By: Stash Graham
The stock market did not realize the Santa Claus rally that market participants hoped for entering December. Major domestic indices all saw multi-percentage point losses. The range of reasons is broad, but as emphasized in our November letter, leading indicators, both domestic and abroad, continue to weaken. The S&P 500 was down -5.9% for December. The Dow Jones Industrial Average and Nasdaq Composite Index were down -4.17% and -8.73%, respectively, for the same time frame. The weak December concludes a historically bad 2022 for financial asset prices across all risk tolerances. For the year, the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite Index lost -19.4%, -8.8%, and -33.1%, respectively. Overall, for equity prices, this was the seventh worst performance since 1929. For safer investors with lower risk tolerances, the U.S. Treasury is generally seen as the most risk-averse investment one can hold; however, for 2022, bond investments like the U.S. Treasury were not spared from the downside pressure as interest rate risk produced a significant headwind on bond prices. The Bloomberg U.S. Treasury Index was down more than -12%, while the widely held iShares investment grade corporate bond ETF (Ticker: LQD) lost -18% for 2022. Precious metal gold, a safe haven, had a good December (+3.5%) to limit losses for the calendar year to just under -2%.
As mentioned in the opening paragraph, leading economic indicators continued to weaken throughout the month. Leading independent economic research firms continue to warn of a recession occurring in 2023 and the chances of a severe recession increasing. We fielded many inquiries from our partners after we disclosed that the Bloomberg Economics team said there is a 100% chance of an economic downturn happening in the United States in 2023. The projections of an economic contraction are probably not a big surprise considering the negative sentiment from market participant surveys. The question surrounding the Bloomberg economics team’s recession model was when the recession started. The Bloomberg team updated the model a few days ago, and their model has the most definitive signal of a recession beginning around September of 2023. Perhaps most importantly, this model showed an increase of 300% and the chances that an economic contraction would start in May of 2023. The timing of an economic recession is critical to weigh as the market tends to fall roughly six months before the actual start of an economic downturn, so while the difference of four months may not seem like a lot for financial asset prices, that is a very long time. Separately we participated in a call with David Rosenberg, the former long-time Chief Investment Officer of Merrill Lynch, and ECRI COO Lakshman Achuthan. ECRI is generally seen as the preeminent firm when observing business cycles. In the call, Lakshman disclosed that ECRI expects a severe economic recession in the U.S. and the rest of the developed world.
When pairing these reputable projections of economic contractions with our study of various leading economic indicators and an increasingly weak global liquidity backdrop, we need help seeing good returns from the stock market in the coming months. As such, the prudent course of action is to underweight equities and overweight high-quality short-duration bonds (corporate bonds or U.S. Treasuries) and our SPAC arbitrage strategy. We prefer to see the leading economic indicators or excess global liquidity increase before we increase our broader equity exposure. It bears mentioning that the current economic data has not been all that bad. The United States fourth-quarter Gross Domestic Product will likely be close to +4%. The forward-looking view is concerning as the economy is about to start to feel the interest rate hikes by the Federal Reserve, which took root during the summer months of 2022. Remember, the monetary policy transmission mechanism has a three to four-quarter lag from when the Federal Reserve raises interest rates to when the rate hikes impact the consumer and investor. We have yet to experience the negative impact of the several months of multi-month, multi-rate hike meetings. In the meantime, we are already experiencing weakness in long leading indicators like building permits and regular leading indicators like new manufacturing orders. The latter leading economic metric continues to be inhibited by the COVID-related “Bullwhip Effect,” Which has caused a historic rise in inventory levels. A glut will force companies to slash prices and hurt expected profitability in the coming year.
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