In what is certainly an understatement, 2022 was a year to wish a less than fond farewell. The Federal Reserve was still pumping stimulus into the economy at the beginning of the year—yes, hard to believe—but by March got, uhm, serious with a 25 basis point increase in its Fed funds rate. Russia invaded the Ukraine in what was expected to be an expedient victory. An energy crisis enveloped Europe, made worse by Russia but not caused by it, as years of European failure to secure diversified sources of energy came home to roost. What ensued was a raging 40-year high of inflation that was anything but “transient,” decimating financial assets in the worst rout seen since 2008.
The big question for many investors: Should I be in the market right now?
The hangover is a doozy and is expected to linger through 2023. The Fed got it wrong, and it’s determined to right the ship to save face, even if the boat sinks along the way. But instead of salvaging its image, the Fed might just be setting itself up for the dubious honor of getting it wrong in both directions. Think about it: One year on, prices have surged to record levels for autos, food, energy and shelter. It could pay to be a contrarian, as investors are stampeding in the same direction to protect against inflation. It may just be time to lock in high yields and dividends with the view that inflation is dissipating. The Fed’s mistake may be that it is looking in the rear-view mirror, fighting the last war. Bad for the Fed, but good for markets.
Despite the stress of higher rates, the private economy continues to be resilient. Wall Street’s expectation is that we’ll see a demand-driven recession and easing demand would help the Fed’s fight against inflation. But that has yet to happen. The economy is being driven by a relentlessly strong consumer in a tight job market, where there are nearly two openings for every applicant. The “delta” of the world economy has recently shifted up like a hockey stick, with China coming back on-line by eliminating Covid quarantines. To see the impact of China’s reopening on the world economy in real time, keep an eye on whether oil prices revert higher.
A — Advancing corporate earnings and U.S. economic growth
The S&P 500 grew earnings in 3Q22 by 4.4%, with topline revenue growth at 11.1%. Over the past seven quarters, positive quarterly earnings growth on an annual basis has been associated with a continued bull market in earnings. The consensus forecast for the full year of 2022 is expected to be 5.8% per share ($220), while 2023 is projected to be 4.8% per share ($230). (Source: Refinitiv)
Corporate earnings growth outperformed the economy in 2022, so what does that mean for the coming year? The economy made a big comeback in the third quarter. Recall that U.S. GDP contracted 1.6% in 1Q (sequentially) and 0.6% in 2Q. But in 3Q, GDP jumped by 3.2%. Personal consumption expenditures increased 2.3%, primarily due to higher services consumption. At the same time, the Atlanta Fed’s GDPNow forecast for 4Q is a robust 3.1%. The private economy is demonstrating an astounding resilience given that restrictive monetary policy has devastated markets globally.
Earnings and the economy may not be the same thing, but they do rhyme. Given our own $237 per-share earnings growth expectation for 2023, what does that imply for the S&P 500’s final print in 2023? That depends on the outcome of the tug of war between hawkish central banks and the world’s resilient private economy.
Recall that interest rates can be applied as a discounting mechanism for future cash flows. Inflation, a key driver of interest rates, is hovering at around 7% in the US. The Fed funds rate is currently 4.5%, on its way to 5% or even higher in 2023. Europe is playing catch-up, with plans to markedly increase interest rates over the course of 2023. Applying the historical P/E ratio for the United States, our $237 per-share S&P earnings estimate equates to an S&P price of $3,555 compared with a 2022 ending price of $3,840 — rather pessimistic given the implied drop in share prices.
In a contrarian scenario (my base case), our P/E forecast jumps to 17.4x, and multiplied by our anticipated earnings level, produces an estimate of $4,125. That result would imply a roughly 7.4% return. That may not sound like much, but it sure beats a hefty negative return. The good news is that I expect better returns out of diversifying into assets such as U.S. Midcap, U.S. Small cap, MSCI Emerging Markets, and fixed income.
