When the yield curve inverted before the 1990 recession, the widest spread between the 10-year and 2-year Treasury yields was (0.43) percent. Ahead of the 2001 recession the curve inverted again, with a maximum distance of (0.46) percent. Before the financial Category 5 event struck in 2008 the inverse spread between the 10-year and the 2-year never got wider than (0.20) percent. With this perspective, what are we to make of the fact that the 10-2 spread today is around (0.70) percent, the steepest inversion any time since the crazy days of the Volcker Fed in the early 1980s?

Getting Real

The question as to whether nominal spreads today are properly priced or not ultimately comes down to one thing, and that one thing is inflation. What matters ultimately are real (i.e., inflation-adjusted) rates. If you believe (as the market seems to believe) that inflation is coming down fast and we will be back at two percent core inflation lickety-split, then a nominal yield of 3.5 percent for intermediate-maturity Treasuries is not unreasonable. If, however, you are focused on the stickier parts of the CPI basket (like the Fed), then you don’t think inflation is going to be close to that two percent target any time soon, and financial conditions in the market today are thus looser than you think, rationally, they should be. With regard to inflation the Fed has one view, the market has another. Powell said as much during his press conference after the FOMC meeting this week, noting on several occasions that the Fed and the market are not on the same page in terms of near-term inflation expectations (on the other hand, Powell didn’t push back much on questions from reporters about whether financial conditions today are too loose, and that seemed to be the catalyst for the market’s torrid rally Wednesday afternoon and yesterday).

Coming Down, Slowly

So who’s right? Let’s look at the data.

The chart above shows core inflation, since that is the measure driving the Fed’s monetary policy decisions. As you can see, year-on-year core inflation has been trending down since it hit a peak of 6.6 percent last September. That’s good. But the month to month data is somewhat stickier, and still trending solidly above pre-pandemic trendlines. In the FOMC press conference on Wednesday Powell called out a number of consumer service areas where inflation has not really been receding at all. Overall it’s a mixed picture. But there is not much, if any, evidence supporting a linear downtrend that gets inflation back to two percent within a twelve month period. That’s especially true if – and this is the other facet of the market’s optimistic pricing of assets today – that fabled “soft landing” actually comes to pass. We don’t think it will, for reasons we have discussed in other recent commentary. But if we are wrong in our expectation that consumer spending is due for a major speedbump in the coming months, then higher inflation is likely to persist even longer.

Un-inverting

So what does any of this tell us about where rates are today and where they might be heading? As far as the yield curve’s persistent inversion, history isn’t really much of a guide. The 10-2 inversion lasted fourteen months in 1989-90, but reversed – “un-inverted” – five months before the 1990 recession actually began. In 2000 the curve stayed inverted for ten months before righting itself out in December of that year, which was again four months before the 2001 recession began. And in 2008 the curve was back in its normal upward-sloping shape by March 2007, a full nine months before the Great Recession began.

Each of those events was unique in terms of the critical inputs – where rates were coming into the cycle, economic and financial market conditions at the time and, critically, the Fed’s operational playbook. It would be facile to extrapolate from any of those patterns in trying to predict when today’s steep inversion between intermediate and short-term rates will start to unwind.

Our expectation is that the Fed will orchestrate another 0.25 percent Fed funds rate hike in March, and then let things sit there indefinitely. So for the short end of the curve we don’t see things moving much from a Fed funds tether of around 5.0 percent.  If the Fed’s view of inflation is correct (which is our current base case assumption) then we think conditions favor an upward movement in intermediate rates.

In other words, from where we are sitting today we think it is more likely that the 10-year yield winds up over four percent than that it falls towards three percent. If we’re wrong about that, the likely culprit will be faster-falling inflation. But for that to happen, something will have to shake loose those sticky prices in consumer services – and that’s something we are not seeing yet.

Money doesn’t sleep, and neither does innovation. Figuring out how to make the most money from innovation is what technology firms do pretty much all day, every day. In the vast swath of tech innovation that is artificial intelligence, Microsoft has just plonked down a major stake in the ground. It would be fair to say that the multibillion-dollar investment into OpenAI, an artificial intelligence startup and the parent company to ChatGPT, the generative AI program that launched a million thought pieces, has the undivided attention of Microsoft’s rivals in the upper pantheon of the Big Tech kingdom. A great deal is at stake here on many levels from college essays to entire livelihoods, so it is useful for the rest of us to understand what all the uproar and consternation is about.

What Is Generative AI?

