2023: What's Trending, What's Ending

In The Ring - January 6th, 2023

Jan 06, 2023

Image: Shutterstock

“If your deficit projection starts to get out of control and your real interest rates start to rise rapidly, you can get into a kind of doom loop. We’re going to need to be watching our own fiscal projections in the (U.S.) very carefully.” -Larry Summers, former U.S. Treasury Secretary, 10/21/22

“The world is leveraged long…most investors are long assets with borrowed money supporting those positions, which is a formula for a shakeout as prices go down and the debtors holding these assets get squeezed.” -Hedge fund legend Ray Dalio, founder of Bridgewater Associates

Topics

We hope you’ll find this whole piece, our inaugural 2023 Haymaker, informative and helpful, but if you’re running on a tight schedule and would like to skip ahead to a specific section, here, listed in order, are the major topics covered:

Inflation
Economy
Stock market
International stock and bond markets
The Fed and interest rates
Credit spreads
U.S. government funding crisis
The U.S. dollar
Global housing market
Energy

Whether you’re bouncing around or reading the edition all the way through, now’s a good time to take a generously deep breath.

-The Haymaker Team

This is, of course, the time of the year when the financial media and Wall Street are frantically churning out 2023 forecasts. Typically not included are recaps of how their previous calls fared, though there are notable exceptions, such as Barron’s.

In recent years, I’ve shied away from this, partially because the usual approach is, in my view, too inflexible. My preference is to make regular updates to my outlook via this publication and its sister newsletter, Making Hay Monday, (and prior to that, my former newsletter, the Evergreen Virtual Advisor; EVA, for short), adjusting periodically as major developments occur. This year, though, I’m going to make a bit of a concession to the norm, even though I prefer to refer to this process as providing anticipations versus predictions. Additionally, I’m going to adopt a technique Gavekal Research’s Charles Gave calls “observing as opposed to forecasting”.

In that regard, let’s consider the major trends that dominated 2022, most of which I was fortunate enough to anticipate (with some shifts along the way as the facts changed). In my mind, the key question to ask with each of them is if they are likely to continue or reverse. Yes, I realize that’s perilously close to attempting a forecast, but it is what it is. Frankly, I believe a non-passive (i.e., non-indexing) investor needs to have some strong opinions on how conditions will evolve. This is despite my belief that the whole calendar-year-forecasting thing is more than a bit arbitrary.

Inflation.

First up — as it had such a massive impact on 2022 — is inflation. The fact that it ground higher through most of last year was unquestionably why it was one of the worst years on record for balanced portfolios. This refers to the traditional half stock/half bond asset allocation, or some variation thereof, like 60% stocks/40% bonds. Millions of investors rely on this mix to mitigate market volatility. However, when bonds fare nearly as poorly as stocks, the counter-balancing effect is painfully missing-in-action. That’s a rare occurrence, but in 2022 virulent inflation was a gale-force headwind for bonds.

Interestingly, the inflation trend did change as 2022 came to a close. There is an unquestionable deceleration manifesting in recent months. Much of this is due to the sharp correction in commodity prices, like oil and natural gas, that occurred in last year’s second half. There is also actual deflation occurring in housing costs, including mounting evidence of rents being cut rather than rising at their recent double-digit pace.

Wages, however, are the primary driving force, at least of persistent upward pressure on the CPI. Those are continuing to increase at an uncomfortably high rate. The nearly 9% hike for Social Security recipients was another, even loftier, income booster (wages overall are rising more like 5%; still a historically high rate).

This moderating trend is one I expect to continue, particularly based on the next section. However, I remain a believer that we are in a structurally higher inflation era. This is due to deglobalization, an aging work force, unrepayable U.S. government debt (more on that in its section), and, perhaps the most important upside driver of consumer and producer prices, what I have long called “greenflation”. Again, I’ll cover that in more detail shortly.

Economy.

This is a tougher trend to discern, given the official negative GDP numbers in 2022’s first two quarters. Those were followed by better readings in the second half. However, it certainly seemed as though the economy was stronger early on and then weakened, judging by the housing market, for example. Moreover, on the critically important labor front, clear erosion appeared to be underway toward year-end.

Two of my favorite economic forecasters are Danielle DiMartion Booth and Stephanie Pomboy. (Serendipitously, I had the chance to meet with Danielle in person recently, which was a great treat.) Danielle has been theorizing for many months that the labor market was much weaker than the Fed believes; or, at least, is admitting.

Coincidentally, earlier in the day, I had listened to a podcast our mutual friend Grant Williams recently recorded with Stephanie Pomboy. Both Danielle and Stephanie are noting the much, much weaker jobs numbers being reported by the Household Survey compared to the more closely followed Payroll Survey. They are convinced that the former is far better than the latter at picking up inflection points. This is, as I have often written, a view I share. Even more intriguingly, they believe Jay Powell is intentionally ignoring this time-tested reality.

