Economic Monitor: What a Year!

BY: Mark Drachenberg


Wasn’t it GREAT? A year full of surprises, unexpected twists and turns, and gains and losses kept us alert and on the edge of our seats. 

Oh, you thought I was talking about 2022? No, I am looking ahead to the end of 2023 and how I might describe this year. But, yes, that could easily describe 2022, except that I think the word “GREAT” would more likely sound like a groan and certainly lowercase letters would be used due to the lack of enthusiasm shown. Anyone making 2022 sound great is certainly being sarcastic or is just foolish (at least when it comes to the markets). A bear market in equities, the worst bond market in 50 years (if not ever), spiking inflation, rapidly rising interest rates, and more made last year the definition of a tough year.

The New Year faces many of the same issues as 2022, but the markets are closer to being fairly valued (pending earnings), the Fed is closer to the top in terms of hiking interest rates, inflation is ebbing, and the surprise factor for the economy is not likely to be as strongly negative as it was last year. So, the New Year will be GREAT, right? Well, let’s not get ahead of ourselves as there is a lot that can, and will, happen this year that will likely throw off everyone’s forecasts. First, let us review last year and then look ahead to 2023 and see what might be in store for the markets and the economy. Hold on, it is going to be a fun (said a bit sarcastically) ride!

Financial Markets

Last month, we wondered if a trend had started in terms of market rallies. Unfortunately, the answer was no, as the markets took back most of what we gained in November. The Dow Jones Industrial Average, on the verge of turning positive for 2022 at the end of November, lost 4.09% in December to finish the year with a loss of 6.86%.  The more tech (and top) heavy S&P 500 lost 5.76% in December and 18.11% for the year.

The lone bright spot (relatively speaking) was the EAFE that lost only 0.01% during December. Even so, the EAFE shed 16.79% on the year. The NASDAQ brought up the rear by losing 8.67% in December and a whopping 32.54% for the year. Bonds faced their worst in year in fifty plus years by falling 0.45% in December and 13.01% in 2022. Talk about no place to hide. Some bright spots emerged such as value outperforming growth, high yield outdoing the overall bond market, cash yields finally rising, and valuations returning closer to normal levels.

The New Year will bring challenges, but the starting point is better than last year. Inflation has begun to inch downward, and the Fed has followed suit by noting that the speed of rate hikes may slow (more on both topics below). Each time the Fed says this the markets rally. Typically, the rally is short-lived, but clearly the markets are ready to move higher should the Fed pause, especially if the economy stays relatively strong.

From a valuation standpoint, the S&P 500 finished 2022 at 16.65x, slightly below its 25-year average of 16.82x on a forward-looking basis. The key will be earnings. Estimates are that earnings will be flat to as much as 8% or 9% growth. Pending a recession, and its length, earnings should gain some ground, but not much. That will not get equity investors too excited, but, if combined with a pause by the Fed, could be enough to drive equities to high single-digit gains in 2023. Fixed income investors will keep an eye on the Fed as well, looking for any sign of a pause or cut in rates. What the Fed does, and perhaps more importantly, what they say, in the first few months of the year, should give investors a strong indication of where rates are headed and how to invest. A rocky year, yes, but one that could reward investors, especially in the latter half of the year.

The Economy

While not in a recession at this point, several factors are pointing in that direction. Manufacturing data shows that things have softened, consumer sentiment has fallen dramatically over the past several months and is well below long-term averages, the yield curve has, or is, inverted at several points and, while not a guaranteed precursor to a recession, the level and consistency of the inversion are pointing that way. The other side of the ledger shows consumer spending remained strong through the Christmas shopping season, which saw sales rise 7.6% from a year earlier vs. estimated sales growth of 6%. The employment picture remains strong, much to the dismay of the Fed, and inflation has started to ease. The latest data shows inflation rising at an annualized rate of 7.1% vs. well above 8% during 2022, and many are forecasting it to fall dramatically this year.

Compared with all the uncertainty on the negative side during 2022, this year should be calmer and have fewer negative surprises along the way. The major uncertainty is the possibility of a recession. While many expect the U.S. to enter a recession during 2023 or 2024, the severity of the recession is the real issue. Most do not expect a deep recession, which is good, but many are concerned it could linger and be harder to come out of, which is not so good. The term I have heard used is that it will be like a swamp – messy, shallow, sticky, and tough to climb out of. One overlooked positive note, though, is that there may never have been a recession that was forecasted more than the one that may be on the way and therefore, hopefully, we will all be better prepared for it, should it arrive.