Let’s start with some background, since “artificial intelligence” is a very broad term and can mean different things to different people. At its heart, AI is about prediction. Help an AI program learn about the features of a cat, say, to the point where the program can identify images of cats from everything else that exists on the Internet. Generative AI, as the name suggests, is when the program gets so good at perceiving and classifying the image that it can then generate one itself. In the past year or so these programs have gotten really, really good at this. A user may prompt the AI company Midjourney to “create a robot sitting at a desk, in the style of Van Gogh” and get a representation the old Dutch Master himself might have produced (had he known what a robot was). Over at DALL-E you can study the groovy four panels of “footballer in the style of Andy Warhol” if you like. Try it out! These sites are, for the moment anyway, free of charge and open to the general public.

The Future of Work, Ads and a Whole Lot More

Microsoft, and others putting their chips on the AI table, believe that generative AI will be the core engine of the next generation of tools and devices for work and play. They have a plan to integrate the fruits of OpenAI (yes, including ChatGPT, the impetus behind last month’s article in Atlantic magazine “The Death of the College Essay”) into the company’s full suite of products and services (Microsoft will be the exclusive cloud provider to OpenAI via its Azure platform).

Perhaps the two firms most rattled by the move are Alphabet (parent company of Google) and Meta (Facebook). Those two companies have also been hard at work developing their own leading-edge AI programs, mostly behind the scenes and either in testing mode or limited public rollouts. They also make the lion’s share of their revenue from online advertising, which for Alphabet in particular presents a problem. The vaunted Google search engine works by directing users to suggested links – and the more links, the more advertising dollars. Generative AI programs can respond directly to queries and save users the additional time and effort of clicking on other links – great for the user, not so great for a company whose business model is based on links, clicks and ad dollars.

But these are early innings in the AI game. Alphabet, Meta, Apple, Amazon and plenty of other tech leaders are going to be ramping up their own capabilities, figuring out both the promise and the pitfalls, and wasting no time foisting their applications on a citizenry that is only just beginning to understand how all this will affect their lives. We expect that the evolution of AI will progress geometrically, not in a linear fashion, and that it will be the biggest generational development in technology since social media a decade and a half ago. This – not cryptocurrencies in perpetual search of a valid use case – will be the real Web 3.0 in our way of thinking. It will be well worth paying attention as the firms make their land grabs and fight for position in this new space.

Every year has its expressions – those words or phrases that sum up the fleeting Zeitgeist. Remember “Bridge to the 21^st Century?” Probably not, because its day in the sun was way back in 1997, and in any case this century of ours has so far turned out to be quite different from those hopeful exhibits and Fleetwood Mac soundtracks that festooned the National Mall at the beginning of Bill Clinton’s second term as president. But here we are nearly a quarter-way into the 21^st century, and one of the defining expressions of our time is “polycrisis.” In 2022 this word gained a large following thanks in no small part to Adam Tooze, a Columbia University professor whose “Chartbook” newsletter is a weekly must-read for economists, financial markets chroniclers and historians of all stripes.

More layoffs in the tech sector. Reserve provisioning by banks against the likelihood of further deterioration in their consumer and small business loan portfolios. A pronounced and protracted slowdown in online advertising. Another month of underperforming retail sales. The signs of slowdown are growing. Analysts’ earnings estimates are finally catching up to the market, which decided already in 2022 that conditions were headed south. The current consensus for S&P 500 fourth quarter earnings, the reporting of which started in earnest last week, is a year-on-year decline of 4.9 percent. That’s quite a bit lower than the estimates those same analysts gave for Q4 earnings last September, when they foresaw growth of 3.5 percent. As companies to continue reporting over the next few weeks the key question will be how much lower those estimates might go. Our thinking is that the downgrades may be in the process of bottoming out.

Not Too Cheap, Not Too Dear

Based on forward (next twelve months) earnings, the S&P 500 price-to-earnings (P/E) ratio is 17.13x. As the chart below shows, that valuation is a bit above the 23-year median of 15.97, and roughly in line with where the market traded during much of the pre-pandemic period from 2017 to early 2020, but well below the peak of 24.02x reached in 2021.

We interpret the current pricing as “reasonable” – nothing like the screaming bargains on hand after the 2008 financial crisis, but also not supremely expensive. Bear in mind that these are forward earnings estimates; essentially, where analysts expect earnings per share to land for each of the next four quarters. As the Q4 earnings season moves from “estimate” to “actual,” the big questions for the forward P/E will center around the first two quarters of 2023. If those estimates come down a lot from their current levels (right now the Q1 estimate is for a decline of 1.29 percent according to FactSet), that has implications for share valuations. Sharp downwards earnings revisions could push today’s “reasonable” valuations into “not so reasonable” territory and raise the specter of another downward trajectory for the market.

