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In the final quarter of 2022, the US economy turned out to be better than many had expected. Or maybe better said, “less worse” than many had expected!
Estimates are that during the final quarter of 2022, U.S. Real (inflation-adjusted) Gross Domestic Product (GDP) rose slightly to 0.5% (annualized). This comes on the heels of a fairly significant jump (2.9%) in the third quarter and outright declines in the first two quarters of the year. Despite those two consecutive quarters of negative economic growth earlier in the year, an official recession, as determined by the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER), was not declared in 2022.
Looking forward, the consensus is that weakness in the US economy will continue to spread in 2023, with outright declines in Real GDP likely to be experienced in the first three quarters. Overall growth for the 2023 calendar year is projected to come in at 0.0%. Therefore, an official proclamation of a recession in 2023 is highly probable. Against this backdrop, for many investors, this potential recession is a foregone conclusion; therefore, with the consequent decline in earnings to come, they have been revaluing publicly-traded equities downward over the past year.
Certainly, a major contributing factor to this stagnant growth environment is the aftereffect of the surge in economic activity that came with the post-pandemic reopening with inventories being drawn down, supply chains restarting, and hiring surging. Also, sadly, the Russian aggression in Ukraine continues and with that, its disruptive effects on the global energy and agricultural markets. Beyond that, the effects of the significant increase in global interest rates are being felt throughout the economy, especially in interest-rate sensitive sectors such as housing and construction. Lastly, while for much of the year, the strong U.S. dollar was a significant headwind for domestic exporters, that strength began to dissipate in the fourth quarter.
Along with the not-so-bad news about economic growth in the fourth quarter of 2022, the inflationary environment turned for the better. While still unacceptably high, inflation has begun to subside. The most recent reading came in at 7.1% (12-month Consumer Price Index change, November 2022), down from 9.1% in June 2022, a four-decade high.
In response to the progress in its fight against inflation, in the fourth quarter of 2022, the Federal Reserve dialed back the scale of its Federal Funds rate increases. While it had been raising rates 75 basis points every FOMC meeting cycle, at the most recent December meeting, the members voted for just a 50 basis point increase (to 4.5%). While many investors keep wishing fancifully for a “pivot” in which the Federal Reserve reverses course and begins to cut rates, a more likely scenario is that future increases are scaled back to just 25 basis points until a “terminal rate” is reached (5%?). Then, overnight rates will remain at that level until inflation permanently subsides around the Fed’s 2% target level.
Meanwhile, despite anemic economic conditions, the labor market remains remarkably resilient. The Unemployment Rate for December came in at 3.5%, equaling a five-decade low, and average hourly earnings grew 4.6% over the prior 12 months. While good for workers, this does not bode favorably for overall economic growth and taming inflation as the labor participation rate (62.3% in December) remains stubbornly low when compared to prior decades.
As if the economy itself did not present enough uncertainties, U.S. politics took it to another level in the fourth quarter. The midterm elections in November did deliver the House of Representatives to the Republican party, but not as decisively as had been expected. The Senate remained in Democratic hands. That outcome, along with the Democratic White House, means a divided government in Washington, D.C. Historically, investors have viewed such a balance of power in Washington DC favorably as it guards against significant policy and regulatory changes. However, given the rampant divisiveness between and even within parties, it is possible that issues could arise in coming to an agreement on debt ceiling increases which could lead to government shutdowns and even potentially impact on the nation’s ability to service its debt obligations.
Globally, investors face similar conditions to those in the U.S.: slowing growth, stubbornly high inflation, and rising interest rates. Continued dissipation in the strength of the U.S. dollar, the denominator for global commodities markets, would serve to ease inflation pressures abroad as well as serve as a favorable tailwind for investors' investments in foreign-currency based assets.
Investors need to focus primarily on their financial goals, ignoring the noise of day-to-day events, and invest accordingly. A recession is likely, but it might not be as deep or long as some fear. Also, now that the inflation “toothpaste” is out of the “tube,” it will be difficult to put back. So, while investors can expect inflationary pressures to subside, it may be quite some time before it gets back down to levels viewed as “normal.” As always, investing with one’s head rather than with one’s emotions is best!
