Unfinished Business from 2022 – December 30, 2022

Unfinished Business from 2022 – December 30, 2022
Morgan Lewis Posted on December 31, 2022

Unfinished Business from 2022

Happy New Year to our MWM clients and all HAI readers! With holiday festivities ongoing, HAI will merely offer some thoughts to cap what has been an amazing year of 2022 and briefly gaze ahead toward 2023. 

With the book now closed on December trading, the final verdict is in. Santa Clause did visit Wall Street this month, but rather than touching off the customary “Santa Clause rally,” not-so-jolly old St. Nick went with the coal-in-the-stocking routine. Rather than a year-end melt-up to delight his fans, Santa let the rally hopes fizzle. The S&P 500 suffered a 5.90% decline.

For the last trading week of the year, the S&P 500 was little changed, while the dollar slipped lower, gold punched higher, and Treasury yields surged into year-end.

As for the final 2022 tally, the record will state that the NASDAQ Composite ended down 33.1%, and notably, on Wednesday, December 28, closed at a new bear-market low. The S&P 500 ended its forgettable year down 19.44%, and winning the coveted best-of-the-bad award, the Dow Jones Industrial Average was down just 8.78% for the year. The divergence in relative performance makes sense in the context of an intact and still unfolding bear market with unfinished business. The more speculative bubble stocks that lead gains in a bull market often top first and lead the selloff as the bear takes hold. As the bear-market matures, the downside leaders are typically and reluctantly followed by the rest of the market.

The year now closing was the worst for the stock market since 2008, and the hard times brought volatility to match. The S&P 500 saw 46 daily moves of 2% or more in either direction, the most since the 2008-09 financial crisis. Worse still, as the Financial Times reports, a traditional portfolio consisting of 60% US stocks and 40% US bonds has seen its worst performance since 1932, when the U.S. was in the midst of the Great Depression. While bonds may catch a recessionary risk-off bid in 2023, equities will likely remain squarely under the gun at least until a substantial Federal Reserve policy pivot. As the folks at Elliot Wave ominously put it, “As memorable as 2022 may be for investors, it is just the appetizer to the main course, which will be served in 2023.”

Leading indicators of economic growth have been in decline throughout 2022, and in the second half of the year these leading indicators reached deeply recessionary levels. Over the last several months we have tracked measures of growth closely, and watched long-lead recessionary indicators inch closer and closer to current coincident conditions. First there were the long-lead recessionary signals, then the short-lead indicators became increasingly recessionary, and now we wait for real-time coincident conditions to turn recessionary and for an official recession to begin.

Nothing is ever certain in markets, but what is certain is that if this current bear market is to avoid a recessionary crunch as finale, a whole lot of “firsts” are required. Certain yield curves that have never inverted without a subsequent recession have significantly inverted. The reputable Conference Board Leading Economic Index (LEI) was the latest alarm with a perfect track record to trigger. The Conference Board’s LEI is a collection of 10 vital economic variables, and it has already plunged to low levels consistent with eight of the last eight recessions in the index’s 60+ year history. 

The percentage of banks tightening lending standards on both corporate and consumer loans has reached high levels that have always been followed by recession in data back to 1990. The University of Michigan Current Economic Conditions Index has not only undergone the sort of sharp and significant drop always consistent with imminent recession, the index has utterly collapsed in record fashion. Since forming a trough in May, continuous jobless claims—a measure that tracks the number of people who have already filed an initial claims application and are now continuing to claim unemployment benefits—have jumped higher by 30.9%. In data back to 1967, such a percentage uptick in continuing jobless claims has happened only in recession. 

In addition, the Federal Reserve’s own projections forecast an increase in the unemployment rate of a magnitude that has never happened outside recession. These data points are but a sampling of historically perfect recession alarms now blaring out of a mountain of additional indications. Meanwhile, of crucial significance, the Fed is still hiking interest rates (a powerful tool that works on a considerable lag) and administering quantitative tightening (QT) into these deteriorating conditions and the most inverted 2s10s yield curve since 1981. As previously mentioned, nothing is ever certain in markets, but HAI doesn’t like the odds of a bet on a soft-landing.

