Jonathan M. Gardey, MBA, CFA®, CFP®
President and Chief Executive Officer
The year 2022 can be defined by a single event: inflation. As the year opened, the Federal Reserve (Fed) firmly believed that the growing inflationary pressures were “transitory”. This turned out to be a mistaken belief, which forced the Fed to take aggressive action by dramatically increasing interest rates.
Inflationary pressures started to build in early 2021, but ultimately peaked in June 2022 at a rate of 9.1%. Since then, the rate of inflation has steadily declined to 6.5% (as of the end of December 2022).
Now, most economic forecasters believe that inflation will continue to decline. Within this common belief, there is a wide range of opinions regarding how fast inflation will decline and at what level it will ultimately stabilize.
What is to blame for record high inflation?
The two primary forces that impact inflation are the economy’s supply and demand for goods and services. Vanguard’s Economic and Market Outlook for 2023 notes that approximately one half of the current inflation was caused by supply issues and the other half was caused by demand issues.1 The supply based inflationary forces were caused by supply chain issues resulting from the COVID lockdowns and the war in Ukraine. These issues are beyond the ability of Fed policies to control.
The Fed Fights Inflation with Rising Interest Rates
The Fed has two Congress-mandated goals: full employment and price stability. They use the economic tools at their disposal—such as interest rates—to control both.
With the challenges employers have in finding employees, full employment is not a current issue for the Fed. But with record high inflation, price stability is.
Rising prices are insidious in that they reduce everyone’s purchasing power, thereby making everyone poorer. But beyond rising prices, the Fed looks to see if inflation appears that it will become embedded in our economy. This can happen when workers start demanding higher wages in response to inflation, which further feeds inflationary pressure. As this process repeats, inflation becomes more entrenched in the economy. Surely, this is something none of us would like to see.
The primary tool the Fed has in fighting inflation is raising interest rates to reduce demand in the economy. Higher interest rates increase the cost of money, which slows demand for products and services, which ultimately slows the economy. A slower economy reduces demand thus reducing inflation. Reducing demand also indirectly addresses the supply issues.
The Fed’s battle with inflation started in March with a small rate increase. They soon realized how terribly wrong they had been about inflation being “transitory”. With this realization, the Fed grew much more hawkish, raising interest rates a total of seven times in 2022 –and to its highest rate since December 2007! Rates have never been increased so quickly so fast.
The initial impact of the Fed’s aggressive interest rate increases was a bear market in bonds which has not been broadly addressed by the media. To me, this is a significant economic/market event.
During 2022, the rate for 10 Year US Treasury Notes, the most important interest rate for the US economy, rose from 1.51% to 3.83%. This rise represents a 16% price decline, which is the worst one-year price decline on record for the 10 Year US Treasury Note. On a broader level, the Bloomberg Barclays US Bond Aggregate Index, which tracks the US bond market, was down 12.9% for the year. This was the worst year for the index since its introduction in 1976. Edward McQuarrie, an emeritus professor in the School of Business at Santa Clara University, said that the one-year periods through the end of October and November 2022 were the worst ever periods for US bonds going all the way back to 1794.2
US stock market returns in 2022 were the seventh worst since the 1920’s. Only three years during the depression, 1974, the Dot-Com Crash, and the Great Financial Crisis yielded worse returns. For 2022, the S&P 500 Index was down 18% while the tech focused NASDAQ Index was down a more dramatic 33%. Large market declines were not exclusive to the US. Outside of the US, European stocks were down 13% (STOXX Europe 600 Index), Asian stocks were down 19% (MSCI AC Asia Pacific Index), and North and South American stocks, were down 19% (MSCI AC Americas Index).
Stocks and Bonds: A 2022 Double Whammy
In my view, another significant economic/market event of 2022 was that both the stock and bond markets declined together. Typically, when stock markets decline, bonds prices increase as interest rates decline. This is what happened during the two most recent bear markets for stocks when bond prices rose during the Dot-Com Crash and the Great Financial Crisis. During trying economic times, when stocks see significant declines, investors move into “safe” bonds to ride out the storm thus driving up bond prices. This did not happen during 2022. The last time that both stocks and bonds declined during the same year was during the 1994 Bond Market Crisis, which is also referred to as the “Great Bond Massacre”.3
Price of Oil
The price of oil went on a roller coaster ride during 2022, finally settling at $80.26 per barrel, an increase of 6.7% for the year. While this price increase was not dramatic, the price of oil varied between $71.02 and $123.70 per barrel during the year. This price volatility caused oil to be a significant driver of inflation during the first half of 2022 and in the decline of inflation during the second half of the year.
