Good-bye and good riddance to 2022

January 23, 2023

Goodbye and good riddance to 2022, and welcome to 2023! I say good riddance because both personally and professionally, I am glad to leave the many challenges of 2022 behind — and I have heard from many of you who feel the same. While we cannot change what happened, we can learn and grow from it and move forward, exactly what we intend to do here at Sterling Financial Group.

Journalist, historian, and author Paul Johnson recently passed away and one of his notable quotes has stuck with me: “There are no inevitabilities in history.” Today, more than 60-70% of financial writers, economists, investment managers are relatively certain that we will experience a recession in the US in 2023, according to the Wall Street Journal, and a sizable portion feel we may already be in one. While the probability of a U.S. recession is high, it is by no means inevitable. Just as everyone “knew” that Europe would have a major energy crisis this winter, with possible human and economic catastrophes, resulting from the war in Ukraine and the anticipated Russian gas supplies being cut off, however, the opposite has happened. The European Continent appears poised to roll through this winter with few economic hiccups, as a result, their equity markets have strongly outperformed US markets in recent months. Based on their coordinated preparation, relative strength, and consumer demand holding up, they proved once again that there are no inevitabilities in history.

The Positives

In the US there are several underlying strengths that temper the large headwinds that would typically point to an economic slowdown. Corporate and consumer cash levels are relatively high, and both banks and private investment vehicles maintain high cash levels, meaning there is still a great deal of “dry powder”. While supply bottlenecks have essentially disappeared, finding workers is still difficult for many industries and locations. Importantly, inflation is on the decline (but still at elevated levels) and that has led to a sharp increase in consumer confidence levels – one measure, the University of Michigan Consumer Sentiment survey unexpectedly rose nearly 10% in December, even though retail sales fell 1.1% that month. And although equity and bond markets simultaneously declined last year, both the valuation levels of stocks and the interest rate paid on bonds are much more favorable now – at fair but not bargain levels. Lastly, the dollar has come down from its 20-year high, (down 12% from Sept. 2022 highs) so selling goods overseas is easier for many US firms, some of whom earn 40% or more of their sales from foreign markets. 

The Negatives

Despite these strengths, we have not likely seen the end of Federal Reserve (FED) rate hikes, whose chair continues stating his conviction that rates will remain higher for longer until they are certain that the inflationary cycle of the past 18 months has ended. Reflecting this conviction, the yield curve is still inverted, meaning short-term 3 / 6 / 12-month interest rates are higher than 2 / 5 / 10

/ 20-year interest rates (see Exhibit A). Historically, such inverted yield curves have often (but not always!) preceded a recession. Inflation for most goods has come down dramatically, and the housing component of inflation will continue to decline; however, services inflation continues to accelerate and services represent a material part of consumer spending (e.g. fixing your automobile, going to the doctor). Many important industries are reporting a downshift in demand (autos, home sales, banking, shipping). For example, rail car volumes were down 4-5% last year, a trend that accelerated in the second half of 2022. This lower demand has led to some well-publicized layoffs, especially in the tech sector, although unemployment nationwide continues at near record lows – 3.5%.

Lastly, and without getting overly political, the House and Senate are now divided; while this will slow down regulatory and legislative changes, it will likely lead to a historic fight over the debt ceiling later this year, and such uncertainty is never a good thing for the economy. Sometimes the economy follows a self-induced feedback loop where negative news leads to consumer and business cutbacks that become self-fulfilling, and we are in that danger zone now. While many leaders “expect” an economic decline, it remains to be seen how many will follow through on that idea, and our view is that it could go either way.

We do hope the FED is not pressured by the marketplace to reduce interest rates too soon, since an economic slowdown would bring a siren call to cut rates immediately. With labor shortages persisting in many industries (the largest cost for most businesses), persistent wage inflation would likely hinder long-term growth potential for the economy. The FED's dual mandate of stable prices (moderate inflation) and low unemployment has rarely been more at odds as they are now. Rising rates are a brake on the economy and reduces employment, while persistent inflation is an insidious thief that robs value from all and erodes confidence. Two other factors concern us for the long-term inflation outlook, and the need for FED vigilance:

First, the sheer number of people who exited the labor force over the past several years. This leads us to believe a chronic shortage of labor may persist, which bodes for continued upward wage pressure.

Second, both business and government see the benefits and security of re-shoring manufacturing and diversifying supply chains. Our view is that these are very worthy goals, but such changes will almost certainly increase costs.

How do we, at Sterling Financial Group, intend to navigate such a challenging environment? With uncertainty high, we will continue to maintain elevated levels of short-term bond positions, while acknowledging that our overall bond allocation has been low for some time; we intend to increase that allocation over this year. We will stay focused on the long-term, as short-term noise ultimately masks the long-term wealth-building effect of markets over five- and ten-year cycles. Our commodity and real estate allocations appear well-positioned, and we may add to our value and dividend-paying equity positions. Our investment process does not rely on timing the interest rate cycle or picking the bottom of the stock market; we don’t believe anyone can do that with consistency. Fortunately, it relies on investments in long-term, cash-producing industries and sectors, that pay reasonable income and have favorable valuation and demographic trends behind them.

All the best to you and your families for 2023!