In investing, as in life, hindsight is 20/20. Looking back on where we were a year ago, two observations stand out:
1.) Equity market valuations entering 2022 were far too high at more than 21x forward earnings. Throughout 2022 markets began to appreciate that an unsustainable post-COVID consumption environment drove a lot of the growth and margin assumptions underpinning that 21x earning multiple and led to the inflation we’re seeing now.
2.) Markets were significantly underestimating the monetary tightening served up by the Federal Reserve. When we released this version of our letter one year ago, headline CPI inflation was 7.1% and accelerating, while market expectations priced in just three 25bps rate hikes from the Fed in 2022. Fast forward to today, the Fed has elevated rates from 0.25% to 4.5%, the largest move since 1980.
With so much to digest, the S&P dropped 20% in 2022, while global markets dropped 18.8%. As long-term investors, it’s important to remember that although 2022 was a challenging year, prospective forward-looking returns on equities are much higher than at the close of 2021.
Where does this leave us for 2023?
A year ago, analysts expected S&P earnings of $220, and the S&P 500 traded at 4766. At 21.6x forward earnings, the S&P 500 traded well above the long-term average of 16x. Analysts expect 2023 S&P earnings of $234 (6.8% growth over 2022). With the S&P 500 trading at 3850 by year-end or 16.4x earnings, stock prices are more reasonable as long as those earnings arrive.
But significant problems remain. Companies are still battling rising input costs, higher wages driven by tight labor markets, and higher interest rates, all of which will pressure operating margins. Because of these headwinds, we’re skeptical that S&P 500 companies can generate earnings of $234 in 2023. Should earnings fall short, equity valuations today may still be too high. Given these elevated expectations and the continued challenging operating environment, 2023 will offer more choppy waters in the equity markets, setting up a compelling buying opportunity for stocks in the year’s second half.
As we look for specific opportunities in the coming year, we expect to see more small-cap companies in our strategies. Small-cap company valuations are near historic lows on an absolute basis and relative to large-cap companies. In the chart below, small-cap P/E ratios are in blue, large-cap P/E ratios are in orange, and they haven’t diverged this much in years. Fears over higher interest rates and a looming domestic recession impacted the prices of smaller publicly traded stocks that may not enjoy the geographic diversity of their larger competitors. As the first to bear the brunt of bad news, small-caps are typically the first to begin performing as storm clouds clear.
From a sector perspective, the equity strategies will start the year looking similar to how they ended 2022. We remain steadfast in overweight allocations to consumer staples, energy, and utilities. As the year progresses, the market will offer us attractive risk/reward opportunities in some beaten-up sectors like technology, real estate, and communications.
Fixed Income Markets
One year ago, at this time, inflation was running at 7.1%, Federal Reserve models were forecasting inflation to decline to 2.6% by the end of 2022, and its forward guidance suggested three 0.25% rate increases throughout 2022.
Instead, as 2022 opened, prices for goods and services continued their climb upward, led by oil. The Russian invasion of Ukraine on February 24th exacerbated the situation. By March, inflation had reached 8.6%, and double-digit inflation became a real possibility, prompting the Fed to adjust its forward guidance. By June, oil was over $120 a barrel, up from $76 at the start of the year, and inflation was running at a 9.1% clip (the blue line in the graph below).
The June FOMC meeting produced the first of four 75 basis point rate hikes (the red line in the graph below) as the Fed realized that inflation would not be transitory. Oil prices declined in the second half, coming full circle to $76 a barrel, and inflation is currently running at 7.1%
Inflation has broadened throughout the economy. The U.S. has a tight labor market with an unemployment rate of 3.5%, 1.8 jobs available for every unemployed worker, and wages growing 6.4%, up from 3.8% last year, as measured by the Atlanta Federal Reserve. If wage inflation continues to grow at 5-6% in 2023, it is difficult to envision overall inflation moderating below the 5-6% range. Though it may be unpleasant, the Fed’s task is to raise interest rates high enough to slow the economy and break the wage inflation cycle.
Over the last decade, the bond market had become complacent to an accommodative Fed and ultra-low interest rates. So much so that the bond market was skeptical that the Fed would raise interest rates significantly in 2022. Thus, the bond market rout began in June when the Fed started raising the overnight rate in earnest. The 10-year U.S. Treasury Note, a proxy for the bond market, started the year yielding 1.52% and ended the year yielding 3.88%.
For 2023 the Federal Reserve models forecast economic growth to slow to 0.5%, the inflation rate to decline to 3.1%, and the unemployment rate to increase to 4.6%. The Fed’s current guidance is to raise rates to 5.0%-5.25% early in 2023 and pause there for the remainder of the year. However, the bond market is pricing in the Fed to increase just one more time to 4.75% in early 2023 and then to begin lowering rates in the year’s second half.
Our economic research indicates that it is a mistake to think inflation will be transitory from here. An overnight rate of 5.25% will not accomplish the Fed’s current forecast of cutting in half the inflation rate in 2023 and bringing the jobs market into equilibrium. Despite the 4.25% interest rate increase in 2022, the Fed has barely begun to reduce demand and still has more work ahead.