The year draws to an end with many questions left unanswered: “Are we in a recession? Is inflation contained? Is the recent market rally sustainable? What is the true impact of long-lasting geopolitical tensions between Russia and NATO? “As these events evolve, we will gain clarity on their financial and economical impact to guide our portfolio management strategy, that has been and will continue to be focused on capital preservation and wealth generation.
In this economic update, we will share our analysis on the many facets shaping the current macroeconomic environment, their impact on financial markets and our outlook for 2023.
Recession and inflation: 2022’s most tensed tango dance
For the better part of 2022, economists and market professionals engaged in unending semantic debates over recession, interest rate hikes and controlling inflation. Notwithstanding the intellectual prowess of the debaters, this has not mitigated the inflationary pressure emanating from the loose monetary policies implemented in the spring of 2020. In explaining the chart below, that shows the evolution of the US fed fund rate from 2008 to today, we will provide some context on why recent interest rate fluctuations are causing headwinds in the market.
In response to the 2008 subprime crisis, the U.S. central bank (FED) lowered interest rates.
Following economic stability and growth, the FED started increasing rates in 2016.
In what we can now say was a panic response to the unprecedented COVID lockdown and liquidity squeeze, the FED lowered interest rates from 1.5% to 0% in the spring of 2020 and introduced quantitate easing to keep the economy afloat. By definition, quantitative easing is “the introduction of new money into the money supply by a central bank.” All-in, money printing totaled $13 trillion: $5.2T for COVID + $4.5T for quantitative easing + $3T for infrastructures.
A larger money supply, combined with low borrowing costs, increased the capital available to consumers who have higher purchasing power and are comfortable “over-bidding” for goods and services, ultimately leading to higher prices and inflation.
To contain inflation, the FED has been increasing interest rates at an unprecedented pace since the beginning of the year. The October inflation numbers for the U.S. and Canada were 7.7% and 6.9% respectively. The last time inflation was at these levels was in the 1980’s. Inflation seems to have peaked in the summer and is starting to decline; however, prices are still rising.
This fast reversal, from extremely accommodative monetary policies to extremely tight monetary policies in less than 18 months, caused a decline in value in both the stock market, because of pessimistic future outlook, and the bond market, because of the inverse relationship between interest rates and bond prices. Faced with this situation, investors have been hoarding over $5 trillion in cash reserve, waiting for signs of economic stability before redeploying capital in the markets.
Despite the recent decline in inflation and Fed chair Jerome Powell hinting that smaller interest rate hikes could start in December, investors should not expect interest rates to return to ultra-accommodative levels. This particular inflationary environment cannot be subdued by classic monetary policy control mechanisms.
When inflation is high, people understandably worry about a recession. According to the general definition — two consecutive quarters of negative gross domestic product (GDP) — the U.S. entered a recession in the summer of 2022. However, the U.S. economy grew at an annualized rate of 2.9% during the third quarter of 2022, giving some hope that the country can avoid a long-term recession. The Fed is facing a difficult balancing act, in bringing down inflation without triggering a U.S. recession. This year’s tense tango dance will continue in 2023 with the whole world watching, eagerly anticipating who makes the first slip.
The impact of high interest rates and a potential recession on the economy
The FED’s focus when raising interest rates is two-fold:
Increasing the cost of loans for both businesses and consumers to disincentivize leveraged financing and control spending.
Encourage people to save money to earn higher interest payments.
The driving motivation is to reduce supply of money in circulation and postpone spending to control inflation.
We will now focus on the impact of tighter monetary policies on consumers, businesses, and the bond market.
Despite rising interest rates and inflation, households have yet to meaningfully demonstrate these concerns in their spending decisions. According to the Bureau of Economic Analysis, inflation-adjusted personal consumption expenditures increased at an annual rate of 1.4% in the third quarter, partially offsetting an 8.5% decline in gross private domestic investment.
On the corporate side, things are a bit less rosy. The tech companies that spearheaded the 10-year bull market, also known as the FAANG, have been laying off staff in cost cutting efforts.
Meta (previously Facebook) cut about 11,000 jobs.
Post-acquisition, Twitter cut about 3,700 jobs.
Amazon cut about 10,000 jobs worldwide.
Overall, more than 88,000 workers in the U.S tech sector have been laid off in 2022. In spite of this, the US economy added more jobs (263,000) than expected (200,000) in November in a sign that demand for new workers remains strong. A strong labour market makes the FED’s mission in controlling inflation even more delicate. They don’t want to cause high unemployment however they want to contain rising costs. Fed officials are chiefly concerned about wage growth and the effect it is having on price pressures. Average hourly earnings in November increased another 0.6%, for a total 5.1% annual jump.
