February 2023 Market Outlook
The 2023 Lunar New Year is the Year of the Rabbit which symbolizes longevity, peace and prosperity in Chinese culture. In fact, the rabbit is said to be the luckiest of the 12 animals. Based upon our reading of economic research and certain 2023 forecasts, we believe that we will need more than the luck of the rabbit to avoid economic recession in 2023.
A key metric for our investment team has been M2 growth in the U.S. economy. M2 grew dramatically during the pandemic, rising as much as +27% between February 2020 to February 2022 which made us skeptical when hearing inflation being described as “transitory.” The M2 growth of 6.3 trillion dollars is real money and when it enters the economy some portion will be unleashed to purchase goods. If productivity cannot keep pace with the extra dollars seeking goods, then inflation results. Since M2 does not go away unless removed, inflation cannot just go away.
The rate of annual increase in M2 fell to +12% as of January 2022 and since that time to +0% when measured year/year in November 2022. While Federal Reserve Quantitative Tightening is impacting M2 since maturing bonds on the Fed balance sheet are not being reinvested in the form of new bank reserves, there is another factor impacting M2 growth.
The U.S. Treasury is holding almost $600 billion in a Treasury account which reduces M2. In addition, the Fed further influences the impact of M2 by dampening the velocity of money through setting higher reserves for risky assets and paying banks an attractive interest rate to hold reserves at the Fed instead of making loans.
Overall, this reduction in M2 growth and circulation of money (velocity of money) in the economy should produce a braking effect on the economy sometime during 2023. While recent and near-term economic data will likely show a healthy economy (4Q22 GDP growth estimated at +2.5% annualized and nonfarm payroll was up in Dec), temporary jobs have been falling 5 months in a row and hours worked are dropping.
Therefore, we are bracing for a “collision ahead” since equity markets do not appear to be pricing in a recession and a prolonged period of higher short-term interest rates. If corporate profits fall by 10% in 1Q23 and interest rates remain unchanged, a 10% – 15% drop in the S&P 500 from current levels could be in scope. Even if a market drop does not occur, further upside in U.S. equities from the 3,900 level in the S&P 500 seems unlikely.
1 Kings 18 in scripture records the story of Elijah’s assistant spotting a cloud coming out of the sea as small as a man’s hand which later turned into a storm. J.P. Morgan’s economic research may have spotted a small cloud which could bring significant pressure on equity prices.
The global value of pension fund assets is approximately $57 trillion, 46% of which are in Defined Benefit Programs. These programs have been significantly underfunded for the past two decades caused by the large drop in interest rates. With the recent rate hikes, these funds are now funded (impact of interest rates and discounted liabilities). In a recession scenario, a drop in rates could push pensions back into an unfunded position. Pension Fund managers have an opportunity to hedge against future unfunded liabilities by selling equities and buying bonds. J.P. Morgan estimates that the magnitude of the expected rebalance could be as high as $1 trillion in sold equities and bought bonds. This would put meaningful pressure on equity values.
Our view as we start the year is to maintain our risk reductions put in place in most of our models in 2022. M2 has dropped and its impact should begin showing up. China’s reopening its economy could add additional pressure on supply chains, energy prices, and inflation. The Fed’s current short-term rate target remains below PCE (their preferred measure of inflation) at 5.6% which does not reflect a “tight policy” with respect to rates.
While Europe appears to be weathering the economic pressures better than expected and the decline in the US dollar is making emerging market equities more favorable in the present environment, we remain US-weighted and more defensive in our current equity posture. While we would like to be wrong and for 2023 to be the year of the rabbit, we believe a risk-based diversified allocations with an active/passive approach provide the discipline and flexibility to adapt to a shifting monetary, fiscal, and geo-political landscape.