Bureau of Economic Analysis
Bureau of Labor Statistics
International Monetary Fund
The Conference Board
The fourth quarter brought back the rally that began in mid-June as the markets tried to retest those lows in early October. The S&P 500 regained some of its momentum until the end of November, along with the US mid-cap and small-cap markets, until all turned south for December. Despite the poor showing in the last month of the year, all three finished in positive territory for the quarter but paled in comparison with the brightest spot in the 4th quarter, which was the International market. Outperforming the US markets dramatically, the International and Emerging markets turned in a quarterly return of 16.53% vs. all the US markets with single-digit returns. The high inflation numbers, Russia's continuing war against Ukraine, and a slowing economy kept us in the “Correction Process.” Even if we have a few more months before we can declare that a new Bull Market has begun, it is starting to appear that the Bear market is losing much of its strength. That being said, we believe it’s time to start believing that the opportunity for positive returns over the next 12 to 18 months could be higher than more downside risk. Although there are pundits out there that are still highly pessimistic, one fact remains – all bear and bull markets eventually come to an end.
The past 12 months have given us not only the correction we have been expecting since the Pandemic recovery but ushered in a simultaneous bear market in global stocks and bonds. The good news is that the worst year in the equity and bond markets together is behind us, but the bad news is that the road ahead could be bumpy for the first half of 2023. We still have the potential of 2 to 3 more interest rate increases, the stubbornly high inflation rate, and an economy expected to slow to the point that confirms the much-anticipated recession. These headwinds have kept the markets on a downward trajectory for the past 12 months. In that time, the S&P 500 had a total return of -18.13%; the S&P 400 Mid-cap index was down -13.10%, the S&P 600 Small-cap index was down -16.15%, and the international markets fell -14.40%. It seems like all of the pundits and talking heads on the financial news networks are even more bearish now than at the first of the quarter, with some still expecting another 20% to 30% downside from here. With so much negativity in the markets and the financial media, “contrarians” believe this could signal that the bottom may be in and has been tested in June and again in October.
Economic Indicators and Calendar
Inflation rose to 0.4% (Month over Month) in October, beating expectations of 0.60%, and fell to 0.10% (Month over Month) in November. The expectation is for the month-over-month number in December to be 0.00% and will be released on January 12th. If we can see month-over-month numbers stay in the 0.0% to 0.20% territory for the next several months, then the CPI year-over-year number will come back towards the 2.5% level over the next 12 to 18 months.
(Source: Bloomberg) (A= Advance; S= Second: T= Third)
GDP growth came in stronger than the initial expectation of 2.2% for the 3rd quarter, with an actual 3.2% for the quarter in the third revision. The debate among economists and market pundits changed during the 4th quarter from whether we are already in a recession to how deep the recession will be in 2023. Although there has been no definite proclamation of a recession yet, it is highly likely we will hear an announcement sometime in the first half of 2023.
The Unemployment rate ticked down to 3.6% in October after spiking to 3.7% at the end of the 3rd quarter and jumped back to 3.7% in November. It is possible we could see the unemployment start to rise in the 1st quarter of 2023 as the economy slows and layoffs increase; however, with so many jobs still open and unfilled in the US, those laid off may not add to the unemployment roles for long if at all.
Nonfarm Payrolls continue to have strong monthly numbers and may remain strong in the face of a recession as those that are laid off in the coming months may be able to fill some of the 10 million job openings in the US. If the employment picture remains this robust in the face of rising interest rates, the Federal Reserve will not be inclined to curb their enthusiasm for higher interest rates as they seem to want to see unemployment rise to 5 or 6%.
The Federal Open Market Committee raised the Federal Funds rate by 0.25% in March, 0.50% in May, and 0.75% in June, July, September, and November. With some signs that the interest rate increases are starting to slow the high inflation numbers, the Federal reserve slowed their pace from 75 bps steps in the past four meetings to an increase of only 50 bps in their final meeting of 2022. Based on Chair Powell’s recent comments, we should expect a rate hike of 0.25% at both the February and March meetings, with a potential terminal rate of 5%. As the Federal Reserve was late to start raising interest rates, it will not be surprising to see them raise interest rates too high, causing unnecessary damage to the economy in their efforts to bring inflation down.
Performance data quoted represents past performance and is no guarantee of future results. Investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For the most recent month-end performance please call 877-658-9473. For standardize performance, click on the fund link below.
