Leading indicators of growth for the US economy are now pointing to marked weakness ahead. In stark contrast, readings for inflation and employment (both lagging indicators) are still too ‘hot’. In response to the latter, over the last nine months we have seen one of the most aggressive US interest rate tightening cycles in history. Price stability will eventually be achieved – but this is likely to come at a high price in terms of employment and output. In this note we review how economic developments have shaped markets in 2022 and begin to explore how the investment landscape might look in 2023.
It seems likely that 2022 will end up in the stock market history books for all the wrong reasons. As the year began, the consensus view was that US interest rates were likely to rise gradually from the emergency support levels that had been in place since the pandemic. At the time, US (CPI) inflation stood at 6.8% but this was attributed to what Fed chairman Jay Powell now famously described as ‘transitory’ factors: changing consumption habits driven by lockdowns, combined with disruption to supply chains. Both were expected to quickly dissipate, with Powell even going on the record saying, ‘We’re not even thinking about thinking about raising rates’. This proved to be very, very wide of the mark. As the year unfolded, inflation proved to be far from transitory and borrowers have had to endure a torrent of interest rate hikes. What was expected to be a maximum of around three 0.25% interest rate rises back in January has turned, by mid-November, into four successive 0.75% hikes – with US interest rates now in the 3.75-4% range. This is up from the 0-0.25% range that was in place until the first rate rise in March. There are more to come.
As a result, bond prices have been squashed. Equity markets have declined in sympathy, driven initially by the higher interest rate applied to discount the value of future earnings and more recently by the weaker outlook for profits as the economy slows under the weight of much tighter monetary policy. This ugly combination earns 2022 its place in history as one of only four years in almost 100 years where both equity and bond prices have fallen in tandem (see chart). The Bloomberg Global Aggregate Bond Index has dropped by 17% over the year to date, while the S&P500 broad US equity index has declined by 16%. We now consider 2023. Is there any relief in sight?
2023 Outlook
Next year is likely to be challenging for the global economy. The IMF’s October 2022 World Economic Outlook highlighted its expectation that more than a third of economies will be in contraction in 2023, with the three largest economies, the US, the EU, and China all likely to stall. Closer to home, the Bank of England’s (BoE) most recent forecasts suggest that the UK economy is already shrinking, and that it will continue to do so for another eighteen months, making it the longest recession in 100 years. These forecasts accompanied the BoE’s largest interest rate increase in more than 30 years. This is remarkable. In most cycles interest rates are increased as the economy strengthens – to head off nascent inflationary pressures. This time, because central banks were caught out by the magnitude of the inflation shock, interest rate increases are taking place into a weakening growth backdrop. This disconnect is vividly illustrated in the chart below. It shows the path of ISM Manufacturing New Orders in the US against the one-year change in 5-year US government bond yields. In essence it shows that, in the past, when the business outlook is improving bond yields tend to be rising, and vice versa. This is logical – but it’s not what is happening now. At present the business outlook, as measured by the historically reliable new orders component of the ISM survey, is deteriorating rapidly while bond yields have increased sharply.
The explanation for the disconnect is high inflation, and the sharp interest rate hikes implemented to address it. However, with many leading indicators pointing to weakness ahead, deteriorating economic fundamentals are now working in the same direction as tighter monetary policy, bearing down on inflation. One notable leading indicator is housing. Housing market activity in the US appears to be grinding to a halt under the weight of 30-year mortgage rates which have moved from 3% to more than 7% in 12 months. This is the fastest pace of increase in forty years. This sector is important as one of the stickiest components of inflation is ‘shelter’ which measures home ownership and rental costs. This is still climbing, perhaps because people are deferring house purchases in the face of much higher mortgage costs. However, given a rapidly weakening housing market and pressure on consumers from higher prices elsewhere, inflation from this source seems highly likely to fall back in due course.
Housing is also important because the construction sector employs close to 5% of the US labour force, therefore along with related supply and service businesses, housing accounts for a great deal of employment. Unsurprisingly, jobs are now being lost in these areas and it seems likely that this will gather pace. A quote from a recent FT article highlights the extent of the impact of higher interest rates:
‘Realtors, mortgage brokers, appraisers and construction groups say they have lost as much as 80 per cent of their revenue since the Fed started raising rates in March.’
US property sector braced for job cuts as rate rises crush home sales FT 11.10.22
Returning to inflation, the time lags involved in the transmission of higher interest rates to the real economy suggests that it will not turn on a sixpence, but, driven by ongoing increases in interest rates and a deteriorating economic backdrop, the direction appears firmly set. Importantly, Jay Powell recently pointed out that medium term inflation expectations remain well-anchored. This means that, in sharp contrast to the 1970s, continued, rapidly rising prices are not yet built into the psyche of consumers and businesses. This suggests that, with the appropriate central bank action, very high inflation should not prove a long-lived challenge.
Portfolio Positioning
Turning to portfolio positioning, financial markets are forward looking and so have discounted at least some of the difficulties ahead. However, we remain concerned that an overzealous Fed, fixated on lagging indicators such as employment and inflation, will drive the US into a recession or trigger a crisis in financial markets or other areas of the economy before it stands down from its war on inflation. We have therefore positioned portfolios cautiously – in accordance with what the leading indicators are signalling about the months ahead. High quality bonds would usually be a haven in such circumstances but have certainly not been the place to be so far this year. We were too early to add here but remain convinced that they are very unlikely to inflict defaults on investors. Also, they now offer significant yields and, more importantly, should provide protection should the US economy really start to show the effects of the continued, eye-watering tightening of financial conditions. Elsewhere, equity allocations are much pared back and focused on large cap, quality businesses that we believe will prove resilient in the face of economic weakness. Portfolios are, in summary, on a recession footing. However, as we move into 2023 the investment outlook should become progressively more positive. Inflation will be easing, and markets will begin to look beyond the economic weakness to the recovery. After the sharp corrections seen this year, there are likely to be attractively priced opportunities for investors.