Crypto Currency Markets
The year 2022 was not a good year for crypto currency investors. The two largest crypto currencies, Bitcoin and Ethereum, suffered losses of 65% and 68% respectively. While these losses seem dramatic, Bitcoin lost 73% in 2018 which shows the level of volatility inherent in crypto currencies. More broadly, many crypto currency owners suffered 100% losses with the implosion of either their crypto currencies, such as Luna, or the firms holding their crypto currencies, such as Voyager and FTX.
Crypto currencies are neither currencies nor investments, they are pure speculations.
The Fed’s need to fix their initial mistake of treating inflation as “transitory” now requires them to aggressively raise interest rates. These interest rate increases take time to move through the economy, which creates a second problem for the Fed: knowing when to stop raising rates and let the rate increases reduce economic demand. This uncertainty can lead the Fed to stop raising rates too soon or raise rates too high. If the Fed does not raise rates enough to slow the economy and tame inflation, it will become more difficult to eliminate. This is what happened when the Fed was not aggressive enough and ended up unleashing the high inflation of the late 1960’s through the early 1980’s. On the other hand, raising rates too high can cause a severe recession when one is not needed. The Fed’s difficult goal is engineering a “soft landing” where the economy slows enough to tame inflation but not enough to fall into a recession. In contrast, a “hard landing” is where the economy falls into recession. The “Great Bond Massacre” noted above led to a Fed engineered “soft landing” for the US economy.
The question of the day is whether or not the Fed can engineer a “soft landing.” But I look at this question a little differently. If the Fed is going to err either by (1) not raising rates enough or (2) raising them too high, which would be their preferred outcome? Based on the Fed’s history in the 1960’s and 1970’s, I believe the Fed would rather raise rates too high than not high enough, with a short recession being preferable to a long fight against inflation.
Currently, many economic forecasters, including the University of Michigan’s Research Seminar In Quantitative Economics4, BlackRock5, the world’s largest asset manager, Vanguard6, and the Capital Group7, purveyor of the American Funds to name a few, are predicting mild recessions.
Outlook: Should We Be Worried?
Capital Group economist Jared Franz stresses that, “Recessions are inevitable and necessary to clear out market excesses, and they set the stage for future growth.”8 In addition, Capital Group Vice Chair Rob Lovelace notes that “downturns are normal, expected, and healthy”.9 In this regard, the US economy is currently stronger and better positioned than most other world economies.
The outlook for bonds has greatly improved now that interest rates are higher. These higher rates, courtesy of the Fed, now make bonds a much more attractive investment. Bonds are referred to as fixed income investments and with the recent interest rate increases, the “income” is back in fixed income. In addition, if the economy moves into a recession, bonds will benefit as the Fed reduces interest rates to counter the recession, driving bond prices up. In this case, bonds would return to their traditional role of rising when stocks decline.
Regarding stocks, lower stock prices always mean higher future returns. The question is, when will these future returns materialize? Stock markets are forward-looking and try to anticipate the future. Thus, stock prices typically turn positive before recessions are over. Attempting to time these types of moves is a fool’s game, though. The old investment saying of “Time in the market beats timing the market” is very appropriate for the current situation. Remaining invested in a broadly diversified portfolio is now more important than ever. As I noted above, the market recovery typically starts before recessions are over, and it is a fool’s errand to try and anticipate exactly when that will be. Instead, we prefer to position portfolios to capture the potential upside when it does occur.
Have a wonderful 2023!
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1 Vanguard Economic and Market Outlook for 2023: Beating Back Inflation, December 2022
2 After a Terrible Year for Bonds, the Outlook is Better by Jeff Sommer, 12/9/22, New York Times.
3The “Great Bond Massacre” 2.0, 5/7/22, Swiss Re Institute
4 The Michigan Economic Outlook for 2023-2024, 11/17/2022
5 BlackRock 2023 Global Outlook
6 Vanguard Economic and Market Outlook for 2023: Beating Back Inflation, December 2022
7 Capital Group U.S Market Outlook for 2023, 12/8/2022
8 Vanguard Economic and Market Outlook for 2023: Beating Back Inflation, December 2022
9 Capital Group Long-Term Perspectives on Markets and Economies, 2023 Edition