We’re closing in on the end of this tumultuous year. As we get nearer to 2022’s “finish line”, it’s helpful to look back at the year so that we can begin to assess what 2023 may bring.
The Federal Reserve’s monetary policy has been the key factor impacting markets this year. To frame what’s happened in the markets this year, let’s consider forecasts and expectations. In Colorado, we have excellent metereologists and weather technology, and most people here actively follow the weather. However, many find it’s difficult to believe and prepare for of extreme weather when the sun is shining. Why get snow tires when it’s 70 degrees outside? When the predicted bad weather finally moves in (“if you don’t like the weather, wait 15 minutes” was my grandfather’s often-used line), the reality of sheets of rain, heavy snow and icy roads still takes many drivers off guard. The analogy extends to the financial markets this year. By the end of 2021, the Fed had set expectations that it would begin raising rates and tightening monetary policy. When the Fed did tighten monetary policy, it still seemed to catch market participants by surprise and financial markets plummeted. The bond market has had the most challenging year in decades. Over the first half of 2022, the situation rapidly got out of hand when inflation reports came in extremely high and more tightening, more quickly was required. We ended up getting a more intense storm than the Fed had forecast and ended up with the market equivalent of cars and trucks all over the highway.
As we moved through 2022, increased geopolitical risk, specifically the attack of the Ukraine by Russia in February and China’s housing market problems, further destabilized the markets. The markets remained laser-focused on the Fed’s every move and reached bear market territory in June 2022. Despite a brief rally in late summer, the markets have been on a roller coaster ride through most of the fall. In November, midterm elections raised market participants’ blood pressure. The elections resulted in a stronger Democratic outcome than expected and effective gridlock in Congress. Gridlock tends to be a positive for the markets, as it’s more challenging to pass legislation and when it is passed, it’s more bipartisan. Less noted by the pundits, but of great importance after recent elections in the U.S., there were decisive (if close) election outcomes and peaceful transitions of power across the country. Today, the political noise has largely abated, and we’ve returned to a calmer state of affairs.
Now, as we’re nearing the finish line of this volatile year, focus has shifted to expectations for next year and the prospects of a recession. The questions on investors’ minds are: what kind of recession will we have? Is a “soft landing” possible, or will economic conditions have to worsen considerably before the Fed stops hiking? Will the Fed have to cut interest rates next year if it causes too much of a recession? What will the cost of the interest rate hikes be, in terms of the ultimate impact on the housing market, jobs and the broader economy?
Despite high profile job cuts the labor market remains strong. However, the housing market, traditionally one of the major ways the Fed’s rate hikes slow down the economy, has worsened quickly. Wealthier consumers, less impacted by inflation, have held up relatively well while poorer segments are much more challenged. Corporations have been whipsawed this year, first by the lag effects of Covid-19 on their supply chains, and then by deteriorating demand which resulted in bloated inventories. While major deterioration in fundamentals has not occurred, many company managements are erring on the side of caution – limiting hiring, imposing cost cuts, slowing investments and growth initiatives and managing profit expectations for next year down.
Adding to the general sense of concern, we’ve seen a major blow-up in the cryptocurrency markets with the collapse and bankruptcy filing of cryptocurrency exchange FTX and the potential of billions of dollars in losses and high-profile write-downs. Fraud isn’t a new phenomenon by any means, and the cryptocurrency market, unregulated and speculative, created the right conditions for someone looking to exploit an opaque situation and investors’ “FOMO”, or fear of missing out.
Despite the weak performance this year the markets remain in a holding pattern, given the unclear economic trajectory and the lack of clarity around future monetary policy. There remains a wide range of outcomes for the markets, including a further drop or a stabilization and steady improvement. A major rally, without real improvements in corporate earnings or the Fed adding significant liquidity back to the market, is less likely. In these types of environments, most market participants seek certainty and the Dow Jones Index, comprised of slower-growth, mature companies, has been a relatively better performer this year than the S&P 500 Index and the tech-intensive NASDAQ Index. We continue to seek out high quality companies with strong cash flow streams, high returns on capital and attractive valuations. The silver lining today is that the volatile market conditions have created attractive opportunities.
Wishing you and your family a festive, happy and healthy holiday season.
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