Asheville, North Carolina holds a special place for the writer and native son Thomas Wolfe, whose 1940 novel’s title You Can’t Go Home Again is a fitting framing for investing in 2023. Many investors are trying to treat the events of 2022 as an aberration in the hope that 2023 returns us to the pre-covid era of cheap money, abundant credit, low inflation, and high security valuations. Such investors are destined to be disappointed.
Start with some variables that will impact the year. First off is the war between Ukraine and Russia, a situation that did not exist prior to the end of February this year. How this situation resolves itself has implications beyond the conflict. If Russia prevails, it will probably be a prototype for Russia and other dictatorships to try similar moves elsewhere. One can see Taiwan becoming an Asian version of Ukraine. If Ukraine prevails, there will be little credibility for Vladimir Putin. Unfortunately, dictatorships have no clear line of succession. It is thus not obvious if his successor would be better or worse.
Interest rates are on most investors’ minds. Unfortunately, their framing of the inflation situation is heavily influenced by the media, which is being fed a scenario where interest rates will go down with inflation. First, inflation shows no sign of declining to the rate of two percent which is the Federal Reserve’s stated goal. Second, the Fed intends to bring interest rates above the inflation rate and keep them there. Two percent inflation translates into a short-term rate of 3-4 percent, which is not that much off where they are now. The most recent reading of inflation put it at 7.8 percent year- over year. Even if inflation were to come down to five percent, it still implies higher interest rates from here. Betting on lower interest rates would not seem to be a good idea in 2023.
The earnings of corporate America are expected to decline in 2023. The last of the stimulus funds are expected to be spent. Technology companies are rapidly laying off workers as revenues slow and profits plunge. While not large in number compared to the overall workforce, their average salary is typically several times higher than the average worker. Expect this to impact localities like San Francisco and Boston, as well as upper end consumer goods. Economists are already referring to this trend as a “white collar recession”. If so, it will be a first.
Looking ahead to 2024, market soothsayers are saying that corporate profits will rebound. They will be aided by a more “normal” investment environment as well as the funding of infrastructure projects passed in 2020 and 2021. If the above forecast is correct, the recession and market decline should be shallow. If it is not there will be further turbulence in the overall indexes.
One way to sidestep this is to not buy “the market” in the form of S & P 500 index funds, and instead focus on sectors and companies that will do well. For 2023 this would include industries such as health care, natural gas, and better managed companies even in out of favor industries. For example, Macy’s has been tested from its experiences before and during covid in ways that Nordstrom and Kohl’s have not.
As for bonds, it is still too early to call a top. Even when one is formed, a bond fund will hold all kinds of issues that have declined in value. If one is too early, a portfolio loss can ensue. If correct on being elevated for a long time, there will be opportunities when and if interest rates decline. Interest rates will not decline like they did in the 1980s.
Truth be known, even indexes can depend on a few stocks to carry them. As the current growth leadership is discredited (Meta (nee Facebook), Apple, Amazon, Netflix, Alphabet (nee Google), it will take a while for new leadership to form. At higher interest rates, investors are demanding a faster and higher return on their investment. The era of investing in firms that generate losses for years is ending. While the investing public focuses on the stock market, far more damage is being done in hedge funds and private equity.
Because there is no index for private equity, data is replaced by rumor and gossip as to the value and health of the investments and sponsors. Many of these investments require low interest rates to compensate for the fees being assessed by the general partner. Sometimes these fees ran to five percent of revenues from the investments, plus additional fees assessed to the investors. As the value of the investment is estimated by appraisal, it is a lagging indicator both on the way up as well as on the way down. These investments were sold to pensions and endowments and “qualified investors” as being “non-correlated” with marketable investments. If falling like a rock qualifies as non- correlated, their worth has been proven. Much of the investing public has been sold on the merits of a portfolio of 60 percent stocks, 40 percent bonds. In October, BofA Global Research noted that to date this year the “60/40” approach has generated its largest loss since 1937. While the magnitude of the loss may be surprising, the existence of the loss should not be. Interest rates have been forecast to rise for years. Portfolio management is not a bakery where various recipes get you different returns over time. The world is more sophisticated and evolving than that. Investment approaches should be the same.
Economic activity, while slowing, continues to be positive. This is a source of consternation to the Fed, who is trying to reduce inflation by increasing interest rates.
For the reason for this, one must analyze the percentage of people working at a given age. The data shows that below the age of 55 work force participation is back to pre-covid levels. Above 55 it is 5-10 percent below pre-covid. The reason for this is two-fold. Older workers had high balances in their 401K accounts pre-covid and decided to retire rather than play Russian roulette with their health in the workplace. Remember that this was the age group that lost the greatest number of contemporaries to the pandemic. It also suffers most from “long covid”, an after effect of covid which renders some workers disabled. The second reason is the lack of immigration policies to replace these workers. As a work force shrinks, the ability to pressure it with interest rates becomes less effective. Pressuring fewer workers with higher interest rates results in higher wages. Due to the population demographics, the pre-retirement group (55-65) is not quite twice the size of the 25-35-year-old workers. Thus, the withdrawal of pre-retirees from the workforce has been proportionately more pronounced in terms of economic capacity and wage inflation.
Inflation is forecast to decline this year from last. How much is up for discussion. The original drivers of inflation were work force shrinkage, energy price spike from Russia and its allies, the sale of the Treasury’s bond portfolio (known as quantitative tightening) and various disasters ranging from food inflation abroad to weather at home. In 2023 there may be a new element: a falling dollar. The dollar’s strength has been multi-year. At this point nothing is prepared to challenge it. However, as other nation’s raise their interest rates, the US will need to do the same to keep up. Otherwise,there will not be enough foreign buyers for US debt, which is a prescription for dollar depreciation. Since most all international transactions are denominated in US dollars, a decline in the dollar will help foreign countries at the expense of the US by increasing the cost of imported items in dollars but less in terms of other currencies.
Interest rates have staged a mini rally of late on the expectation that a 50-basis point increase by the Federal Reserve Wednesday is somehow a harbinger of lower rates to come. Don’t believe a word of it.
For starters, the Fed has not ruled out additional increases going forward. The difference between three 50-point increases and two 75-point increases is one of timing. So long as the Fed believes that interest rate increases will reel in inflation they will continue. There is a school of thought that believes that higher interest rates will not reduce inflation so long as inflation is driven by restrictions in supply rather than excess demand. For supply inflation, steps like raising the minimum down payment on credit items including homes and balancing the federal budget would do more to quinch inflation than increasing the cost of money. There is also the need to keep the value of the dollar elevated, mentioned above.
The Stock Market
Stocks presumably discount the future, so the shape of 2024 will have an impact on their 2023 valuation. More currently, stocks are under pressure from reducing earnings forecast as well as competition from short-term investments like money market funds. Value stocks have outperformed growth stocks for about 18 months now. There is not a lot to change that on the horizon. What one must watch for is the shifting definition of value. Utilities are value stalwarts. They have as a group had a good run this year but have historically low yields, pushing most out of the attractive investment column. With the cost of electric car generation and grid upgrading on the horizon, they may soon be users of capital rather than distributors. When utilities must raise capital, they become political footballs.
Warren M. Barnett, CFA
December 13, 2022
Statements made within the Perspective are those of the author and should not be considered as individual investment advice. For personal investment advice, please contact the firm at 423-756-0125 or