Making Sense of the 2022 Markets and Economy
By David DeBellis, CFA & Portfolio Manager
A big question any stock or bond investor could ask is, why is the Federal Reserve being so deliberate in adjusting short-term interest rates? Couldn’t the Fed have been more aggressive and simply made a larger increase to the Fed Funds rate when it first detected inflation and have vastly reduced the uncertainty that has had such a big influence on the stock and bond markets? The methodical interest rate policy of the Federal Reserve since early 2022 has caused enormous volatility in prices and led to a bear market that has deeply affected both personal and institutional investment portfolios.
The answer is, a previous Fed strategy did exactly that back in 1980 in a successful anti-inflation strategy, but the cost to the economy was severe. Inflation had been embedded in the economy for more than a decade and peaked in March 1980 at 14.8%. To combat this, the Fed went on an aggressive tightening campaign, raising the Fed Funds rate from an average of 11.2% in 1979 to a peak of 20% in June of 1981. This action broke inflation’s back and by 1983 inflation was below 3%. The price of this tightening campaign by the Fed was a double-dip recession that started in 1980 and ended in 1982. During this recession, the national unemployment rate rose to over 10% and provoked many political attacks and widespread protests against the Federal Reserve.
The current Federal Reserve leadership has learned from that episode and is trying to slow economic growth without causing a recession by making gradual changes to interest rates until inflation subsides. As it does so, the Federal Open Market Committee (FOMC) is making clear that it will continue to increase the federal funds rate until price inflation is tamed and reduced to its target rate of two percent per year.
In the meantime, stock prices that had gone up sharply in 2021 have dropped as much as 25% peak to trough, as what appeared to be a temporary rise in price inflation turned out to be embedded into overall economic activity. Stock price volatility has been significant as a result of the uncertainty surrounding future Fed policy changes, with prices going up one day following hopeful news, only to decline in the next trading session.
The main culprit driving these big market swings has certainly not been earnings, as those continued to rise during the year. Instead, a shifting of perception about interest rate changes is to blame. Complicating economic analysis are enduring supply chain issues, surging demand for goods, and record amounts of cash from the government stimulus of 2021.
The big question for market participants now is, what level of labor slack is necessary to bring wage pressure down? With higher interest rates cooling economic activity, demand for labor should ultimately slow, reducing demand for goods and services across the board and hence, price inflation.
It is important to know that Fed rate hikes take time to work, leading to the next question: When will the Fed be done? A clue is evident in the bond market, which as of mid-November was telling us that the terminal rate for fed funds will be somewhere around 4.5 percent, close to where it would be after an expected hike of another three-quarters of one percent.
The Conference Board business research organization indicates the probability of recession has risen to more than 95 percent. Some analysts suggest that we may already be in a recession. The real question seems to be, how bad will a recession be? It appears that unless the employment picture becomes very bad, it will be hard to see a deep recession occurring like the 1981- 1982 recession, which lasted 16 months, or the Great Recession of 2008-2009, which lasted 19 months.
We suspect that we will be hearing the phrase, “challenging environment,” quite a bit in upcoming corporate earnings reports. One positive development that I will be watching for is an increase in share repurchase programs. There are many companies that have a lot of cash on their balance sheets that will likely look at current lower share prices as an opportunity to buy back more of their own shares. That action would almost certainly serve to support the stock prices of those companies.
We believe that, in an environment of tightening financial conditions, focusing on high-quality companies will be very beneficial for investors. These companies have strong balance sheets (more cash and less debt than their competitors), higher returns on equity or return on capital, and more stable growth.
One of the biggest factors affecting equity performance over the last several years has been the expansion of prices based on company earnings – the ratio of price to earnings. This has been especially true of “longduration” equities, where the market was pricing stocks relative to anticipated earnings that would not be realized for years. We are now seeing a reversal of this trend. At the start of 2022, the U.S. equity market as a whole traded at 21 times forward earnings – a large multiple, historically speaking. Today, the market trades at around 15 times forward earnings. This big compression of price-to-earnings multiples has been concentrated in those highest-growth companies. Many of those companies have seen declines in their multiples of 50 percent to more than 60 percent. Companies with nearer-term visibility of their earnings and cash flows are likely to do much better in the environment where we are headed.
When we consider equity portfolios managed by the Trust Company of Vermont, we can confidently say that most companies in which we own stock fall into the category of high-quality companies – that is, those with nearer-term visibility of earnings and cash flows. They are very large companies with strong balance sheets and long-term track records of earnings and cash flow. For this reason, we feel good about how our clients’ equity portfolios are positioned for the uncertain market and economic environment ahead.
David DeBellis, who holds the Chartered Financial Analyst (CFA) designation, chairs the Trust Company’s investment committee.