Eyes Front

The good news is that much of the negative sentiment is already reflected in share prices. The market is a forward-looking creature. The events the market had turned sour on in 2022 are now closer to actually happening. As we have noted in our annual outlook for 2023 (the investment thesis for which we published in this space a couple week ago), we do expect that the visible signs of slowdown we see today will lead to a cyclical recession at some point this year. If our analysis is reasonably on target, this would be more likely to be a relatively brief event and not a wrenching, long-drawn out affair. More like 1990, less like 2008 or 1980 or 1973. As always, we caution that any number of things could upend this scenario and produce very different outcomes. Based on what we know today, though, we think that the lion’s share of earnings downgrades have already taken place. Going forward, an increasing share of that “next twelve months” formulation will factor in post-recession assumptions; i.e., a resumption of growth.

Growth, But No Unicorns

That being said, we are not as optimistic that the growth trend off the recessionary low will be as robust as they have been in past situations. The S&P 500 price gain in the twelve months following the low point for each of the past four recessions has been 39.8 percent on average – a pretty stupendous twelve month growth rate. We think growth may be more restrained this time around, due to contextual factors like a slower uptrend for consumer spending and business investment. Not to mention that valuations this time, as we noted above, are starting from a position of “reasonableness” rather than “screaming bargain-basement sale.” As we said in our investment thesis a couple weeks ago – in looking ahead to 2023 it would be wise to do two things at once: first, don’t panic and, second, don’t expect unicorns. We’ll stick by that recommendation today.

One of the big stories late last fall was the abrupt about-face turn by the Chinese government on its zero-Covid policy. Following a series of highly unusual public protests in a number of cities the government backed away from the draconian lockdown policies that had bedeviled its citizens and its economy for the better part of the year. The reopening theme caught fire among foreign investors, and suddenly China was hot again. In the last couple months of the year it was not unusual to see the Shanghai and especially the Hong Kong markets register intraday percentage moves in the high single digits.

And then suddenly it was Europe’s turn. Since November 1 last year the MSCI EU index has jumped up nearly 19 percent, well ahead of the comparatively staid 2.9 percent price gain of the S&P 500 for the same time period. An international flavor is in the air in these first early weeks of 2023. Is this the beginning of a longer-term dynamic, or a short-lived flash in the pan in the manner of so many other brief spurts of strength from non-dollar equities in recent years?

Europe, It’s a Gas

There is a connection of sorts tying together the newfound fondness for Chinese and European assets. China is the EU’s major trading partner, and its reopening (though sporadic, with Covid cases continuing to surge around the country) is good news for French luxury goods makers and German producers of high-end manufactured goods. But arguably the biggest driver of good cheer on the continent is the weather (unless you are an avid skier). Warm days and nights have been the norm this winter, with Alpine ski slopes of green and brown more evocative of May than January, and home heating bills that don’t break the bank. Europe bought massive amounts of liquefied natural gas last year, filling up its gas storage units to offset the energy disruptions proceeding from the neighboring war in Ukraine.

All of this together amounts to a reasonably valid argument that things in Europe could be a whole lot worse than they seem to be. Some economists are raising their forecasts for the EU’s economic outlook this year, although the consensus expectation is still for a recession at some point (the European Central Bank’s latest forecast still assumes a Eurozone recession starting sometime in either the fourth quarter of last year or the first quarter of this year). Observers also note that core inflation in Europe is trending at a lower pace than US core inflation, with energy prices (not a core inflation category) having been the main driver of higher prices there, while consumer demand has kept the core number higher here.

But Will It Last?

So does it make sense to push a bit more money into European equity plays? Here is where our Euroscepticism comes into play. We think the factors driving EU equity outperformance today are more of a short-term cyclical nature than a structural trend likely to persist over a multi-year time horizon. For taxable portfolios in particular that presents a headwind; even if you are right about the tactical play (and that is giant honking “if,” to be clear), the quick get in – get out leaves you with a hefty short-term capital gain. It takes some serious outperformance to more than offset the bill when that comes due on April 15.

And even for qualified non-taxable portfolios that “get out” part of the equation can be vexing. We have seen pockets of outperformance for both non-US developed and emerging markets portfolios throughout the years. Over time, though, those bets have not delivered, as you can see in the chart below.

As the chart shows, over multiple market cycles starting in the mid-1990s the returns on the three non-US indexes shown (the MSCI EU, Emerging Markets and EAFE indexes in gray, crimson and green respectively) underperformed both the S&P 500 and S&P 600 Small Cap (blue and orange respectively) by a magnitude of more than three times cumulatively. Note that we express these returns in US dollars, which is what matters for a US-domiciled portfolio and thus accounts for currency translations.

