Navigating the Uncertainty
As we move into 2023, it’s important to reflect on the past year and look ahead to what the future may hold. 2022 was not only a year of transition but also a year of pain for the markets as we witnessed equities and bonds locked in a downward spiral of tumbles and rallies. The pandemic era’s unprecedented policy support, coupled with disruptions in energy, other critical product supply chains, prompted inflation to surge globally and contributed to an unpredictable investment landscape.
In the U.S., the Federal Reserve raised its federal funds rate from .25% to over 4% in less than a year. Even with well telegraphed decisions from the Fed, investors remained skeptical of Chairman Powell and company’s commitment to raising rates which contributed to the bedlam and volatility experienced throughout 2022.
All told – last year will go down as the worst year for the stock market since 2008 with the benchmark S&P 500 falling -19.44%. Other equity indices experienced similar declines with the Dow, S&P Small Cap 400, and Nasdaq down -8.78%, -32.5%, and -14.48%, respectively. The Nasdaq for its part, was particularly vulnerable as higher interest rates took the air out of bloated valuations of many risk-on era darlings. At Parrish Capital, we have remained disciplined in our focus on valuations. The insane prices and valuations reached during the monetary stimulus binge of 2021 may take years of actual earnings growth to recoup if ever at all for some stocks. Our focus on valuation, value, and quality promoted stability with less downside relative to the benchmarks.
Given the historical shift in interest rates, the bond market experienced the worst annual performance on record with the benchmark Bloomberg Aggregate Bond Index and Bloomberg Aggregate Corporate Bond Index contracting -13.01% and -15.76%, respectively.
The bond market rout is a stark reminder that the “status quo” is not always permanent. The 40-year bull market in US Bonds which witnessed yields on the benchmark 10-year Treasury yield fall from 15.3% in 1981 to .54% in March 2020 is no longer. The carnage caused was much worse than the index reflects as many unsuspecting investors were heavily invested in bonds funds and exchange traded funds (ETF’s) with no stated maturity. Many of these funds underperformed the benchmark bond indices in 2022. Retired individuals relying on age old rule of thumb models (i.e., 60% Stock/40% Bonds) faced a pummeling that may alter their standard of living for years to come.
Our strategy of staying relatively short term and investing in predominately hold to maturity securities limited the downside for clients invested in fixed income securities for liquidity needs. History has shown that time horizon is paramount in equity investment, because stocks recover with time. However, principal damage via fixed income mutual funds can be permanent.
Throughout 2022, the markets also had to wrestle with geopolitical uncertainty revolving around the Russian-Ukraine War and more stress as it relates to China. As the War approaches the one-year mark, an amicable end appears to be distant and the risk of the U.S. becoming more involved grows by the day.
As the civilian and military casualties sadly surges into 100,000’s, the economic toll has cost hundreds of billions of dollars. The 33% or so contraction in the Ukrainian Economy pales in comparison to the vast destruction of critical infrastructure which may take decades to rebuild. The implications are global given Ukraine is one of the largest exporters of grains accounting for an estimated 10% of the world’s supply. The U.S. Federal Reserve estimated that the Ukraine war contributed 1.3% to 2022 global inflation. At this critical juncture in the global economic cycle, the Ukraine-Russian war will continue to be a source of angst for the world.
Against all odds and a hawkish Federal Reserve, the US Economy managed to increase GDP by 2.1% in 2022. Consumer spending, exports, private inventory investment, and nonresidential fixed investment help overcome the economic drag of residential housing and lower federal government spending. The annual growth in the US Economy for 2022 was somewhat miraculous while highlighting the imbedded resilience of the US economy.
The Road Ahead – “Don’t look a gift horse in the mouth”
In our semi-annual report, we discussed the possibility of a recession in the near term. In 2022, the economy did not get the memo. With the recent softening in inflation data points and the moderation in Federal Reserve interest rate hikes, the market sentiment has shifted from “definite recession” to “probable soft landing.” A soft landing is a cyclical slowdown in economic growth that avoids a recession. We would be delighted if the economic cycle flawlessly shifts to slow-to-no growth and then accelerates into a wonderful cycle of growth. However, it is never that simple.
The full effect of monetary policy is never instant but has lagged historically up to 18 months. Interest rates adjust up quickly for debt like credit cards or floating rate corporate debt. However, the spending associated with such debt is often inelastic earlier on. In other words, even with higher debt, consumer spending continues. As debt service cost began to impact the bottom-line, spending becomes elastic, and demand is stymied. The same applies to inflation. Consumers can stomach higher prices in the short term, but as higher prices become more permanent, they search for alternatives. Eventually, demand becomes more price elastic. Credit Card balances at $986 Billion, as of the 4th quarter of 2022, is at an all-time high which is a troublesome backdrop for the near term.
Plainly, inflation is a rate, not a level. If it rises 9.1% one year, then 0% the next year, living costs remain 9.1% higher than they were before. This has a cumulative effect as consumers keep spending more on the things they need. Wage growth helps, but that same wage growth has its own inflationary effects.
