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Quarterly Commentary – December 2022

The last quarter of 2022 saw U.S. Equities move higher until the end of November, only to resume downward, but still close at slightly higher levels relative to the last quarter. Equities ended down for the year with significant disparity between the various areas of the market where shares of some of the larger capitalization growth companies significantly underperformed. The Nasdaq index has had its worst year since 2008.

The following are performance numbers from various popular indexes. Please remember index numbers are not individually comparable to a properly diversified portfolio. Each portfolio may include an allocation to securities similar to these indexes in varying amounts based on your personal risk tolerance and should only be compared in that context. Year to date for 2022, the S&P 500 was down xx%. The Dow Jones Industrial Average was down xx%. The Nasdaq Composite Index was down xx%. The Russell 2000 Index was down xx%. International equities as represented by the MSCI AC World Ex U.S. Index were down xx%. The MSCI Emerging Markets Index was down xx%. Fixed Income as represented by the Bloomberg Barclays Aggregate Bond Index ended down xx% year to date.

2022 was about the War in Ukraine, Inflation, and the Fed. Throughout, there was an obsessive focus on the Federal Reserve which raised its policy rate by 50 basis points at its latest December meeting, providing somewhat of a reprieve relative to the prior four 75 basis points increases. This represented the fastest increase in rates since 1970 and a total increase of 4.25% in 2022.

The US economy had been robust up until very recently. Consumer spending has not changed much, unemployment has stayed low, and the purchasing managers index is still close to 50 despite having fallen from its high (levels above 50 are considered expansionary). Although this emphasizes how strong the economy is, monetary policy has a delayed effect on it. Historically, on average, unemployment began to increase two and a half years after the first Fed rate increase and peaked two years after the final increase. Additionally, consumer spending usually peaked on average around a year after the rate hike cycle ended. Given how quickly the Fed has raised rates, the damage may be done more quickly this time around. The consensus is that growth will significantly slow throughout 2023 and see a high likelihood of a recession in the latter part of the year. The Fed’s hawkish narrative has also contributed to some added volatility.

Recessions typically start about 7 months after the most recent Fed rate hike if they start at all. Strong consumer and labor markets could serve as a double-edged sword, delaying the impact of rate hikes on the economy and maintaining investor hopes for a gentle landing but also posing a threat to keep inflation higher for longer. This is one of the most challenging conditions in which investors have found themselves in the past few decades. This is in part due to a level of inflation not experienced in a long while and the stark contrast from the upbeat phase that was observed in the market’s aftermath following the low point in March 2020 relative to what we experienced in 2022.

By historical standards, this Bear Market has been mild. Even though the market spent the entire year trying to catch up to the Fed’s actions, it looks to have finally found a point of equilibrium since October. One positive aspect of the current situation is that the market’s current valuation is lower than indicated by its price-to-earnings ratio prior to the Pandemic. All indications point to the fact that inflation has reached its peak and is now steadily dropping. Housing has traditionally been a reliable leading indicator for the economy as a whole; but the housing market has been sluggish recently due to high-interest rates and affordability concerns, which have halted activity in the housing market. Employment has been one of the economy’s bright spots, but despite appearances, it is not as robust as it seems on the surface.

Even after the nearly 20% losses on the U.S. and worldwide equity indices in 2022, investors should probably prepare for further near- to mid-term turbulence. It is fair to ask what would cause further material declines from here. This would probably be driven by weaker earnings. Although consumption has been strong, the U.S. economy may lose the incremental boost supplied by this significant driver if large household savings are depleted. This would happen if a sluggish labor market makes it harder for employees to demand higher salaries. Reduced household spending would probably make the current inventory building worse, forcing producers of products to reduce output even more. This has happened before as central banks apply the brakes on an overheating economy as a result of the rush to meet post-recession demand.

Even if a recession does not materialize, a mid-cycle adjustment is likely with some type of slowdown which could last several months. We are entering a slightly different era and things will be different than they have been during the previous 15 years. Real interest rates, which are adjusted for inflation, will most likely continue to rise. The cost of capital will therefore be higher and investing will require a focus on businesses that can expand their earnings and produce positive cash flows, rather than those that typically have gotten by based on low-cost financing. Those days are no longer. Looking for growth at a reasonable price, managing diversification and a focus on risk management will be important. Solid returns are still possible, it is just that being selective will be key as the markets will be less forgiving in that type of environment.

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