Rates, Recalibration and Recession
As has been communicated widely and with great frequency, 2022 was an extremely challenging year for investors. Historical correlations between asset classes succumbed to a causality that impacted both equity and fixed income investors. This causality can be characterized by three words: rates, recalibration and, yes, recession.
The first characteristic, rates, is a byproduct of the rampant rise in the rate of inflation that took hold in 2021 and continued through June of 2022. As has been well documented, inflation, on a year-over-year basis, rose to multi-decade highs in 2022. In fact, when the peak year-over-year for the Consumer Price Index (CPI) hit 9.1% in June, it was first time we reached that level since November 1981. To put this in historical perspective, in November 1981, Ronald Reagan was in his first term as president of the United States and some of the top fashion trends included leg warmers and parachute pants.
As the rate of inflation accelerated to the upside, the Federal Reserve began implementing an aggressive policy of raising short-term interest rates and reducing the size of its balance sheet. As this process became entrenched interest rates quickly began to rise. This situation led to the second characteristic, recalibration. With the increase in interest rates, bond prices declined and fixed income became an alternative to equities in a way we hadn’t seen in years. Growth stocks with high price-toearnings (P/E) multiples experienced the most aggressive level of recalibration and were most impacted. As equity valuations declined due to the recalibration in valuations, stock prices also declined.
And as the Fed continued to raise interest rates in its effort to subdue inflation, concerns mounted that rateswould become overly aggressive and prospectively push the economy into recession, the third characteristic. This concern of prospective recession proved to be the other shoe to fall for equities as the more moderate valuations that evolved from the aforementioned recalibration would not be enough to prevent further decline as downward earnings revisions became a concern.
It is this series of events that have gotten us to where we are today, a rare scenario where bonds and stocks simultaneously experienced significant declines. Historically, bond prices often rose when equities declined as investors sought out the lower risk associated with fixed income relative to equities. Given the driver of restrictive Fed policy, the historical correlation typically present between these two asset classes was shattered. So as 2022 ended, we had a 10-year U.S. Treasury note yield of 3.8% compared to 1.5% at the close of 2021. For equities, the current P/E ratio is 18.6x versus the 29.3x it was at the prior year-end.
First Quarter Outlook
The U.S. economy, per the GDPNow model estimate from the Atlanta Fed, grew by 3.8% in the fourth quarter. A more modest expectation for the period is seen in the 1.1% forecast from FactSet Research. The key takeaway is that the fourth quarter delivered a second consecutive reading of positive GDP growth. As we journey through 2023, the current expectation is that economic growth will hover around zero with neither a meaningful expansion nor contraction occurring. While the probability of recession has increased, we do not feel it will manifest itself in the early months of 2023.
Numerous indicators and opinions have supported the belief that we are currently in a recession or that the occurrence of one is inevitable. As previously stated,we acknowledge that the probability of a recession has increased as the Fed remains committed to its policy of raising interest rates and reducing its balance sheet as a means to bring the rate of inflation down to its targeted level. One of the factors contributing to this school of thought is the ongoing firmness in the labor market. The rate of unemployment continues to be near an all-time low, the number of job openings according to the JOLTS survey continues to exceed 10 million, and it is estimated that over four million jobs were created in 2022. While wage growth is decelerating it remains at a level that is much higher than the rate in place prior to the pandemic. While this data is subject to change, particularly with the Fed’s stated resolve to reduce inflation, it is hard to see an imminent recession when people are working, their wages are growing, and job openings continue to be plentiful.
On the inflation front we are seeing a moderation in the reported rate. Contributing to this is a decline in the price of several key commodities such as natural gas and oil. Specifically, oil has seen its price decline by a third over the past six months and natural gas, which hit a price of $9.85 in August, closed the year at $3.52. Even wages, which we noted earlier were increasing at a healthy rate, have seen a deceleration in their rate of growth.
The sum total of these observations is an economy which will exhibit little to no aggregate growth but continues to see a solid employment market and a
moderating level of inflation. Of course, there are numerous factors that could prospectively lead us to change this outlook, such as the reopening of China
and the ongoing war in Ukraine.
As always, we will continuously monitor data as it is released and if the data suggests our outlook needs modification, we will make the necessary adjustments.
Asset Allocation Overview
With the negative returns recorded for both the equity and fixed income markets in 2022, the performance for each of our strategic allocation investment objectives were negative as well. The year did end on a bright note, however, as each of the five objectives generated positive returns for the fourth quarter. Interestingly the much-maligned international equity component of our balanced and all equity allocations generated the strongest level of performance for the quarter.
During the quarter we did make an adjustment to the roster of fixed income managers in our Navigator allocation product. This consisted of adding several managers to the fixed income asset class. These additions were inserted into the line-up to create an additional level of risk mitigation to the asset class. As the probability of recession has increased, we took this step to help offset any prospective credit risk that might arise as corporate credit potentially deteriorates in a contracting economy. There were no other changes within our allocation strategies during the quarter.
Even with the addition of several fixed income managers our overall allocations remained neutral to their respective benchmarks. This neutral stance is not indicative of some sort of stasis or unwillingness to act but rather a reflection of the current positioning in financial markets and the current muddled economic outlook.
Given the performance of financial markets in 2022, we would remind investors to take this experience as an opportunity to assess their investment goals and objectives and determine if they continue to reflect their risk tolerance, growth expectations and income needs.
Source: BTC Capital Management, Ibbotson Associates, FactSet, Refinitiv.
The information provided has been obtained from sources deemed reliable, but BTC Capital Management and its affiliates cannot guarantee accuracy. Past performance is not a guarantee of future returns. Performance over periods exceeding 12 months has been annualized.
This content is provided for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Statements in this report are based on the views of BTC Capital Management and on information available at the time this report was prepared. Rates are subject to change based on market and/or other conditions without notice. This commentary contains no investment recommendations and should not be interpreted as investment, tax, legal, and/or financial planning advice. All investments involve risk, including the possible loss of principal. Investments are not FDIC insured and may lose value.