Of additional import is the following consideration. When reflecting upon Fed policy maneuvers in 2022, a very fair conclusion might be that the Fed’s actions confirm it is highly aware and deeply concerned about its enormous credibility problem. Throughout this tightening cycle, despite the rate-hike blitzkrieg and Jay “Volker” Powell’s uber-hawkish pronouncements, this market has consistently called the Fed’s bluff and attempted to front-run an expected stimulative dovish policy pivot. If the observation of Powell’s preoccupation with the Fed’s credibility crisis is accurate, inflation considerations aside, the market’s ongoing tendency to ignore Fed guidance is a massive problem.

The Fed has two impactful policy settings—it has an accelerator and a brake. If the market ignores hawkish Fed guidance in this tightening cycle, then, practically speaking, the Fed no longer has a policy brake with which to rein in the market when necessary. A loss of the monetary brake is equivalent to the Fed losing control of markets, and is a necessary first step toward a runaway, inflationary, crack-up-boom dynamic that would almost certainly end in calamity.

If credibility is indeed center stage, to truly restore it and the efficacy of the monetary policy brake, the Fed will need to see the market actually price in the implications of stated Fed policy—in other words, the recession the Fed is essentially aiming for. The only other option for the Fed to regain credibility, if markets are non-cooperative, is to continue to raise rates and tighten the screws until it triggers a painful recession or something critical breaks. If the Fed doesn’t do it now, the process will only get exponentially more difficult going forward. It seems to be now or never. 

HAI could certainly be wrong, but does expect that Chairman Powell’s Fed will attempt to seize the opportunity and delay a true pivot until any of these conditions are met—or at least as long as it is able. Such a scenario likely translates to a rocky road for risk assets for at least the first half of 2023.

As mentioned, if markets are proven correct in their insistence on discounting Fed guidance and front-running a Fed pivot in the face of a likely incoming recession, then the damage to the Fed may be permanent. In such an instance, expect market functioning to crack, but counterintuitively crack upward.

One way or another, the markets’ preoccupation in 2023 will likely revolve around clearing these issues related to Fed policy and recession as a first order of business. Lurking in the background is a secondary factor that may soon become primary: the ramifications of 2022’s apparently decisive turn from globalization to deglobalization, and from relative peace toward geopolitical tension and increased hostility. These issues, along with the weaponization of the dollar following Russia’s invasion of Ukraine, all seem to incentivize a more determined scramble to find a viable competitor to the US dollar system on the part of a large and growing number of disgruntled parties. 

In addition, these key factors are likely to lead to an increased realization of the importance of scarce real assets. As famed Credit Suisse analyst Zoltan Pozsar wrote this week, “resource nationalism is in the air, but markets don’t seem to price it as a potential driver of inflation.” In HAI’s view, markets aren’t pricing in this potential driver of inflation—yet. It may be an unwanted “gift” bestowed by 2022 that will require a much more thorough unwrapping latter in 2023. As we welcome in the new year, let us hope all of these issues can be resolved in the best of possible ways.

Weekly performance: The S&P 500 lost 0.14%. Gold was up 1.22%, silver gained 0.50%, platinum was higher by 5.18%, and palladium gained 3.81%. The HUI gold miners index was down 0.88%. The IFRA iShares US Infrastructure ETF was down 0.79%. Energy commodities were volatile and mixed again on the week. WTI crude oil gained 0.88%. Natural gas crashed again, down another 10.14%. The CRB Commodity Index was little changed, down 0.13%, while copper was flat, up 0.04%. The Dow Jones US Specialty Real Estate Investment Trust Index was off 0.60% on the week, while the Vanguard Utilities ETF (VPU) was off 0.63%. The dollar was off 0.71% to close the week at 103.27. The yield on the 10-yr Treasury was up 13 bps, ending the week at 3.88%.

Have a wonderful weekend and a very happy New Year!

Best Regards,

Morgan Lewis
Investment Strategist & Co-Portfolio Manager


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