— 2022 Q4 UPDATE —
Summary:
- 2022 will be remembered as the year the Federal Reserve (Fed) stopped the party because they served everyone way too much for way too long.
- The Fed was at the center of causing the 60/40 portfolio, the portfolio that is at the heart of so many retirement plans, to have the worst year since the great depression.
- During most of 2022, monthly CPI reports were the main variable controlling the direction of equities and fixed income because that was the report the Fed was basing their interest rate decisions on.
Market Returns:
Quarter 4 Returns:
Source: Y-Charts
See important disclosures at the end of document
Equity Style Snapshot Benchmarks: Large Value – CRSP US Large Cap Value Index Total Return, Large Blend, CRSP US Large Cap Index Total Return, Large Growth – CRSP US Large Cap Growth Index Total Return, Mid Value – CRSP US Mid Cap Value Index Total Return, Mid Blend – CRSP US Mid Cap Index Total Return, Mid Growth – CRSP US Mid Cap Growth Index Total Return, Small Value – CRSP US Small Cap Value Index Total Return, Small Blend - CRSP US Small Cap Index Total Return, Small Growth – CRSP US Small Cap Growth Index Total Return> The Center for Research in Security Prices (CRSP) is a provider of research-quality, historical market data and returns. Once securities are assigned to a size-based market cap index, they are made eligible for assignment to a growth or value index using CRSP’s multifactor model. Securities are scored and ranked for both Value and Growth factors, then ranked. Investors cannot invest directly in a benchmark.
2022 Total Returns:
Source: Y-Charts
See important disclosures at the end of document
Equity Style Snapshot Benchmarks: Large Value – CRSP US Large Cap Value Index Total Return, Large Blend, CRSP US Large Cap Index Total Return, Large Growth – CRSP US Large Cap Growth Index Total Return, Mid Value – CRSP US Mid Cap Value Index Total Return, Mid Blend – CRSP US Mid Cap Index Total Return, Mid Growth – CRSP US Mid Cap Growth Index Total Return, Small Value – CRSP US Small Cap Value Index Total Return, Small Blend - CRSP US Small Cap Index Total Return, Small Growth – CRSP US Small Cap Growth Index Total Return> The Center for Research in Security Prices (CRSP) is a provider of research-quality, historical market data and returns. Once securities are assigned to a size-based market cap index, they are made eligible for assignment to a growth or value index using CRSP’s multifactor model. Securities are scored and ranked for both Value and Growth factors, then ranked. Investors cannot invest directly in a benchmark.
A year in review:
2022 will be remembered as the year the Federal Reserve (Fed) stopped the party because they served everyone way too much for way too long. For the first time (excluding some brief periods) since the Great Financial Crises (GFC), the Fed began to perform quantitative tightening and raising interest rates in a systematic fashion. They were trying to quell a problem that had not been of serious concern since Paul Volker broke the back of inflation in the late 1970s by raising interest rates above 20%.
From a normative economics perspective, having interest rates consistently at the lower bound of 0% causes numerous societal ills including but not limited to widening the wealth gap, funding zombie companies, and distorting investors perception of risk. (1) The whole world saw this play out in real time during January of 2021 when retail investors caused short squeezes in multiple stocks that were close to bankruptcy, increasing the market capitalization of the cash flowless asset Bitcoin to over $1 trillion, and spending millions of dollars for digitized assets that depicted monkeys. (2) However, these Fed induced societal and market distortions did not only cost speculative retail investors millions when the Fed raised interest rates. The Fed was at the center of causing the 60/40 portfolio (60% equities and 40% bonds), the portfolio that is at the heart of so many retirement plans, to have the worst year since the great depression. (3) This is due to interest rates being near the lower bound of 0% for an extended period of time which caused sky-high valuations in stocks and bonds at the same time which led to a reversal in those sky-high valuations when interest rates rose. This led to a decoupling of the normal low correlation between the assets that tend to provide diversification in portfolios, which caused a lot of investor grief during 2022.
