A voice was heard in Ramah,
weeping, and great mourning,
Rachel weeping for her children;
and she refused to be consoled,
because they are no more.
Matthew 2:18 (CSB)
The magi from the east caused quite a stir when they arrived in Jerusalem, inquiring after the newly born “king of the Jews.” After consulting with his experts, King Herod sent them to Bethlehem, but with one caveat: on their way back home, they were to let him know where the child was so that he could also pay homage. But Herod, smelling a threat to his power, just wanted to know where to send his killers. God intervened and sent the magi home a different way. Outwitted, Herod flew into a rage and ordered all the boys two years and younger in the region slaughtered to eliminate the Christ-child. Outside of Matthew, there is no record of Herod’s brutal action against tiny Bethlehem. History tells us that blood and violence marked Herod's reign. The death of a few dozen peasant infants didn’t even warrant a mention in the royal records. Millennia later, Herod’s name is still remembered, while his victims have long since been forgotten. But the truth is, Herod was just one villain in a long stream of villainy. For much of human history, brutality and oppression have been the rule, not the exception.
But the boy survived. As the king's butchers descended on the village, Jesus and his family slipped away to Egypt. His heavenly father eventually “called” him out of Egypt (verse 15) so that he could finish the work he started when he came to earth. Evil forces couldn’t take his life. He gave it up willingly on the cross to redeem us. That child that fled for his life in the dead of the night will someday return as our righteous king.
He will right every wrong.
He will heal every abuse.
He will restore every loss.
The birth of Christ was a down payment of what will come. That first Christmas put the evil forces in creation on notice. Every Christmas morning should dawn as a reminder of our glorious future because he reigns. Every Christmas is a celebration of hope.
One word describes the past twelve months: volatility. Between geopolitical events, worldwide inflation and an unprecedented wave of monetary tightening by global central banks, markets and investors have whipsawed back and forth. In this year’s last Weekly Macro Minute, we wanted to take a quick look back over the year and offer a snapshot of what we will be watching for heading into 2023.
Even though the year began with a historic level of inflation (at least for that time), rising tensions between Russia and Ukraine quickly took over global headlines. Saber-rattling erupted into war as Russia invaded Ukraine on February 24. Nations worldwide exerted punitive pressure by imposing sanctions on Russian exports and excluding several Russian banks from the Society for Worldwide Interbank Financial Telecommunication (“SWIFT”) network, effectively isolating the Russian flow of capital from much of the rest of the world. Many international companies and banks ceased their Russian operations, while major financial index providers removed Russian securities from the indices. As a result, Russia essentially has become a “pariah state.” The war has exacerbated inflation and supply chain problems, as these countries are significant producers of oil, natural gas, grain, fertilizer and many other commodities. We expect to see elevated prices and extreme volatility for commodity markets for the foreseeable future, and the economic consequences of the war are likely to resonate for years to come.
However, as the war ground on through the second quarter, the world’s attention returned to the global inflation problem. In the U.S., the Consumer Price Index (CPI) climbed steadily over the spring and summer to peak at the end of June with a year-over-year rate of 9.1%, the highest increase since 1981. November’s CPI report indicated that inflation dropped to 7.1% year-over-year, a marginal improvement but still intolerably high, especially relative to the Federal Reserve’s goal of 2%.
The Fed launched its first salvo against inflation in the spring. On March 9, it ended the quantitative easing program it had started in March 2020. Less than a week after its last bond purchase, it initiated the first federal funds rate increase since 2018 at 25 basis points. Additional increases soon followed: 50 basis points in May, four consecutive increases of 75 basis points in June, July, September and November and a 50-point hike this month – 425 basis points in total, a far cry from the beginning of the year estimates of 75 basis points during 2022. June also saw the Fed implement a rarely-used quantitative tightening program – shrinking the size of its balance sheet by allowing maturing bonds to roll off without replacing them with other assets, thus reducing liquidity in the economy.
With fiscal stimulus drying up, the current inflationary environment and tightening monetary policy have taken their toll on financial markets. Raising the federal funds rate from 0.25% to well over 4% in less than a year was unprecedented and accounted for much of the volatility experienced in the markets. After a seemingly endless climb in 2021, this past year in equities has been characterized by repeated cycles of declines and rallies as investors carefully parsed every statement from the Fed, looking for signs of a pivot towards an easing of monetary policy. By the end of November, the S&P 500® Index had fallen -13.10%. Rising short- and long-term rates pushed bond prices down, and the Bloomberg U.S. Aggregate Bond Index posted a -12.62% loss.
