In 2022, the financial markets had to absorb two powerful shocks: inflation and interest rates both soared over a short period, which negatively impacted asset valuations for many investor’s portfolios. A simultaneous decline in both bonds and stocks is extremely rare, but often when this has happened historically, both moved higher the following year. Today, stocks and bonds are priced cheaply, inflation and bond yields are falling, and labor markets are loosening. The three-month rate of change in the consumer price index (“CPI”) core goods measure has already declined to less than 2%, which is below the Federal Reserve’s (the “Fed”) long range target, and we think the Fed may be close to ending rate hikes. The challenge stocks still face is how far earnings may decline in a recession, but that is not news and if the Fed is easing later in the year, stocks will likely look through to the next up cycle. The one risk that keeps us cautious is the possibility that the Fed’s sales of securities to reduce its balance sheet, its “quantitative tightening” policy, causes a recession or a liquidity squeeze in the financial markets. We think that risk will subside by mid-year and in any event the central bank is fully capable of quickly responding and diverting any long-term negative effects. Should this be the case, bonds and stocks are, we believe, highly likely to end the year with positive returns. But as we have seen in the past, recoveries can be rapid and difficult to time.
We think the Fed will ease sooner rather than later, simply because liquidity pressures on the economy and securities markets are far too intense to sustain. Over $93 billion each month is being taken out of the financial markets through quantitative tightening, and money supplies and deposits are falling, sending incomes and asset prices lower. Yield curves are inverted, and commodities and freight costs are falling sharply. Rents are also declining and once that trend begins, it usually persists because falling rents mean the rental stock is overbuilt and more supply is coming on. Mortgage applications are off 67% and current futures prices indicate gasoline prices are on their way to $3 per gallon. There is still a lot of money in consumer hands available to spend but installment credit outstanding is almost 20% higher than it was a year ago, indicating consumers must borrow a lot at 20% interest costs to sustain current spending. That’s impossible to do for very long. If monetary patterns affect the economy with a 1–2-year lag, we are building in a weakening economy for a lengthy time and a possible return to very low nominal interest rates.
If we are correct and the earnings recovery is sluggish, popular indexes like the S&P 500 Index and NASDAQ Composite Index should provide, at best, modest gains during the remainder of the 2020s, similar to what occurred during the 2000-2010 timeframe. A long unwinding of excess capacity in software, excessive expansion in semiconductor capacity, much of it political, and a rapid proliferation of Internet social platforms have to be worked off. Many of the earnings drivers for Big Tech are weakening. Online advertising has slowed, social media has become intensely competitive, and many companies are laying off employees. Even after the declines of 2022, mega-cap growth stocks still make up a large percentage of the indexes. Tech stocks may occasionally rally, but we think it is unlikely to have the leadership capacity of the past decade. Trillions of dollars will have to be reinvested elsewhere and that is the opportunity.
The key, at this point in time, we think, is to focus an equity portfolio on companies and industries that are generating high free cash flow and that do not depend upon a strong economy. Wherever there is growth, we believe that values are likely to rise, especially as we return to low growth and low interest rates.