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Cause and Effect
What is in store for 2023
The past twelve months have proved challenging for both fixed-income and equity investors—arguably one of the most brutal years in half a century. These conditions were primarily the result of the drastic tightening of monetary conditions by central banks. To identify the best opportunities for 2023, we should first understand the key events of 2022. In this letter, we will examine Cause and Effect to map out where we expect the best returns will be found next year. If you want to see how last year’s forecast played out, follow the link below:
December 2021 Letter
In past letters, we stated that the primary risk to market returns would be a tightening of monetary policy. This tightening policy would likely come in several forms:
1) Ending of Quantitative Easing (the major central banks’ bond-buying program).
2) Introduction of Quantitative Tightening (de-grossing of central bank balance sheets).
3) And finally, the sledgehammer of all monetary policy, raising the overnight lending rate from central to commercial banks.
Let’s take the US as an example. Beginning spring of 2022, the market got #1; in the summer of 2022, the market got #2; the market has been getting healthy doses of #3 since March. The impact of these three measures is reflected in the return equities and bonds generated in 2022 (Cause and Effect). It’s more important to examine what drove Central Bankers to release the hounds that almost destroyed the 60/40 portfolio. We understand the “cause” was inflation, and there is no need to argue that point. What we next need to understand is how inflation is measured.
Let’s focus on the most widely used measure that tracks inflation: The Consumer Price Index (CPI). The changes in the individual components of each index make up the CPI and PPI monthly index. You might hear or read that “the inflation index rose by a 7% annual rate.” That rate of change measures the most recent level of the index (a proxy for price levels) compared to the level twelve months earlier. One trick when seeking insight is to look at each month of the series and determine what number is dropping off (i.e., thirteen months ago) and what number is replacing it (twelve months ago). In December 2021, for example, the CPI index rose by 0.7% vs. the previous month. That monthly rate equates to 8.7% annualized inflation (taking compounding into account). For January 2022, the increase was 0.6%, Feb 0.8%, and March 1.2%. Horrific prints, all of them. However, since March (with the exception of May and June, each over 1%), we have had inflation running at 2.6%. What? Yes, inflation has been running at an annualized rate of just over 2.6% for the past five months. Here is where it gets interesting –the vast majority of economists, strategists, and traders forecast that the economy will slow and demand will soften due to Central Bank measures taken this year. If you accept this, it’s safe to conclude we will likely see Q1 ’23 CPI roughly in line with December of +0.2% (maybe even lower). By removing the high base numbers from December 2021 to March 2022 and replacing them with the low numbers we expect for the coming six months, we KNOW, or at least are highly confident, that inflation will run between 3 and 4% for the first half of next year. Hopefully, you can use this parlor trick at your holiday parties this year.
One of the partners in the fund has an expression that is apropos at this point: “Where in this conversation am I making money?” We’re glad you asked. Remember cause and effect? It is accepted that overstimulating the economy during the height of the pandemic caused inflation to spike to 10% in an already tight labor market. This, in turn, caused Central Banks to reverse monetary policy tools into tightening mode.
Then valuations on growth stocks fell, and bonds depreciated, which brings us to where we are now. We are confident that inflation is nearing an inflection. Where do we believe the best place to invest is?
We feel the best investment opportunity exists in short-duration corporate bonds whose yields are still elevated due to current earnings and economic and monetary policy concerns. We will invest as long as we have a firm conviction that:
1) We will be repaid our principal,
2) The yield appropriately compensates us for the risk we are taking,
3) The monetary policy outlook remains constructive for fixed-income investments.
We have allocated 10% of the portfolio to this strategy and will be increasing that over the coming weeks as we identify more opportunities. We figure we can generate a return in the low teens with this strategy. Based on what you just read, we have this conviction, which is exceptionally bullish for bonds. We are sticking to the shorter term as that is where we see the best risk-adjusted returns. We still feel equity valuations are elevated, but we will revisit this as the winter progresses.
Market-neutral strategies will continue to offer the best equity-related investments. For the latter half of 2023, we still need to believe that the shift in monetary policy will provide a reinflation of valuations or sufficient earnings growth to generate substantial equity returns. We are always available to speak to our partners on this or any other topics. Finally, we extend warm wishes to you and your family for a healthy and happy holiday season.
We thank you for your confidence and capital,
Jeff and Glen.