During most of 2022, monthly CPI reports were the main variable controlling the direction of equities and fixed income because that was the report the Fed was basing their interest rate decisions on. However, to the surprise of many, that slightly changed in December when in the face of the November CPI report that was better (lower) than expected, the Fed said they were not changing course from their original plan of raising interest rates because they saw asymmetric upside inflationary pressures from both the demand and supply side. (4) The supply side issues can be whittled down to supply chain bottlenecks, commodity shocks, and energy shocks with the causes of these coming from different sources including the elongated recovery of supply chains from the pandemic induced lockdowns, the Russia-Ukraine war, and China’s reopening. The demand side risks centered around the strength of the labor market because the Fed’s models view employment above “full employment” as inflationary and the labor market is what the Fed is eyeing as a key variable in continuing to reduce inflation. (5)
Even though the Fed has said they are focusing on employment as a key variable moving forward, starting the fourth quarter the shorter term endogenous risks for inflationary pressures were reduced in the markets eyes. Two of the main factors that caused inflation in the first place, pent up consumer demand due to excess savings and supply chain bottlenecks (as measured by the Drewry supply chain index) have been largely rectified.
- Cost to ship a 40-foot container.
Source: Drewry Supply Chain Advisors
According to Drewry Supply Chain Advisors, “The cost to ship a 40 foot container is now 80% below the peak of $10,377 reached in September 2021 and is 23% lower than the 10-year average of $2,694 but remains 46% higher than average 2019 rates of $1,420.” (6) Therefore, the current price, while higher than pre-pandemic levels, is well within the range of normal for the previous 10 years. With the supply side normalizing, how did the demand side fare?
- Gross Private Savings divided by CPI.
- Gross Private Saving divided by Gross Domestic Product
Source: FRED
Based on these previous charts, it is easy to see where inflation came from. A mix of pent up demand with record savings coming out of the pandemic lockdowns combined with an eightfold increase in the price to ship goods around the globe led to an inflationary spike. This spike was seen as transitory at the time because once these two factors normalized, business was expected to return to normal. Now the supply side is normalizing and gross private savings divided by either CPI or GDP show levels as low as 5 or 13 years ago respectively. This is partially why markets bounced back in the fourth quarter, because it is not obvious where inflationary pressures are going to come from moving forward, which implies the Fed will lower interest rates in the second half of 2023 (the reason the yield curve is in backwardation) because the inflationary pressures they are fighting by raising interest rates will have subsided. However, this view ignores the fact that global markets and the world economy have changed since 2020.
We have had a regime shift from a continually globalizing world which is deflationary in nature to a multi-polar world which countries are factioned together to create centers of influence. This market update will not get into the current geopolitics of the day because it is too complex for a simple market update, however, the shift has happened as evidenced by Russia’s invasion of Ukraine and China’s aggression towards Taiwan. Energy and various commodities could potentially be a volatile source of inflationary pressure moving forward. Supply chains are going to be built with more redundancy to avoid such catastrophic results from disruptions like we have seen over the past few years. There is going to be a push towards autocracy, where countries will not search for the cheapest labor around the globe but will instead want to produce goods and services domestically that they deem vital to national security. These are all inflationary events in nature, and while a reduction in consumer spending from a lack of private savings or a slight economic downturn may depress inflation for a bit, the Fed will not be worrying much about fighting deflationary pressures over the next few years like they did for the 2010s. Therefore, moderate interest rates are most likely here to stay with some volatility in the rates moving forward and energy shocks, commodity shocks, and geopolitical movements will play a much larger role in financial markets in the 2020’s than they did during the Great Moderation from 1990-2020.
Ultimately, the Fed cannot control worldwide supply chain bottlenecks, commodity shocks, or energy shocks directly. What they can do is control the purchasing ability of consumers and the labor market by making the cost of borrowing more expensive and slowing business activity, therefore, reducing the demand for goods and services. It is an indirect and painful way of dealing with inflation and it is partially what investors felt most of 2022. When all you have is a hammer, everything looks like a nail.
The remedy for these events could be a combination of a diversified portfolio that takes advantage of diversification, skilled active management or low cost ETF’s in diversified markets, and a long term financial plan that has strong conviction backing it. These are all goals we strive for at K2 Financial Partners.
Conclusion:
Here at K2 Financial Partners, our main mission is to help you reach your financial goals. We understand that the financial markets are an ever-changing adaptive marketplace and that is only exacerbated during a time when inflationary pressures are at the forefront. Therefore, it is important to have a well-diversified portfolio and contact your advisor when you have questions, comments, or concerns. At the end of the day, we are here to help you!
Sources:
- Chancellor, Edward. The Price of Time. Atlantic Monthly Press, 2022.
- The Bored Ape NFT craze is all about ego and money, not art | Art and design | The Guardian
- 60/40 Portfolios Face Worst Returns in a Century (investopedia.com)
- Inflation poses 'upside' risks: Fed official | CFO Dive
- How does the Fed define “maximum employment”? (brookings.edu)
- Drewry - Service Expertise - World Container Index - 19 Jan
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