Not Believing But Seeing
What you see depends not only on what you look at, but also where you look from. – James Deacon
2022 will be memorialized for investors by market commentators by their use of tag lines such as “returns for 60/40 portfolio investors worst since 1871”. For those investors whom I’m best acquainted with, such as yourself, I’m looking at returns for the year in the negative 14% to 16% range, so maybe things haven’t been all that bad over the past one-hundred and fifty-two years. But one does recollect the Global Financial Crisis of 2007-2009 and that wasn’t this, thank heavens. So, it’s a new year and a good time to step back, size up last year and what it was, and do our best to take the rear view and turn it into a windshield so we can gaze into the year ahead and do our best to set expectations.
Two errors many observers of the financial markets may be making is their confusing cause with effect and their use of an incorrect starting point to begin their analysis. First, 2022 isn’t particularly difficult to explain. Interest rates began the year at exceedingly low levels and the increases in rates, if not that great in the absolute, were very great in relative terms as rates on the ten year US Treasury rose from 1.52% to 3.88%; sufficient to create losses of over 15% in those and similar investments at year’s end; not very far distant from the -18% return for the S&P 500 for 2022. The result was investors were left having nowhere to go to protect their capital outside of cash. The decline in the stock market isn’t difficult to explain either. The value portion of the S&P was down a modest 5.2% so it was growth’s decline of 30% causing the real damage. Markets discount future streams of financial benefits using a discounting factor based upon levels of interest rates. Rates go up significantly, so does the discounting factor used to value them, and growth stocks, which by definition are more dependent upon their prospect for future growth, get hammered as their valuations get marked down while value stocks survive relatively unscathed.
Interest rates went up substantially because of the Fed aggressively raising interest rates with the Fed Funds Rate rising from essentially zero at the start of the year to 4.50% at the end of it. 10 Year Treasury rates, as mentioned above, also rose but only by half that amount, leaving the interest rate markets in the extraordinary position of offering investors higher rates of return for lending to the US Treasury for one day than for thirty years. If you think that is unusual you are exactly correct. It is.
So next we ask, why did the Fed believe it was a good idea to raise interest rates so aggressively last year? You know the answer to that question as well. A word we hadn’t heard for awhile until last year. Inflation. So finally, we get to the single most important question of all; the cause that explains the effects we’ve discussed thus far. Why, after having gone AWOL for so many years, did inflation reappear in 2022 or, more accurately, in 2021? Now we need to get to the correct starting point for the various parts of our analysis to fall together into a hopefully neat and comprehensible narrative. THE PANDEMIC. Closing down the global economy was a very large deal. So large it had never happened before in the entirety of human existence. Exiling working people from the work force left tens of millions of us dependent upon the federal government for our financial support. But our uncle was not Uncle Scrooge but rather the most generous person whom you can imagine. So generous in fact, that it left American’s with $2.3 trillion more in their bank accounts after the lockdowns end than before it. For those counting, that is a 2.3 followed by ELEVEN zeroes. Even in an economy of $25 trillion that is a great deal of money.
We had all that money to spend but, outside of receiving visits from the Amazon truck, not many places to spend it. As the economy rose from the horizontal and struggled to go vertical there was an additional problem; supply chains. The stuff people wanted to buy either couldn’t get produced because of producers’ inability to get the stuff to make it or, even if they could make it, they couldn’t get it to you. So, if we connect the dots, the picture we see is a great deal of money available to buy things that had a great deal of difficulty being produced leading to…you guessed it. Higher prices, aka inflation.
Now, you may be thinking two things. The first being that if the pandemic caused inflation, then why did the Federal Reserve need to raise interest rates given that the pandemic (here we fold our fingers together in prayer) was a “one and done” event leading one to believe that inflation was going to go down even if the Fed had done nada? I really don’t know. If you would like to call the Federal Reserve and ask them their phone number is 1-888-851-1920. Really. The second thing you may be thinking is, “the pandemic will have happened three years ago in just a couple of months. Isn’t that getting to be kind of a long time ago?.” Again, you are correct. It is also correct that while the global economy is a very large lake, the shutting down of the global economy was a very large boulder to drop into the middle of it. To this very day its rippling effects continue to radiate outwards but with a steadily diminishing effect. So, we are getting back to life as it was pre-pandemic. The economy will grow. The markets will rise. Jerome Powell will cease his impersonation of your most mischievous family member. The sun is preparing to shine ever more brightly.
Mark H. Tekamp/January 8, 2023