—Matt Melott, Manager
—Jacob Chandler, Manager
SPLIT PERSONALITY - the yield curve spiked higher on the shortest part of the curve while falling in the intermediate area and rising for the longest maturities confusing the fixed-income markets. Interest rates for the 1-month to 2 years maturities and the 10 to 30 years maturities all went up in the 4th quarter. At the same time, the 3, 5, and 7-year bonds fell as the Federal Reserve let up on the gas pedal slightly of the interest rate increases with jumps of 75 bps in November but only 50 bps in December.
As of the end of the 4th quarter, the 1-year US Treasury yield increased from 3.989% to 4.710% (a 72 bps increase) vs. the 10-year US Treasury, which rose from 3.832% to 3.877% (for a 4.5 bps rise). Analysts failed to predict that the 10-year rate would hit 4.5% by the end of 2022.
The 2-year U.S. Treasury yield increased from 4.281% to 4.429%, the 5-year yield fell from 4.092% to 4.005% (a decrease of 8.7 bps), and the 30-year treasury rose from 3.779% to finish the quarter at 3.966% (an increase of 18.6 bps).
The probability of a recession is still high as the economy is slowing. However, with strong employment numbers and consumer spending, a recession is still avoidable if the Federal Reserve will not push their rate increase process too far.
Geopolitical Risks and Volatility
It has become challenging to understand where things stand regarding the Russian/Ukrainian war, especially given the media’s conflicting reporting. Russia has ratcheted up its military operations since October, while Ukrainian President Zelenskyy has ratcheted up his rhetoric (even suggesting that Ukraine will take back Crimea, which it lost to Russia in 2014). It seems certain that Russia is determined to continue its course, and some say it is preparing to launch an unbridled offensive soon to end the war. It is reported that Putin is orchestrating an increase of troops in Belarus (north of Ukraine) while at the same time continuing his troop build-up on Ukraine’s eastern border. Some suggest that Russia now amassed nearly 700,000 soldiers versus only 100,000 for Ukraine. The Russian onslaught could pave the way for sooner negotiations with Ukraine; however, as long as Ukraine keeps receiving military support (primarily from the US), the conflict could drag on, which will continue to impact the global economy and the capital markets. From a humanitarian standpoint, many observers are worried about the infrastructure damage in Ukraine, making the situation more pronounced heading into the colder winter months.
Inflation and Money Supply
The November CPI month-over-month reading was 0.1%, coming in below the consensus gain of 0.3%. Year-over-year inflation fell from 7.7 to 7.1%. Although inflation has come down, it will remain elevated until the Fed consistently gets the growth of the money supply (M2) under control, as that tends to be a leading indicator of inflation.
The Consumer and GDP
Revised third quarter GDP came in at 3.2%, coming on the heels of negative growth rates for the first and second quarters. Although the 3Q datum supports the view that we are probably not quite in a recession, it doesn’t mean everything is rosy. Most of the GDP growth was led by net exports, which should not be as strong going forward. Slowing growth could worsen, especially if personal consumption, business investment, and home building continue to slow/decline going into 2023. We will continue to keep a close eye on growth figures going forward.
In last quarter’s commentary, we discussed how corporate earnings had been rising in 2022, but there are signs that earnings are starting to fall. Indeed, profits declined modestly in Q3 (versus Q2), and we expect profits to continue to fall, particularly given the impact of higher interest rates and potentially slowing consumer demand. As a result, we will continue to keep a close eye on corporate earnings, as this will impact equity performance going into 2023.
The markets have started to show signs that this Bear Market may be ready to hibernate as we finished the year with the only quarter in 2022 with positive performance. Although we are glad to see a positive quarter, we may have several more months to run before the next bull market starts. As we are still facing the same headwinds from the last four quarters – inflation, rising interest rates, War in Ukraine, and slower economic growth we need to remain patient and focused on long-term opportunities.
Beware of the negative sentiment we see in the media and the majority of the so-called market experts, as they could be wrong, and this bear market may be over sooner than most pundits expect. By the time most people feel good about the stock market again, the next bull market will already be several months old.
Whatever may come, our Lord is still in control. We remain thankful for the provision, protection, and blessings that we received from our Heavenly Father and are looking expectantly to what God has in store for 2023.
We thank each of you for bringing Glory and Honor to our Heavenly Father and our Savior Jesus Christ through Biblically Responsible Investing.