Further, they each contend he is doing so to justify continued tightening with the goal of driving stocks down further as part of his effort to once and for all lay to rest the infamous “Fed Put”. This is the idea that our central bank will bail out financial markets when they look to be on the verge of a major meltdown. That approach has repeatedly recurred since Alan Greenspan activated the Fed Put for the first time in 1987, but it clearly wasn’t the case in 2022. This broke a trend that, over the past 35 years, has worked extraordinarily well for investors.

However, these days, I agree with Danielle and Stephanie that the Fed Put is kaput, as I’ve written previously. Powell is unquestionably willing to endure a recession — after all, he’ll still get his paycheck! — to put The Put to death. That’s bad news for both stocks and the economy.

Even though it bothers me that the recession call seems obvious right now — and the obvious often turns out to be obviously wrong — I’m in the same recession-anticipation state of mind I’ve been in since last June. Listening to Danielle and Stephanie elevated my conviction level in this outcome. Thus, I believe the first half of 2023 will bring increasing evidence that the first traditional recession since 2009 is underway. (We might have experienced one in 2020 had Covid not created that economic flash-crash, but we’ll never know for certain; regardless, it definitely wasn’t a normal downturn.)

To learn more about Evergreen Gavekal, where the Haymaker himself serves as Co-CIO, click below.

Private Wealth Management

Stock market.

Its trend is a no-brainer, though I continue to marvel at how many so-called “pundits” seem to be brainless when it comes to the obvious bear market behavior. This state of denial has extended to retail investors who have continued to plow new money into equities during severe weakness for the first time I can recall. The fact that the ARKK Innovation Fund has experienced net inflows, despite being down about 80% from its peak, is another vivid example that the classic capitulation reaction which coincides with major market bottoms is nowhere to be seen.

Also, while I have sympathy for those who believe this is the most anticipated recession ever, and, therefore, not likely to happen for that reason, it’s a different story with corporate profits. Wall Street continues to forecast 2023 as an up year for S&P 500 earnings. This is truly nonsensical when viewed in the light of a consensus recession call. Goldman Sachs is a rare dissenter to this view… despite that it could end up laying off 4000 souls, around “8% [of] its workforce” (and is drastically slashing bonuses).

My suggestion is to follow what Goldman is doing, not what it is saying. Be prepared for S&P earnings to tumble 15-25% this year and for the stock market to do roughly the same, at least through the first six to nine months. However, I do anticipate a trend reversal later in the year. This is predicated on the Fed beginning to cut rates around next summer. Should that be delayed until late in the year, or even 2024, I’d expect any rallies to continue to be of the bear-market variety.

International stock and bond markets.

My partner and bestie Louis Gave has been repeatedly and vehemently making the case lately for emerging markets. Similarly, I almost fell down while running our dogs last week listening to Grant Williams tell Stephanie Pomboy that he is bullish on Japanese stocks. (One could make the case that Japan has become an emerging economy, at least based on its fiscal and monetary policies.) Grant has been bearish on Japan, appropriately, for what seems like decades.

Recently, the trend of the U.S. outperforming overseas markets has begun to run out of steam. This is much overdue considering the S&P has returned 13%/year over the last decade compared to a mere 5% for the MSCI EAFE, a leading non-U.S. index. Valuations are, in most cases, far more alluring in developing and other developed equity markets.

However, because of my concerns about a global recession, I prefer emerging-market bond funds, for now. Many of the closed-end variety are selling at meaningful discounts to their underlying portfolios (i.e., net asset values). They also provide high single-digit yields. In my opinion, they could generate total returns (price appreciation and yields) rivaling stocks during the early stages of the next bull market.

The Fed and interest rates.

For many years, these two have been essentially synonymous, including in 2022. The Fed wanted rates higher — actually, much higher — and it got what it wanted. Accordingly, the Fed being in control of the bond market looks to be an ongoing trend.

This is where I’m venturing into dangerous territory by calling for a reversal, with the Fed increasingly struggling to bend the bond market to its will. However, I’m going to save most of that argument for an upcoming section. Early in the year, there’s little doubt it will continue to press short-term rates higher. How high is high? That’s a tough one – I’d speculate likely 5½%, a bit higher than the consensus.

Another difficult anticipation is how the longer-term bond market will react to that. Toward the end of last year, there was a powerful rally in the 10-year T-note. Its yield plunged from 4.3% all the way down to 3.4%, with the 4 and the 3 ironically changing places. That’s a serious rate decline. However, the last few weeks of 2022 saw that rally fizzle out. Yields spiked by ½% (50 basis points), another surprisingly husky move in such a short timeframe. This left 2022 as among the worst return years for bonds since 1788. That’s kind of a long time.