Source: Refinitiv – Thomson Reuters and FactSet, Voya Investment Management, as of 12/31/22. Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. The S&P 500 index is a gauge of the U.S. stock market that includes 500 leading companies in major industries of the U.S. economy. Past performance is no guarantee of future results. Indices are unmanaged and not available for direct investment.
The U.S. ISM dropped from 49.0 to 48.4 in December, indicating economic contraction based on new orders and shipments despite the growth in employment. In the most recent December report manufacturers’ prices paid dropped to 39.0 from the 78.5 reading of June. Manufacturers are facing major headwinds from high interest rates and mounting indications of recession. At the same time, they’ve benefited from the need to rebuild inventories into 2023 following a prolonged period of supply chain disruptions. This supply chain rebound has had an immediate remedial impact on inflation.
Source: Institute of Supply Management, FactSet. The Purchasing Managers’ Index (PMI) is an indicator of economic activity in the manufacturing sector. Measures above 50 indicate economic expansion, measures below 50 indicate economic contraction. PMI’s as of 11/30/22.
The strong U.S. dollar, though off its high in September, makes exports more expensive and imports cheaper, further hurting U.S. sales. A strong dollar also raises the prices that foreign nations pay for U.S. goods, directly hitting U.S. companies’ bottom lines.
Generally, a strong dollar would benefit these foreign countries by increasing their competitiveness on exported goods prices. Instead, the Fed’s lightning-speed rate increases have wreaked havoc on their currencies, especially in the UK. Britain is already in a recession and Europe will likely follow. It’s the U.S. and China that will keep the global economy out of generalized recession, or at least pave the way for a soft global landing.
Source: FactSet, Fed Funds Target Rate, data as of 12/30/22. Average Fed Funds Rate is average since 1988. “FAIT” is the FOMC’s “Flexible Average Inflation Targeting”.
Europe and Britain Hit by Trifecta of Inflation, Energy and Deficits
Action Economics, LLC, reports that “the ECB’s quantitative tightening has a non-negligible risk that the withdrawal of (monetary stimulus) support won’t be as smooth as officials hope. Governments,” they continue, “are facing higher debt financing costs and are forced to invest heavily in new energy-infrastructure with the transition away from Russian gas. On top of this, lower growth means lower tax revenues, and government also need to finance energy-support measures. Rising deficits mean that governments are set to flood markets with higher debt issuance, just at the time that the ECB is reducing its balance sheet.”
The ECB and BOE are late to the party but intend to bring hawkish monetary policy to raise yields significantly. The BOJ to a lesser degree, but Japan’s central bank has raised its cap on interest rates (yield curve control). These global rate increases will exert more pressure on the U.S. dollar and likely prop up U.S. yields as demand for high-yielding currencies sends investors elsewhere.
China lockdowns and slowing growth
The lockdowns in Shanghai and other cities throughout China are winding down, allowing its 1.4 billion people to travel without restrictions. But many countries are restricting Chinese movement on concerns of triggering a new wave of the pandemic. Meanwhile, the Caixin China General Manufacturing PMI unexpectedly edged up to 49.4 in November 2022 from 49.2 in October, above market forecasts of 48.9. However, these weakish production numbers could look very different in the months to come in the wake of reopening.
China is the wild card in markets, spurring on global growth just when global central banks are trying to slow things down. Domestic travel in China alone will raise demand for oil and gas, just as prices have been coming down.
Consumers could be the gamechangers
The consumer could have a major impact on the direction of the economy — but will it be positive or negative? U.S. retail and food services sales dropped 0.6% in November 2022 compared to the previous month. But more recent higher-velocity data from Mastercard SpendingPulse showed that retail sales payments jumped 7.6% during the critical holiday season from November 1 through Christmas Eve.
Consumer spending is predicated on job growth, and the December nonfarm payroll report pushed the unemployment rate down to 3.50%, adding 223,000 jobs. U.S. household wealth fell in the third quarter to $143.3 trillion for the third consecutive quarterly loss.