Looking ahead, here are three things we expect to see in 2023.
Inflation is a global problem, with this year seeing almost 2 billion people experiencing levels of inflation over 10% – and 1.5 billion people experiencing inflation above 15%. In the U.S., inflation has come down from its peak but still sits well above the levels experienced in the last 40 years. To reduce inflation, the Fed must create lower consumer demand (through slower economic activity) which requires the imposition of tighter financial conditions. As a result, the central bank must remain in tightening mode to materially lower inflation and eventually bring it down to its 2% target. Unfortunately, inflation will not drop to that target quickly. The CPI includes several sticky components (for example, rents and housing prices), so lowering inflation will take time. In every cycle since 1974, the Fed has had to raise the federal funds rate above the inflation rate to bring inflation down to its preferred level. With CPI at 7.1% and the fed funds rate at 4.5%, it could take at least another 12 to 24 months to bring inflation in line with the target. The ultra-tight labor market (unemployment was 3.7% at the end of November) and wage gains have given the Fed the green light to continue ratcheting interest rates higher. The Fed has staked its credibility on reducing inflation to target. Barring financial or market instability, a material increase in the unemployment rate or a sustainable trend of falling inflation, a pivot to lower rates is unlikely anytime soon. In short, expect a higher fed funds rate for longer than typically seen in prior cycles. Current projections have fed funds hitting a terminal rate of around 5% in the early second quarter of 2023 and staying above 4% through 2024.
Though the market has dropped sharply over the year, we believe equity valuations are still too high and have further to fall. Much of the recent decline in equities has stemmed from Price Earnings (P/E) multiple compression. When the Fed flooded the market with liquidity by keeping interest rates low for so long, it drove those multiples up. This year, the Fed has been pulling liquidity from the markets by raising rates, thus pushing multiples down and lowering the value of equities. In other words, this year again has demonstrated that it’s not wise to “fight the Fed.” We anticipate a decrease in corporate earnings to add further pressure to stocks over the next 12 months. Note that historically, on average, earnings fall 36% in a recession (see the next section). Earnings growth has already started to show signs of decay. As of the end of the third quarter, earnings were up 2.2% year-over-year – an increase but well below expectations. However, if the energy sector is excluded, earnings actually fell 5%. We expect this fall to become more broadly based, but right now, the equity market is trading at a level that has yet to factor in the anticipated decline. As earnings fall, the market will continue to trend downward next year. But the market rarely travels in a straight line, and bear market rallies are likely to occur along the way.
Our highest probability outcome and the best-case scenario for the U.S. economy is a mild to moderate recession next year. Rising rates and oil prices typically cause recessions, both of which are in play now. A recession is generally defined as two consecutive quarters of negative real GDP growth — more specifically, an extended period of decline in employment, real income and aggregate demand. Though growth has been slowing, the U.S. economy still has to decline further before hitting recessionary levels. Consumer spending has been resilient as savings and a strong employment market with historically high job openings have provided consumers with a cushion. However, housing and commodity prices have fallen recently due to recession fears and rising interest rates. Additionally, the U.S. Treasury 2/10-year yield curve remains inverted, indicating that investors are becoming more pessimistic about the economic prospects for the near future – a clear recession signal. Note also that economies typically do not feel the full effects of monetary policy tightening until 10 to 24 months after implementation. Based on even the shortest of this time frame estimates, we have yet to fully feel the effects of the Fed’s initial 25-basis point rate hike in March 2022.
But on a positive note (and one we’ve mentioned many times throughout the year), recessions are a normal part of the economic cycle. They effectively correct economic imbalances (such as too-high housing prices and a too-tight labor market) while reducing inflation to a more tolerable level. A mild to moderate recession is preferable to a sustained stagflationary period of sub-par growth and high inflation. Additionally, stock and bond valuations are already much improved, leading to a better opportunity for gains in all asset classes in 2023.
We are likely in store for additional volatility as rate hikes make their impact and markets begin to factor in earnings declines and recession. As a reminder to investors: with market volatility comes the temptation to make investment decisions as a reaction to the headlines. But investment decisions should always be strategic and based on long-term goals. Following a disciplined, long-term approach to investing is the key to riding out turbulent market periods.
Thank you for allowing GuideStone to serve you. We wish you and your families a Merry Christmas and a blessed New Year.
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