For companies, corporate profit growth will be challenging in the coming year. Companies that may have performed well in the past due to a lower cost of borrowing will find the current environment far more demanding. We will continuously monitor the balance sheets of companies while paying special attention to the debt level and the cash balance to proactively identify the high-risk ones and adequately manage our exposure.
At time of writing, the 2-year treasury yield is approximately 4.3% while the 10-year treasury yield is approximately 3.5%. Normally, short-term interest rates are lower than long-term interest rates. However, when short-term interest rates are higher than long-term interest rates, the yield curve is inverted. Historically, an inverted yield curve has been a precursor, but not a guarantee of, a recession, so we will continue to follow the shape evolution of the yield curve.
A recession can have a sustained negative impact on both consumers and businesses. As the FED tries to avoid a recession, we are closely tracking key economic indicators such as: GDP growth, consumer price index, ISM manufacturing index, retail sales, unemployment rate and many more to make the appropriate tactical allocation decisions in your portfolios that best protect the capital.
The rippling effect of China’s zero-COVID policy on global supply chain and inflation.
China is the world’s largest exporting economy and second largest importer, holding eight of the top twenty ports globally. Almost three years into the pandemic, China’s zero-COVID policy remains in effect and is exacting a heavy toll on economic growth and global supply chain, as well as causing widespread protests across the country. For the first time since the spring of 2020, China’s exports and imports unexpectedly contracted in October. Outbound shipments shrank 0.3% from a year earlier, below analysts' expectations for a 4.3% increase. Supply chains thrive on predictability, yet China’s continued zero-COVID policy is causing uncertainty and decreased confidence in supply chain management. The situation is impacting global companies:
Apple has already warned of Christmas shortages for the iPhone 14
Honda has paused production at its factory in Wuhan.
Volkswagen has been forced to suspend making vehicles at its facility in Chengdu because of a rising number of Covid cases.
The country’s pivotal role in global trade balance and supply chain management cannot be understated. “Normal inflation” stems from healthy economic growth that the central banks can contain with monetary and fiscal policies. We now understand that it’s not positive economic growth, but rather supply chain mismanagement and liquidity injection that are at the source of the current inflation.
Market performance recap
The table below recaps the YTD market performance (until November 30th) of the major indices: TSX (Canadian market), S&P500, Down Jones, Nasdaq and the bond index (US AGG bd). Both equities and bonds have negatively performed for the year. Nevertheless, there has been an uptick in the month of November, as reflected by the 1-month performance (column in green), due to better-than-expected inflation and GDP growth numbers. We wouldn’t be surprised if there is a mini rally before the end of the year, however we will still remain cautious in our asset allocation strategy considering the underlying uncertainty in the economic environment.
outlook for 2023
In light of what we have explained in this economic update, caution and prudence will be the guidelines of our portfolio management strategy in 2023. Our team has worked hard to substantially de-risk your portfolio by investing in low volatility stocks, with a strong balance sheet and good cash position. We sill have liquidity available to invest and are actively looking for undervalued, attractive investment opportunities. Defensive and value stocks are likely to remain strong investing themes for 2023 as investors await turning points for inflation and GDP growth. The full extent of long COVID ‘s impact on the health system remains unknown. Public and private capital has been going to the life and sciences sector to fund innovation in response to the pressure health systems have been experiencing the last three years. As funding continues to flow, we will pay special attention to emerging companies in the pharmaceutical and Health-Tech sector. The renewable and sustainable energy sector is also one to keep an eye on in 2023.
Conclusion
Our team has over 35 years of combined experience in wealth management and has dealt with many market cycles. We understand the mechanics of both bear and bull markets and how to invest money accordingly to maximise value while offering downside protection. We will continue to stay disciplined and be available to answer any questions you may have.
We would like to thank you for your continued trust and wish you and your family a wonderful holiday season filled with love, health and success.
The particulars contained herein were obtained from sources we believe to be reliable, but are not guaranteed by us and may be incomplete. The opinions expressed are based upon our analysis and interpretation of these particulars and are not to be construed as a solicitation or offer to buy or sell the securities mentioned herein. The opinions expressed do not necessarily reflect those of NBF. I have prepared this report to the best of my judgment and professional experience to give you my thoughts on various financial aspects and considerations. The securities or sectors mentioned in this letter are not suitable for all types of investors and should not be considered as recommendations. Please consult your investment advisor to verify whether the security or sector is suitable for you and to obtain complete information, including the main risk factors. Some of the securities or sectors mentioned may not be followed by the analysts of NBF.