For sure, the trend in rates has been up over the last year and I suspect that will continue. My weak-conviction belief is that the 10-year T-note will peak out in the 4½-5% range (it could easily be lower than that, but probably not much higher, barring the scenario I describe below on the U.S. government’s funding needs).

At some point, there should be an even more robust price rally/yield decline than we saw in the fourth quarter of 2022 since interest rates consistently fall in recessions. However, I am highly confident the 40-year bond bull market has been slain. One sign of that is that the trend of lower highs and lower troughs in yields has been arrested. 2022 saw that downtrend in yield peaks decisively broken to the upside. As far as the prior trend of lower lows in yields, I can’t see the yield nadir of ½%, set by the 10-year in the summer of 2020, ever touched again, much less penetrated. Yes, “ever” is a long time, but I’m sticking with that belief for reasons to be further discussed shortly.

Credit spreads.

Almost on par with interest rates in terms of market and economic impact, is the spread measuring the difference between U.S. government and corporate borrowing costs. As I’ve written many times, when spreads are widening, as they did during the worst of the 2022 slide in both stocks and bonds, that’s seriously bad news. When they shrink, especially off a high level, that is the stuff explosive bull markets are made of.

The latter is was what happened in the spring of 2020 when the Fed forced it to occur by announcing its unprecedented — and questionably legal — corporate bond-buying intervention. The Fed’s triage triggered the explosive bull market in stocks back then, despite the fact that the Covid news was still terrifying. Consequently, this demonstrated the extreme influence of credit spreads on corporate debt and equity securities. Spreads also impact the real economy in many ways, such as by raising or lowering mortgage rates. One reason housing was clobbered last year was that not only did overall rates spike, so did the spreads of mortgages over treasuries — even those that were government guaranteed.

Spreads have narrowed dramatically since the summer of last year. For example, credit spreads on junk bonds tumbled from roughly 6% (600 basis points) over government debt at the worst point, around mid-year, to a low of 4.5% (450 basis points). This catalyzed a couple of rousing rallies in stocks. This catalyzed a couple of rousing rallies in stocks. The current spread is ~4.8% (480 basis points).

During a garden-variety recession, however, spreads on junk bonds tend to hit around 7% over treasuries. For the reasons to be covered below, I anticipate this one will be more severe than normal. Therefore, I suspect spreads are going to experience another pronounced widening. If I’m right, that’s reason enough to fasten your seatbelts and be prepared for the market turbulence to continue this year.

U.S. government funding crisis.

Most of the above risks are widely perceived and, as a result, partially, if not largely, discounted. However, I don’t believe that applies to this section, nor the one immediately following, even though they both involve well-established trends.

Frankly, I am astounded at how complacent Wall Street is right now over the growing risk that the markets will not be able to absorb all of the debt the federal government needs to rollover and newly issue. We ran this table previously but it’s worth repeating for emphasis.

Table: Evergreen via Bloomberg

Top Line: Total U.S. debt outstanding
Bottom Line: Amount maturing in 2023 and 2024

This $9 trillion of maturing U.S. government debt over the next two years is problematic enough. Yet making this much more so is that the Fed has pivoted from a nearly limitless buyer of treasuries — using, of course, its Magical Money Machine — to a seller of over $1 trillion/year. This is due to its switch from Quantitative Easing (QE) to the photographic-negative process of Quantitative Tightening (QT).

Many questioned the linkage back then, but the fact of the matter is that the QE blowout during the pandemic coincided with the greatest speculative mania of all time. QT is in its infancy, but it’s going to become an increasingly heavy drag on the stock market. It is also nearly certain to create extreme challenges for the U.S. government to fund deficits that are poised to explode during the assumed upcoming recession.

Adding to this risk, the central banks of Japan and China, two massive holders of treasuries, are also selling as opposed to buying. Then there is the Social Security Trust Fund, which has morphed from ravenous buying into forced liquidation of government bonds.

As I mentioned earlier, interest rates typically fall in a recession. It’s always dangerous to say “this time is different”, but the aforementioned numbers strongly suggest it is. Should the bond market lose confidence in the ability of the U.S. government to fund itself, longer-term rates could rise, quite possibly significantly, rather than fall, even as real GDP goes negative. (GDP growth, including inflation, the nominal version, is unlikely to fall below zero.) If so, it will almost certainly amplify the recession… if one does occur.

Hopefully, the Fed and the Treasury can continue to forestall the inevitable as they have done many times (though this does make the ultimate reckoning more ominous). But 2023 has the potential to be the year they lose control of the situation. If so, it’s highly likely to force Powell to halt QT and almost immediately restart QE in order to fund the erupting deficits and the selling of treasuries by foreign central banks. Such an about-face by Jay Powell would probably catalyze a punchy rally in stocks, especially of the hard-asset variety. However, the long-term implications would be exceedingly ominous. The above is not to say there won’t be some compelling trading opportunities on the long side – in both senses of that phrase – with bonds this year.