Rising inflation is cutting into consumer discretionary spending, weighing heavily on the consumer and will likely fall further in subsequent quarters. The consumer discretionary sector continued to be among the worst of the big sectors in the S&P 500, declining –37.4% in 2022. There is likely more pain to come if the Fed keeps rates higher for longer in an elevated inflation environment.
The October 2022 U.S. Employment Cost Index (ECI) tracked consensus estimates with a 1.2% rise in 3Q. The year-on-year ECI gauge slipped to 5.0% from a 32-year high of 5.1% in 2Q. The most recent wage cost report from the December non-farms payrolls data showed a decisive drop in average hourly earnings to 4.6% year on year, from 5.1% in November. This is great news to potentially temper future FOMC rate increases.
As of 11/30/22. Source: FactSet.
Market Review Summary, 2022
It was the worst year for U.S. stocks since 2008 as the FOMC slammed the brakes on runaway inflation. But it was the 2022 bond market shock that shook the world with the worst bond bear market since the Volker Era, worse than the Great Bond Massacre of 1994. The pain inflicted was widespread as U.S. Treasuries, high-grade corporates, global bonds and high-yield bonds all experienced double-digit losses. In other words, there was no place to hide in 2022.
The S&P 500’s –18.1% nearly matched the MSCI Emerging Market’s –19.7% return. The S&P Midcap and S&P Small cap stocks fell –13.1% and –16.1% respectively. The worst performing equity was Global REITs at –24.4%. U.S. Treasury 20+ year bonds returned –31.1%; U.S. Corporate Investment Grade returned –15.8%; Global Bonds returned –16.2%, and the best-performing category was surprisingly High-yield Bonds, returning –11.2%. The CBOE volatility index closed at 21.7% and the S&P GCSI commodity index was up 26%, led by the S&P GCSI Energy sector, up +42.3% for the year.
Source: FactSet, FTSE NAREIT, Voya Investment Management. The Overall Average model allocation includes 10 asset classes, equally weighted: S&P 500, S&P 400 Midcap, S&P 600 Smallcap, MSCI U.S. REIT Index/FTSE EPRA REIT Index, MSCI EAFE Index, MSCI BRIC Index, Bloomberg Barclays U.S. Corporate Bonds, Bloomberg Barclays U.S. Treasury Bonds, Bloomberg Barclays Global Aggregate Bonds, Bloomberg Barclays U.S. High Yield Bonds. Returns are annualized for periods longer than one year. Past performance is no guarantee of future results. An investment cannot be made in an index.
* Simple averages of all the indexes included in each group: all equity indexes, all fixed income indexes and a combination of all equity and all fixed income indexes. Please see disclosures at the end of this commentary for index definitions. Past performance is no guarantee of future results. Investors cannot invest directly in an index.
Conclusion for 2023
Our outlook is predicated on the tug of war between a hawkish Fed and a resilient private economy. The “Fed put” has expired — for the first time in 20 years, the markets are on their own, without the safety net that the Fed will step in and backstop investors’ overzealous risk-taking. The good news is that the private economy should be able to take an inflation hit.
The most optimistic outlook is that upcoming inflation data will be significantly lower than expected, and there are signs it may be. A slowdown in inflation would normally put the Fed on pause, but a halt in rate increases is anything from certain, in part because there is also a very real concern that Congress will continue to spend aggressively. The current $1.65 trillion Omnibus Bill represents a 9% increase over FY2022. Some believe that 2022 was a year of “negative surprises,” so 2023 may be a year of “positive surprises.”
As we enter 2023, income and dividend yields are at their most attractive levels in more than a decade. Valuations have normalized significantly, especially in the most speculative parts of the market. Illiquidity risk is decelerating from a lofty level, lowering the probability of a Black Swan event. And currency risk will be lower as the U.S. dollar index has climbed down from its peak. These factors are all potential pluses for investors, but pay attention to Voya Global Perspectives’ catch phrase coined in November 2010 regarding “the folly of gaming diversification” and make sure your portfolio is truly diversified.