2022 will be remembered as the year the Fed finally took Covid inflation seriously. After having increased the economy’s money supply by $6T or 40% in the first two years of the pandemic, the Fed recognized they had better stop providing that direct source of inflationary growth. The Fed also embarked on the most rapid rise in interest rates in more than forty years. Over the year, as the Fed raised overnight interest rates by 425 bps from 0.25% to 4.5%, asset prices reset lower across the board. Each of these monetary actions are extraordinary; investors are concerned that the Fed may have misjudged this inflation cycle once again.
While investor angst has continued through yearend, equity index prices actually improved by about 5% this past quarter. Still the S&P500 finished the year down 19%. Other 2022 comparisons include the higherrisk Nasdaq down 33%, and the defensive Aggregate Bond Index down 14%. The asset price reset truly was across the board, but we believe this process is nearing its end.
Real-time inflation trends are widely understood to have already dropped dramatically with lagged disinflationary impacts still to come from the policy actions already taken. However, the Fed remains overly focused on extinguishing remaining service sector wage inflation. They see this as “sticky” inflation and seem intent on lowering economic demand down to the level that can be absorbed by the existing workforce. They recently raised both their inflation expectations and their future interest rate expectations while, at the same time, lowered GDP estimates and raised unemployment estimates. This has cast a gloom on the 2023 economy and is the main source of investor concern regarding a potential recession. We see this as the Fed deciding not to follow the data as they said they would; instead, they seem to be concerned about the potential longer-term aspects of labor scarcity theory.
In the near term, we are concerned about economic uncertainties and potential policy mistakes; however, longer term, we remain optimistic as the extraordinary imbalances of the Covid economy are resolved favorably over time. Also, we believe many investors are far too discouraged (bearish) with the present environment and are not recognizing the benefits to businesses as we return to a more normal economic and investment landscape. Inflation is falling, transportation and shipping costs are significantly down, money supply is declining, and the Fed has dry powder once again to support the economy. Equity valuations are historically reasonable and speculation has been greatly reduced. Unemployment remains near historical lows. Banks and consumers are in good shape. Supply chains have improved and the disruptions from over-ordering and demand-pull are better understood. Companies have realized that overhiring has hurt productivity and have responded with widespread layoffs, especially within tech, which should remove some wage price pressure.
Meanwhile our portfolio companies continue to do what they do best – run their businesses. Our focus on financially healthy businesses that generate substantial free cash flow is an advantage. We can wait out these periods of market unease while our clients benefit from increased dividends and accelerated share repurchases. Time is on the side of long-term investors. We feel there is significant value to be realized over the course of 2023-24 as the economy normalizes and investors recognize that the Fed headwind will eventually become a tailwind.
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