- Inflation is not dead, and in fact, is very much alive.
- The Fed takes inflation seriously. This year we learned the Fed is as committed as ever to bring inflation down.
- Corrections in stocks can be severe. This lesson isn't new, but it's certainly one that 2022 drove home for us.
- Classic “inflation hedges” didn’t work, including cryptocurrencies.
- Home prices are not impervious to rising mortgage rates; historically rising rates have typically not translated into lower home prices.
It's been a rough year for investors. Inflation spiked, interest rates surged, and stocks plunged. But, looking back, we've identified seven lessons to learn from the year that was, and three things we expect will change in 2023.
Inflation is Not Dead
As recently as late 2020, economists were debating whether it was even possible for inflation in the US and other developing countries to rise materially. Nearly three decades of slowing inflation brought on by long-term issues like demographics and globalization had many thinking that inflation was no longer an issue. The cover of Bloomberg Businessweek's April 22, 2019 issue summarized it best by asking, "Is Inflation Dead?" In August 2020, investors were mostly dismissive when Federal Reserve Chair Jerome Powell announced the Fed would be willing to let inflation run a bit above their 2% inflation target.
However, now we know better, but time will tell if this year's inflation will turn out to be a one-off episode or a more lasting problem. But we have certainly learned that inflation is very much alive.
Fed Takes Inflation Seriously
The Fed got caught up in the idea that forces like demographics and globalization would hold inflation down. When inflation started to rise in the middle of 2021, the Fed thought it would be transitory and therefore did not take any action to arrest it.
Of course, we now know that was the wrong move, but its hesitancy to act last year caused some to question the Fed's commitment to price stability. This year we learned the Fed is as committed as ever. The Fed has now hiked interest rates at a faster pace than any calendar year in history and even warned that it was willing to cause a recession if necessary to bring inflation down. You should undoubtedly believe that lowering inflation is Powell's top priority.
There is No “Fed Put”
The term "Fed Put" isn't new. It dates back to at least Alan Greenspan's chairmanship in the 1990s. But in 2020 and 2021, some investors began to assume that Fed Chair Powell would simply not "allow" stocks to fall for very long. Instead, he'd either cut interest rates or employ Quantitative Easing to juice stock prices again. In this case, a "put" is a situation where a company agrees to buy back an asset at some set price, protecting the owner from any price decline.
Indeed, the Fed has frequently cut rates after stocks have fallen. But, in reality, it's a result of why stocks are falling. Stocks generally decline in value because investors anticipate the economy weakening. If the economy weakens, the Fed will typically respond with fresh stimulus. So it isn't that the Fed is trying to goose stock prices; rather, the Fed and stocks are reacting to the same economic indicators.
In 2022 we learned the distinction between the two. Stock prices fell, but the Fed's focus remained on curbing inflation. The Fed isn't there to protect investors from losses in the short term but rather to keep the economy well-balanced for the long term.
|Quarters where S&P Falls at least 10%|
|Period||S&P 500 Return||Fed Response|
|2Q 2022||-16.11%||Hiked by 275bps|
|1Q 2020||-19.60%||Cut rates to 0%|
|4Q 2018||-13.52%||Cut rates by 75bps in 2019|
|3Q 2011||-13.87%||Announces buying of $400 billion in longer-term bonds|
|2Q 2010||-11.43%||Announced a new QE program|
|1Q 2009||-11.01%||Cut rates to 0%|
Corrections in Stocks Can Be Severe
This idea of a "Fed Put" probably led to some speculative buying in the last few years, as some investors started to think that interest rates would never rise and stocks would never stay down for long.
In 2020 and 2021, buying activity was especially concentrated in fast-growing technology and consumer stocks. However, that reversed sharply in 2022. According to Bloomberg, U.S. Technology stocks returned -27%, and Consumer Discretionary returned -35%, much worse than the overall market at -19%.
Some of the post-COVID high flyers were hit especially hard. Among the stocks that fell at least 75% in 2022 were Lucid, Wayfair, Redfin, Carvana, and Roku. All of those stocks had at least doubled in price over the three years ending 2021.
This decline highlights the importance of diversification. All of these stocks are within Facet's ETF mix, but the losses are diluted within the 8,000+ stocks in our total portfolio. If you held one of these stocks as a material part of a concentrated portfolio, those kinds of losses could impair your ability to meet your long-term goals. This lesson isn't new, but it's certainly one that 2022 drove home for us.
