indeed, cash allocations continue to run well above the long-term average as fund managers remain defensive. Health Care and Consumer Staples are among the biggest sector overweights, the Bank of America survey shows, while the highly cyclical Consumer Discretionary sector is the largest underweight. A mild winter and less spillover from the Ukraine war is raising hopes in Europe, where valuations look attractive. But China is top of mind. Its lifting of Covid restrictions, high household savings and desire to spur growth after two years of the doldrums is not so different from the set-up in the U.S. in June 2020, when a reopening economy, cash-heavy investors and record low interest rates sent the equity market on a tear. China’s abrupt turn creates the best chance in many years for Asia and EM equities to outperform, given earnings downgrades here and the reverse there, the positive implications for commodities of a China reopening and a weakening dollar as the Fed nears an end to tightening. Indeed, after generating the largest abnormal gains among all major global financial assets BCA Research tracked in the 2022’s first nine months, the greenback fell 9% in the closing quarter.
A very divided Congress and House GOP is a good candidate for a 2023 challenge. If the prolonged fight over electing House Speaker McCarthy is any indication, a nasty debt ceiling fight can’t be discounted. Citigroup’s head of government affairs says a lot of freshman Republicans seem to lack an understanding of economic risk around the issue that crushed the market and brought the nation on the brink of default the last time congressional Republicans played chicken with it in summer 2011. It doesn’t help that Freedom Party members who opposed McCarthy (and effectively can get rid of him as speaker any time) are committed to cutting government spending and debt regardless of the optics. New December budget data show a deteriorating fiscal environment, with tax revenues declining, interest costs soaring and the deficit set to exceed levels from before the Fed exited QE last spring. This could pull forward the potential crisis, now penciled for mid to late summer, as the Treasury runs out of extraordinary items to delay the showdown. Democrats who have made it clear they won’t negotiate this time, a debt-laden student loan program and a regime change on interest costs add to the drama, as do rules new members of Congress may not understand. To actually cut spending, as the Freedom Party wants, nearly every House Republican must vote to raise the debt ceiling. I’m loading up on popcorn as 2023 could feature a wide training range and opportunities for those who are perched for such.
What else
End-of-bear necessities? No bear market has ended before a recession begins, suggesting one or more of the major indexes could make a new low at midyear. Also, Evercore ISI says no bear market since 1962 has ended without a significant volatility spike, a missing ingredient in 2022 and a potential “fat pitch” this year that could mark the beginning of the next bull market.
Who says demography is not destiny? Despite French philosopher Auguste Comte’s famous quip, India’s largely youthful population should surpass China’s this year, making the sleepy Asian giant the world’s biggest potential market. By 2050, India will be home to 350 million more people than China, with a median age still south of 40, vs. above 50 in an aging China.
You don’t have to pay a robot and he shows up most days A month after McDonald’s launched its first fully automated drive-thru in Texas, CEO Chris Kempczinski sent a memo to staff alerting them to planned layoffs that will begin in April. With wage demands still rising in a structurally inflationary cycle, the use of automation continues to increase.