The U.S. dollar.

Because I wrote on this extensively two months ago in The Next Big Short, I’m going to keep this as brief as one of Jay Powell’s recent speeches. The dollar’s monster up-move last year put downward pressure on almost all investments. Over the last four months of 2022, however, it went into reverse.

It’s been such a sharp selloff that a bounce-back is probable. But I do think this trend is in the process of reversing. In fact, if the Fed is forced to resume QE (i.e, ginormous money printing), that should clobber the dollar and ignite the aforementioned traditional inflation hedges. In that regard, it’s interesting how perky gold mining stocks have been lately, including into the fledgling year.

Global housing market.

Past Haymaker editions have expressed mounting anxiety over the bursting of the latest rich-world real estate bubble. In many ways, it exceeds 2008’s oft-described “Bubble To End All Bubbles”. The risk of the fallout from this detonation also has the potential to be just as cataclysmic, possibly more so.

Usually when prices are cratering, as they are now doing in a number of developed countries, interest rates are being cut. Instead, they continue to rise. Consequently, affordability is going from bad to worse. For homes to sell, something has to give and that would be the asking price. This trend is both established and intensifying. My expectation is that it will continue well into 2023, if not beyond.

The reality is that homes are the biggest asset for most people. When they fall meaningfully in price, that has a profound impact on consumer sentiment and, in turn, the global economy, particularly if it truly is a multinational bubble. There is no question in my mind that it has been, with a plethora of data to back up that contention.

Yet, I read and hear almost no discussion of this risk. That astounds me, considering what happened 15 years ago. Again, this housing downtrend isn’t a prediction on my part. It’s already unfolding. If it was the only big risk out there, it would be disturbing enough. As we’ve just seen, that’s clearly not the case. Of course, there are positives to focus on, including asset classes that can provide upside even in a wickedly difficult environment.

Energy.

Readers of this newsletter and its EVA predecessor are well aware that the energy sector has been my favorite in recent years, despite a brief hunkering down in the early stages of Covid. In late 2020, I pressed that bet with my EVA issue titled Totally Toxic, making the case that oil and gas shares were as undervalued two years ago as tobacco stocks were in 2000. (The latter instance was prior to enormous outperformance of the S&P over the next two decades by companies like the old Philip Morris.)

Since the end of 2020, the energy sector is up north of 150% while the S&P has now returned a limp 5% thanks to last year’s serious correction. Energy’s nearly 60% return in the brutal year of 2022 was truly remarkable. After we sent out last week’s review of my 2022 anticipations, it dawned on me that I had neglected to list this as one of my hits. (Hey, no one can accuse me of padding my performance!). It surprised me a bit that no readers pointed this out, many of whom I know profited from the energy sector’s exceptional performance. Maybe it was a situation of too much egg nog and other similar holiday libations.

Of course, it’s really on me to point out such things. In this case, I was more focused on my embarrassment over having been wrong about how far oil prices would tumble on recession fears. Yet, my tout was much more on the energy equities than it was on oil itself, at least until later in the year.

Yet, the far more pressing issue is what is likely to happen with oil and gas stocks in 2023. My anticipation is a third consecutive year of outperformance, though of a much more muted variety. Valuations remain undemanding and dividend yields are still, in many cases, mouthwatering. But they are obviously not nearly as fire-sale as they were a year ago, much less two years back. One reason I see another year of superior performance is that I have a high degree of confidence in oil prices surging back over $100 this year, possibly far above that level. This is a key reason why I also believe inflation has another up-leg looming, once the Fed reverses its tightening, and asset-deflating, ways.

The “Greenflation” caused by placing the oil and gas industry into a long-term penalty box, greatly inhibiting desperately needed capital spending, is a trend to which I would attach “mega”. In my usual renegade view, I believe we could see oil prices exceeding $150 at some point over the next 12 months. That’s another in the long list of reasons I see 2023 being a challenging year for stocks, at least until the second half.

Clearly, my anticipations have a negative skew at present. This is because I strongly believe now is not the time to bury your head in the sand and pretend it will all turn out just fine. Based on the way a long list of things are currently trending, including the unfolding housing disaster, a hefty holding of short-term government bonds is beyond essential. If I’m reasonably on-target, that will give you substantial buying power to pounce once the typical retail investor is in full-on panic mode. As we’ve seen, that’s not close to the case for now. But given another significant swoon in the S&P, accompanied by a slew of bad news on the economy, a blow-out in credit spreads, and a potential U.S. government funding crisis, my main anticipation is of a revulsion convulsion in the months ahead. Caveat investor!

Haymaker