2022 Q4 Commentary: The Great Interest Rate Reset

2022 was the most challenging year for investors since the Great Financial Crisis, as both the stock and bond markets suffered double-digit losses. To put in context how difficult this past year was for investors, Bloomberg reported that 2022 was the first year since at least the 1870s that both U.S. stocks and long-term bonds fell by more than 10%. The primary cause for these declines was likely elevated asset prices colliding with surging inflation. Entering 2022, both stock and bond prices were richly valued. The yield on short-term treasuries in 2021 was close to zero percent, offering as Jim Grant would say, “return free risk,” meaning zero return and all downside risk. It became evident in 2022 that the Federal Reserve’s (the Fed) confidence the inflation we were experiencing would be “transitory” was misplaced; it turned out to be much stickier and more persistent than previously expected. In response, the Fed began one of its most aggressive monetary tightening campaigns in history, hiking rates from essentially 0% to 4.5% in one year! This was a shock to the financial markets and acted as gravity to asset prices. Many of the darling growth stocks when interest rates were near 0% suddenly succumbed to the pull of higher interest rates, declining 50% or more. Investors became increasingly focused on each new inflation report to determine how much more the Fed might need to increase interest rates to tame inflation. The adage, “don’t fight the Fed,” was ringing in everyone’s ears. If the Fed were to continue to raise rates, financial assets would likely continue to struggle. Everyone awaited signs that the persistent inflation was beginning to cool. And sure enough, some of those signs started to appear in early 2023 when the labor report showed a deceleration in wage growth and the Consumer Price Index came in as expected, showing a small month-over-month decline.

Strategy

Our base case for 2023 is that the U.S. economy will enter a recession in response to the monetary tightening the Fed undertook in 2022 and will likely continue into 2023, but at a slower pace. This is clearly the consensus opinion of Wall Street which makes us a bit uneasy . Typically, when most investors expect one thing, something else happens. If a recession does occur this year, it will likely be one of the most forecast recessions in history. The expectation of an impending recession, however, is not without merit. The following are a few data points indicating a slowdown is already occurring.

The U.S. Services PMI contracted for the 6th straight month in December.
ISM Manufacturing declined for the 9th straight month in December, the longest stretch of declines since 1974-1975.
Of the 18 industries in the ISM report, just 2 are reporting any growth with 13 in contraction. This disparity was last seen in April 2020 (pandemic).
The yield curve is massively inverted with short-term interest rates significantly higher than long-term interest rates.

There are some notable positives, however, if one remains objective.

The labor market remains very tight with the unemployment rate at 3.5%. While it is true companies have begun to lay off workers to adjust their cost structure, many are still in need of new employees.
China has reversed its zero-Covid policy and begun to reopen. This should help alleviate supply chain issues contributing to global growth.
Inflation appears to be slowing, and if future economic reports confirm this slowing, the Fed may cease raising interest rates by as early as this spring.
Stocks have declined significantly, offering a better long-term risk/reward opportunity.
Bonds now offer a compelling yield to conservative income-oriented investors.

While we do expect a recession in 2023, we remain humble knowing anything can happen. We are not “macro” investors basing our investment decisions on our guesses about the future. Rather, we are focused on constructing resilient portfolios through prudent diversification and security selection based upon fundamentals. After this great interest rate reset, we are finding more attractive opportunities on both the stock and bond side to invest capital at reasonable prices. Our focus will remain there.

As always, we appreciate the trust you place in us, and we remain committed to helping you achieve your financial goals.

The opinions expressed are those of PYAW’s Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward looking statements cannot be guaranteed. The sources of information used are believed to be reliable. PYAW has not independently verified all the data used in the presentation and its accuracy cannot be guaranteed.

PYA Waltman Capital, LLC (“PYAW”) is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about PYAW’s investment advisory services can be found in its Form ADV Part 2, which is available upon request. PYA-23-05