We expect the Fed to remain hell-bent on meeting its targets for inflation or something close. The Fed created a credibility problem by allowing inflation to get out of control. Getting the inflation genie back in the lamp is underway, but prematurely taking its foot off the brake, would not only be hazardous to the economy, but a death blow to the Fed.
The current consensus forecast for 2023 GDP is for an increase of 1.3%. The numbers have surprisingly risen slightly over the last three months. The adage “Don’t Look a Gift Horse in the Mouth” is apropos. In the face of history and after the most aggressive stimulus campaign ever, it is natural to feel a little relieved and even celebrate a potential victory over inflation. At Parrish Capital, we firmly feel that a victory lap at this stage would be premature. While we do not believe a disastrous contraction in the US economy is in the cards, the euphoric mood brought on by a few months of better inflation data may be fleeting. We fully expect a deceleration in the economy driven by lower corporate spending, weaker activity in real estate, and a potential softening in consumer spending.
In our semi-annual newsletter, we discussed how quickly markets recover after severe market declines. As a leading indicator, the market tends to overlook negative developments and factor in a brighter future in its pricing. For this reason, we modestly rebalance to maintain exposure and avoid timing the market. Yet our observations of the market as of the writing of this newsletter suggests that the market may be a little over its skis as it relates to the potential impacts of higher rates.
Corporate earnings as measured by S&P 500 Companies have held firm against the historical trend of declining with rising rates of the scale we have seen. With the 4th Quarter 2022 earnings season underway, we feel that the inevitable decline in corporate earnings is upon us. Earnings thus far for the 4th Quarter point to a decline of -2.8% followed by a projected decline of -3.7% and -3.1% subsequently for the 1st and 2nd Quarters of 2023.
Revenues have bucked the trend and are expected to outpace earnings growth with a 5% showing for the 4th Quarter. This is a sign that inflation is impacting margins and could be a major impediment to earnings as top line revenues are expected to decline in the next two quarters.
Fundamentals matter, especially when they change abruptly. Corporate earnings have enjoyed stable growth since the grand reopening after Covid. Higher corporate capital cost, elevated input costs and growing consumer debt enhances the prospect for a rough earnings cycle for 2023. We believe a bear market bottom was made in 2022, but continue to expect severe volatility throughout 2023.
The transition through a weaker earnings cycle will present opportunities for long term investors. The current valuation for the market is slightly above the long-term average at 18.5 times earnings. Even with a strong rally for the market year to date, there are many great companies trading well below the market average. At Parrish Capital, we continue to posture portfolios to take advantage of what we feel will be a solid market over the next 3 to 5 years. In the face of potential economic weakness, we expect a high single digit total return for the S&P 500 through the end of the year. As counter intuitive as it is, the stock market as a leading indicator looks past rough seas and forward to better days in the distant future.
Our Major Market Themes for 2023
- Inflation remains elevated with CPI remaining above 5% prompting the Fed to raise the fed fund rate to 5.5%.
- The US economy enters a minor recession in second half of 2023.
- The Ukraine-Russia war intensifies and costs Vladimir Putin the Kremlin.
- China’s full reopening stokes prospects of world economic growth leading into the 4th quarter of 2023.
- Oil prices rise to over $100 a barrel on increased demand from China.
Beyond the Market
Now that the new year is upon us, it is important to take a moment and look a little closer at your overall financial well-being. At Parrish Capital ,we can’t stress enough how important it is to plan for the future and all the twist and turns it brings. That is why it is essential to look at doing a comprehensive financial plan. A proper financial plan is neither a “success” nor a “failure.” It’s a projection of what we expect could happen based on today’s assumptions and financial goals, and a tool to help with the what-ifs in life. For example, what if your investments are better or worse than projected? What if there’s a spike in inflation? What if you live shorter or longer than anticipated? Testing your financial plan with different scenarios can help you be prepared. This past year has shown us that preparedness is the key to surviving and thriving in uncertain environments. Our comprehensive management of your financial circumstances will enable you to anticipate opportunities and prepare for contingencies.
Class Action Settlement Processing
Over the years, we have received inquiries from many of you regarding security class action paperwork. Parrish Capital has engaged Chicago Clearing Company (CCC), a securities and class action claims service specialist to automatically procure potential class action claims. CCC eliminates the burden of claim filing, ensures you keep up with every potential recovery opportunity, and lets us focus on the real work of investing. As our client, you will not have to lift a finger when you receive litigation paperwork concerning equities you have owned or currently own. Going forward, although not required, please feel free to forward documents to one of our associates at Parrish Capital.
In closing while 2022 was a year of transition. We at Parrish Capital stand steadfast that our philosophy, discipline, and market expertise will help guide our clients through the market unknowns. Thank you to all of our clients that continue to trust us with their lives’ savings.
We would like to emphasize the importance of referrals as the ultimate form of compliment to our firm. Nothing speaks more highly of the value and trust we bring to our clients than when they recommend us to their friends, family, and colleagues. As such, we encourage all of our clients to share positive experiences with others and continue to support our business through referrals.
AS ALWAYS IGNORE THE NOISE, STAY FOCUSED, AND PROSPERITY BE UNTO YOU!!