As 2022 draws to a close, we look back on a tough year for investors and consumers, who felt the sting of inflation and high interest rates for the first time in a generation. On the heels of $5 trillion in pandemic-era fiscal stimulus and zero interest rate policy at the Federal Reserve, the rise in prices proved to be more than transitory. This would be no surprise to renowned economist Milton Freidman, who famously observed that inflation is always and everywhere a monetary phenomenon of too many dollars chasing too few goods.
As Russia waged war on Ukraine and U.S. oil companies adhered to capital discipline, consumers endured gasoline prices that eclipsed $5/gallon and grocery store visits that became considerably more expensive. On its way to a peak of 9% in June, steadily rising inflation forced the Fed to shift gears and embark on its most aggressive pace of interest rate hikes since the 1970s. Its goal is to reduce the economy’s aggregate demand and return inflation to the central bank’s 2% target.
During the holiday season, we observe credit card rates that now exceed 20%, mortgage rates that have doubled and home prices in the Portland-Vancouver metropolitan area that are declining from highs reached this summer. Housing activity is down, retail sales and manufacturing are slowing, and stock prices are under pressure. These key indicators reflect the early impact of Fed rate tightening.
Nine months after the Fed’s first rate hike, GDP should still grow this quarter, but economic activity is receding and may turn negative in the new year. What has not cooled as much is the labor market. Wages are growing at mid-single-digit rates, reflecting an excess level of unfilled jobs relative to those still seeking work. With generationally low unemployment, industry-leading companies have the pricing power to pay up for employees and then pass along the added cost. This is significant because labor makes up more than half of most companies’ cost structure.
While we think peak rates are in sight, the Fed remains in rate tightening mode as it aims to preclude a broader wage-price spiral from taking hold. With price increases beginning to recede this fall amid a slowing pace of economic activity, we are confident the Fed will succeed in slaying the inflation dragon.
Indeed, demand destruction is evident amid inflationary pricing and restrictive interest rates, resulting in reduced sales. Against a higher cost backdrop, profit margins may also suffer. An environment like this is conducive to eliminating excess job demand but could also result in layoffs as companies attempt to right size their cost structure. If the economy slows too much, the double-edged sword of rate hikes may push the economy into recession, an outcome that most economists are in fact predicting for 2023.
Regardless of whether a recession ensues, we do expect lower corporate profits next year, reflecting weaker aggregate demand and lower margins. If a recession occurs, our expectation is that it will be shorter and shallower. In contrast to 2008 and the Global Financial Crisis, the U.S. banking system is healthy and much better capitalized, consumer balance sheets are sturdier and lower labor force participation should ensure a better underlying bid for workers.
For investors, the first half of 2023 may remain volatile as stock prices discount a weaker near-term earnings picture. We see this environment giving way to a more constructive second half as investors anticipate an earnings recovery in 2024, amid what many expect will be Fed rate cuts by late next year. For now, our stock selection has become more defensive and asset allocation more balanced. In recognition of higher bond yields and a slowing economy, we expect fixed income securities to resurrect the diversifying qualities they failed to demonstrate in 2022.
Ferguson Wellman, Octavia Group and West Bearing do not provide tax, legal, insurance or medical advice. This material has been prepared for general educational and informational purposes only and not as a substitute for qualified counsel. You should consult qualified professionals to understand how this information may, or may not, apply specifically to you.
Shawn Narancich, CFA, is executive vice president of Equity Research and Portfolio Management with Ferguson Wellman Capital Management. Ferguson Wellman is a 47-year-old registered investment adviser serving multigenerational families and nonprofits. Ferguson Wellman and its division, West Bearing Investments, manage $6.6 billion for 941 clients. More than $1 billion of the firm’s assets are managed for clients residing in Washington. (Data as of September 30, 2022)