GDP (Gross Domestic Product) – GDP rose in the third quarter at an annualized rate of 3.2% (revised) after falling 0.6% in the second quarter and 1.6% in the first quarter. Fourth quarter numbers vary greatly but most are looking for a gain of 1% to 1.6%. Likewise, full year estimates have been all over the map but are currently running in the positive 1% to 2% range. With a looming recession in 2023 or 2024, GDP estimates are hard to come by, but many expect a return to the longer-term trend of 2% - 2.5% growth going forward. When, or if, a recession hits, the numbers will take a hit initially, then be fairly strong for a quarter or two as the recession fades, before falling back to the long-run average.

Inflation – Inflation moderated slightly more than expected to 7.7% in October and then dropped to 7.1% in November. Investors cheered the news expecting that the Fed would finally pivot, stop raising rates, and possibly start cutting them. Those expectations were dashed time and again by the Fed as they continued to raise rates.  With many forecasting the rate of inflation to fall significantly in 2023 (possibly due to a recession), the Fed may be forced to stop raising rates sooner than planned or run the risk of pushing the economy deeper into a recession. Wages are a key because spiraling wage growth combined with a tight labor market only drives prices higher (this is a key component of what the Fed is looking at). Since many inputs are seeing prices fall such as commodities, shipping, energy, etc., the rate of inflation should fall, but not likely as fast or as far in 2023 as some expect. That is good because a rapid decline in inflation would mean a dramatically slowing economy and we don’t want that.

Unemployment – The labor market showed continued strength in December as nonfarm payroll hiring increased by 223,000 and the unemployment rate fell to 3.5%. Not exactly what the Fed wants to see. On the other hand, wages increased by “only” 0.3% in December which was lower than estimates. For the Fed, this is good news, but it is only a single data point, and the Fed will likely want to see a trend before making any adjustments. Recent reports by several employers, including Amazon, show that they are planning cuts to shave expenses in 2023. As with inflation, the Fed will be keeping a close eye on this data but likely will not make any changes until the unemployment rate begins to tick higher. One wonders if the lower workforce participation rate will become permanently entrenched into our economy, forcing the Fed to adjust its employment and inflation goals.

The Fed Watch

Could this be the year of the Fed Pivot? It certainly could, as the data largely supports a cooling economy and lower inflation. Yes, the Fed is expected to raise rates at its next two policy sessions, but then things will get interesting. Barring some unexpected event, the fed funds rate will likely be at or above the rate of inflation, which would mean that real interest rates would no longer be negative. This would push the argument that the Fed should pause. Then, any weakness the economy shows, such as falling into a recession, would provide the Fed with ammunition to start cutting rates.

Erring on the conservative side, I would guess that the Fed may raise rates three times in the first half of 2023 (25 basis points each time) before pausing. Should a recession ensue (when it does and the severity of it will also factor in), then do not be surprised to see the Fed cut rates by the end of the year. We might be touting the Fed’s praises at the end of the year, especially if they somehow engineer a soft landing, although I doubt it on both counts. As has been the case for some time now, all eyes are on the Fed!

Outlook/Summary

The story just does not change, and neither will this outlook. Opportunities always present themselves in times of major market movements and this time is no different. New opportunities exist in the fixed income markets due to the rise in interest rates and the ability to start enjoying yield again. The time to extend durations may be soon upon us and the potential for capital gains could present itself should the Fed pause or even cut rates (late 2023 or into 2024). On the equity side, it still pays to be defensive with a value tilt, although many traditional growth investments are trading at valuations not seen in quite some time. We remain diversified, keeping a focus on downside protection, but ready to take advantage of opportunities as they present themselves. Overall, a balanced portfolio could see average returns this year of mid-single digits even though the year will be somewhat rocky. Would be a welcome change from 2022 and we might even call it GREAT! To discuss your portfolio, please call the Wealth Management department of the State Bank of Cross Plains at (608)826-3570. We look forward to speaking with you.

Market/Economic Data

As of December 31st, 2022…. (Unemployment data is through December for national, November (preliminary) for both Wisconsin and Madison, inflation data through November):

Index Month Return YTD Return Index Month Return YTD Return or Current
DJIA Industrials -4.09 -6.86 EAFE -0.01 -16.79
S&P 500 -5.76 -18.11 Bloom US Agg -0.45 -13.01
S&P 500 Equal Weight -4.71 -11.45 Inflation (CPI All-items) 0.10 7.10% annual
S&P 400 -5.54 -13.06 U.S. Unemp. n/a 3.5%
S&P 600 -6.71 -16.10 Wisconsin Unem. n/a 3.3%
NASDAQ -8.67 -32.54 Madison Unemp. n/a 2.0%

Thank you for your business – we look forward to speaking with you soon. (Note – this commentary used various articles from JP Morgan, Morningstar, the Wall Street Journal, Investor’s Business Daily, Northern Trust, CNNMoney.com, msn.com, Kiplingers.com, nytimes.com, Fidelity Investments, American Funds, LPL Financial and other tools as sources of information

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