Classic Inflation Hedges Didn’t Work
It was a difficult year for most asset classes, but one surprising weakness was in assets that were classically considered inflation hedges. Real estate stocks, gold, oil, and even Treasury Inflation Protected Securities (TIPS) all lost money in 2022. Despite the surge in inflation this year, these assets weren't much help.
Even worse is the fact that through most of the last 20 years, these asset classes have either been high volatility, low return, or both. Investors in these spaces have suffered through all of that, only to have the asset fail to even produce positive returns in a high inflation environment. To us, 2022 displayed that inflation hedges just aren't worth the trouble.
Cryptocurrencies Aren’t An Inflation Hedge Either
One of the most persistent claims cryptocurrency devotees have made over the years is that crypto can't be cheapened by money printing, unlike dollars or other traditional currencies. Bitcoins have a literal cap on the total supply that will ever be created, and other cryptocurrencies have arrangements to control the amount of new crypto. The claim was that inflation would erode the value of dollars over time, but crypto would not have this problem.
Had this been true, 2022 should have been crypto's moment to shine. But, as we know, that was not the case, with Bitcoin down 75% from its peak toward the end of 2021. What we've learned instead is that crypto prices appear to mirror general investor sentiment around risk-taking. Because of this, crypto prices have moved more in line with smaller technology stocks than being a hedge against anything.
Home Prices are Not Impervious to Rising Mortgage Rates
Activity in the housing market plunged in 2022, as rising mortgage rates have made it difficult for many to afford a home. According to the Mortgage Bankers Association, the pace of mortgage applications is the lowest since 1997, worse than at any time during the Great Financial Crisis. This slowed pace is starting to impact home prices as well. According to the S&P CoreLogic Case-Shiller index, home prices have fallen about 2.2% over the last three months.
Historically rising rates have typically not translated into lower home prices. For example, of the prior five calendar years where mortgage rates rose, home prices averaged an 8.85% price gain in that same year. But with mortgage rates hitting multi-decade highs in 2022, we learned there's a limit to how much the housing market can handle.
After a Tough 2022, the Outlook For Bonds is Rosier
The Bloomberg Aggregate, an index that includes all of the major U.S. taxable bond segments, returned -11.13%. By year's end, that will be the worst calendar year in the history of that index, which dates back to 1976.
The good news is that while bond prices have fallen substantially, the yield on the Aggregate Index is the highest it has been since 2009. Yield, which is just another name for the interest payments bonds pay out as income to investors, is the dominant source of returns for bonds over time. In the history of the Aggregate index, 99.6% of investor returns have come from income payments and only 0.4% from price return. So today's significantly higher yield tells us that the forward-looking return potential is as high as it has been in 13 years.
Inflation is Responding to The Fed’s Actions
As recently as this summer, it was unclear what it would take for inflation to start subsiding. There were fears that the US could experience so-called "stagflation," where inflation remains high but economic growth falters.
The stagflation scenario now seems less likely. Already we are seeing inflation decelerate as consumer spending has slowed. In the first half of 2022, spending at retail stores (including online stores) increased at a 16.3% annualized rate. During that period, the price of goods, as measured by the Consumer Price Index (CPI), rose at a 5.4% annualized pace. From June to November, retail sales have only risen at a 1.5% pace. As a result, goods prices have actually declined at a 0.3% pace. While this only covers spending on goods, we also know that a large portion of Services within the CPI is only still rising because of lag effects.
While we do not know if there will be a recession in 2023, we can comfortably say that if economic growth slows, we have strong evidence that inflation will also.
Focus Will Not Solely Be About Inflation in 2023
In 2022, the only thing that seemingly mattered for markets was inflation and what the Fed would do to curtail it. This singular focus will shift in 2023, partly because inflation is already decelerating and partly because the economy is slowing. Even if the economy avoids an official recession, profit growth will likely slow in 2023, and stock investors will become more focused on which companies can better weather that slowdown. We believe those companies will be the ones with greater financial flexibility, less historic revenue variance, and higher profitability.
Our ETF mix has a higher weighting to companies with these characteristics. We believe this is the right way to protect your portfolio from a recession. These companies should still do very well if the economy continues to be strong but may provide some degree of protection should we enter a recession.
2022 brought investors a lot of surprises, and there's a good chance that 2023 will also. To that end, we think our process of optimizing for risk/reward within portfolios offers the best opportunity to produce solid results, even in uncertain times.