We don’t yet know whether 2022 will be seen as a great inflection point in the unfolding global economic narrative, but it certainly feels like a big reset for many markets. We’re sure 2022 will be remembered (or perhaps best forgotten) for some of the following factors:
- A swift escalation in interest rates in response to inflation borne from covid-related supply chain issues
- Geopolitical uncertainty (Russian invasion of Ukraine, China’s controversial “zero covid” policy)
- Employment disruptions
Bond prices fell in response to rising rates and general uncertainty about how the Fed would respond to the inflation crisis caused stock markets around the world to fall. As 2022 comes to a close, we begin to think about the promise of a fresh start that a new year brings and what could be on the horizon for 2023.
Trying to predict what the markets are going to do is notoriously difficult (a fool’s errand, in our opinion). Similarly, trying to predict what the economy will do in the near future is also challenging because the business cycle (peak to trough to peak) never unfolds in exactly the same way. With that said, there are some economic themes we can point to that may indicate what could be in store in the near and intermediate-term future:
Persistent Volatility
The reversal of low interest rates and low inflation, coupled with the unraveling of globalization, may be a critical inflection point that leads to higher volatility for both stocks and bonds over the long-term. The last 10+ years in markets have been unique compared to long-term history. One could describe markets since the Global Financial Crisis in 2008-2009 as having low interest rates, low inflation and low growth coupled with accommodative monetary policy and maximum liquidity. These conditions have led to abnormally low volatility and have encouraged investors to take additional risk. Reversing some, but not all, of these conditions may lead to higher volatility across multiple asset classes in the future. In other words, the playbook of the last 10 years is not likely to be the same for the next 10 years, making risk management and asset allocation even more important than it has been in the recent past.
Moderating Inflation
It is unlikely inflation in 2023 will fall straight to the Fed’s target of 2%. However, that is not what is required for a market bottom or for the Fed to pause its current aggressive hiking stance. The impact of higher interest rates is likely just beginning to take hold, as we’re beginning to see inflation on goods moderating (inflation on services, however, seems to be picking up steam). As monetary policy actions begin to affect prices, we may see further moderations of inflation figures which may allow the Fed to slow or stop hiking rates. So, while inflation may moderate over the years to come, its pivotal moment in shifting market sentiment may be closer at hand.
Bear Market Bottom
When looking at significant stock market pullbacks (20% or greater), since 1950, the average pullback has lasted approximately 14 months; the longest of these was 31 months from March 2000 to October 2002. The shortest drawdown was less than two months in 2020. While there is no such thing as an average bear market, with history as a guide, our 11-month-old bear market is likely closer to its end than its beginning.
Now, how do bear markets typically unfold? Most commonly, markets decline due to what’s called “multiple contraction,” then the Fed ends a hiking cycle or begins an easing cycle and finally, earnings and expectations fall. This creates a new base on which to build healthy forward expectations.
When you buy a stock, the price you pay is comprised of two primary components, earnings per share and multiples. Most simply, earnings per share is a representation of the economic value created by a business. Multiples, on the other hand, are a reflection of how much an investor is willing to pay for the earnings of that business. Multiples are often driven by investor sentiment and therefore tend to influence prices (market fluctuation) before other factors. Corporate earnings, on the other hand, are backward-looking since the impact of interest rates and/or slowing demand takes time to appear in financial statements. Therefore, the typical pattern of bear markets is to see multiple contraction first, leading the market lower, followed by declining earnings.
Market sentiment has been negative for most of 2022, so we know that multiple contraction has played a large role in the decline of asset prices this year. The question remains, what role will earnings play in the market bottoming this time around? Excluding energy producers, second and third quarter corporate earnings were negative, which perhaps suggests that earnings are beginning to reflect the economic reality of a moderating economy. This is a healthy step forward for a bear market bottom and again suggests we are nearer the end than the beginning.
Finally, what role does the Fed play in all of this? Likely a very important one. History has shown that markets tend to reach their bottom after the Fed is done raising rates. Intuitively this makes sense. If the Fed is raising rates, they are proactively looking to cool economic activity. Yet given the Fed’s dual mandates of price stability and full employment, the operative word is cool, not kill. When the Fed sees modest success in controlling inflation they will stop or pause raising rates. However, the full effect of higher rates takes some time to work through businesses and markets. It is similar to turning the shower handle to change the temperature: you have to wait a bit to see if you got it right. Therefore, businesses are often amidst contraction when the Fed stops increasing rates. It is certainly conceivable that the market bottoms before the Fed officially changes course. However, the market is less likely to bottom if the Fed is accelerating or maintaining its hawkish stance.
Final Thoughts
2022 was the reset button for many markets. Ending “near zero” interest rate policies, moderating inflation and repricing of global assets have all helped sow the seeds for a brighter outlook in 2023 and beyond. While we anticipate volatile asset prices will persist in the years to come, leaning into newly created opportunities may prove to be the right decision over the long-term.
The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding investments, sectors or markets in general. The above statistics and/or commentary has been obtained from sources we believe are reliable, but we cannot guarantee their accuracy or completeness. Past performance is no guarantee of future results. This is not a complete analysis of every material fact regarding any company, industry, or economic condition. Due to shifting market conditions, all expressions of opinion are subject to change without notice.
The information contained in this document does not cover all tax strategies that may apply, is not a complete guide to tax planning, and does not constitute the rendering of legal, accounting, or other professional advice or opinions on specific facts or matters. Before implementing any ideas suggested here, consult with your tax advisor regarding your specific tax situation. Talk to your financial advisor before acting on information in this document.