Newsletter – Quarter 4, 2022

What a difference a year makes!  For much of the last decade, accommodative monetary policy fueled appreciation in almost every asset class.  Holders of stocks, bonds, and real estate saw their portfolios increase in value as central banks around the world, including our own Federal Reserve (“Fed”), kept interest rates low and engaged in Quantitative Easing (QE) to stimulate their economies.  While the goal of this policy was to boost the real economy, the byproduct of easy monetary policy was higher asset prices.  Central banks were emboldened to continue this policy through the Covid pandemic given the fear of deflation and persistently low inflation seen over the past decade.  In hindsight, this proved to be a costly error.  The combination of easy monetary policy, unprecedented fiscal stimulus, supply chains unable to support demand from a reopening economy, and geopolitical events that drove commodity prices higher proved to be the perfect storm that stoked inflation to levels not seen in decades. In response, the Fed and other central banks were forced to end the era of easy monetary policy by raising interest rates at an aggressive pace in an attempt to restore price stability.  

No asset class was spared in 2022.  Stocks and bonds experienced double-digit percentage declines, and it looks like cracks are forming in the real estate market.  Much of the blame can be attributed to the Fed raising interest rates higher and faster than most investors expected.  To give some context, in December 2021 the Fed forecasted that it would gradually raise the fed funds rate to about 1.6% by the end of 2023.  Yet the Fed has raised the fed funds rate from zero at the beginning of 2022 to its current level of 4.25% – 4.50%!  And the Fed is currently forecasting additional rate hikes in 2023.  This tighter monetary policy has started to show early signs of success in combating inflation, with recent inflation data moderating.  Yet many market participants are wondering at what cost.

It takes time for the full effect of Fed rate hikes to trickle through the economy.  A majority of economists agree that the Fed has gone too far, too fast and that a recession is likely in the next 12 months.  Bond markets, which have a solid track record of predicting pending recessions, agree.  Yet there are some who have hope.  For example, Goldman Sachs’ economists believe the US will avoid a recession in 2023.  Even Chairman of the Federal Reserve Jerome Powell believes an economic soft landing is possible.  Given recent missteps, it would be fair to question the Fed’s credibility in making such a call.  However, it does appear inflation is coming down from its June 2022 peak.  Additionally, market expectations for inflation in future years are also coming down.  But again, caution is warranted.  As market commentator Lyn Alden points out, bouts of inflation typically come in waves.  This was the case right after WWII and in the 1970s.  

Given today’s outlook, where does it leave us from an investment perspective?  We believe there are great opportunities in fixed income and for long-term investors in stocks.  The market is forward looking and has priced in a lot of the gloomy outlook.  Valuations for stocks and bonds are down from their highs.  Regarding fixed income, interest rates have come up and many bonds are generating a positive real yield (the quoted yield of a bond minus inflation expectations).  For much of the last decade, real yields were negative.  This is great news for those investors who are more focused on generating income from their portfolio while preserving purchasing power and taking less risk.  As for stocks, they will likely experience more volatility in 2023 as the market continues to price in the likelihood of a recession.  It is impossible to predict a market bottom.  Nonetheless, valuations have been reset lower, and gradually adding new funds during times of fear should reward investors who are willing to hold for many years. 

We have experienced many economic and investment cycles since our founding, and our investment philosophy has stood the test of time.  That investment philosophy is based on the belief that buying companies with healthy balance sheets, strong cash flow streams, good management teams, and attractive growth opportunities at reasonable prices will generate attractive long-term returns.

We wish you all the best in 2023 and look forward to working with you throughout the new year.  Thank you for your continued trust.

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