We would note in addition that non-US equities tend to be more volatile in general, partly due to the added variable of currency risk, and so on a risk-adjusted return basis the US – non-US gap would be even more pronounced. The idea behind investing in a riskier asset of any nature is that, over time, those risks should be compensated for by higher returns. Such, here, is not the case.

On the other hand, small-cap domestic stocks do still seem to demonstrate at least to some degree the long-term equity risk premium the financial theory textbooks say they should. As we look ahead this year to a potential rebound in equities from the tough environment of last year, we are more inclined to see additional value from US small caps as a way to extend our risk frontier. We’ll have more to say about this in the weeks ahead.

2022 was a bad year for most kinds of core investment assets, from the least-risky Treasury securities to the most volatile corners of the equity market. Persistently high inflation forced central banks to adopt an increasingly hawkish posture on interest rates as the year progressed. The Fed funds rate rose more sharply, in a more compressed window of time, than at any time since the early 1980s. By late summer it seemed that both headline and core measures of inflation were peaking; yet the Fed’s unswerving insistence on rates remaining higher for longer took the wind out of the sails of sporadic attempts by the market to sustain a rally. The focus turned to what many see as the increased likelihood of a recession in 2023. Companies in some industry sectors, notably tech, started announcing layoffs. Those haven’t shown up yet in any meaningful way in the unemployment numbers (this is being written before the release of the BLS jobs report today), but that is probably not too many months away. Meanwhile, household finances are not looking great as the economy heads into a cooling-off period, and businesses are drawing down inventories in anticipation of a slower demand environment.

Our Thesis

We expect there will be a recession in the US at some point in 2023, driven by a combination of cyclical factors. Household savings are low, debt levels are elevated, and higher interest rates are starting to have the effect of dampening demand (which, after all, is the entire point of an inflation-fighting tight monetary policy). Europe may already be in recession, China’s growth remains hampered by Covid, and there are few other bright spots in the global economy. We also expect this recession, if there is one, will be relatively brief and shallow – a standard-issue cyclical downturn rather than the collateral damage of a global health or financial crisis, which were underlying drivers of the 2008 and 2020 recessions.

In the absence of unforeseen threats not known at this time (and which by all means could materialize), we expect that the US equity market will find its footing sometime in the first half of the year and eventually deliver a positive performance. In the bond market we expect to see some widening of credit risk spreads, while Treasuries should stabilize once the Fed reaches the terminal rate in its tightening cycle. We believe that terminal rate will be somewhere within the range of 5.0 to 5.5 percent. However, bond market stability will also depend in no small part on the pace at which the Fed reduces its balance sheet, which at $8.5 trillion remains elevated and not far off its $8.9 trillion peak.

Equities: A Question of Leadership

Historically, equities have done relatively well in the twelve-month periods after reaching their recessionary lows. But past is seldom prologue, and every downturn has its own unique tale of woe. One of the main questions we are thinking about in looking ahead is equity market leadership. For most of the past decade that leadership has been virtually unquestioned, in the form of the major technology platforms. But the so-called “FAANG” complex (Facebook (Meta), Apple, Amazon, Netflix and Google (Alphabet)) all underperformed the S&P 500 in 2022, by either a little (Apple) or a lot (Meta). It turns out that even dominant tech platforms are not immune from old-fashioned economic cycles. At their peak, these five companies commanded more than twenty percent of the total market value of the S&P 500; today, that figure is just 13 percent.

If not FAANG, then what? If this really is an old-fashioned cyclical recession, as we opined above, then we are probably right now in the latter part of the phase where slow, predictable earnings and high dividends dominate; witness the massive outperformance of the Dow Jones Industrial Average over both the S&P 500 and the tech-heavy Nasdaq in 2022. As prices more fully bake in the economic downturn, we could imagine a momentum shift back towards cyclicals sometime before the end of the year. Semiconductors, one of the most beaten-down sectors last year, in particular could be in the forefront of a pro-cyclical shift. As always, however, we caution that there are plenty of lurking X-factors out there that could scramble any scenario for market leadership and overall market performance.

Fixed Income: Yields and Spreads

Bond yields offer something in early 2023 they have not offered for at least two decades: a satisfactory income stream. This is good news particularly for income-oriented portfolios. Yet two other issues present challenges for the bond investor. The first is safety: in 2022, bonds in general did not provide an adequate hedge against declines in the equity market. The Bloomberg-Barclays Aggregate US Bond index, a widely-used benchmark, fell 13.01 percent in 2022, while the index for 10-20 year Treasury securities fell 25.2 percent – more than the S&P 500! Bond prices decline when yields go up, and the magnitude of the price decline increases, all else being equal, the longer the bond’s duration or maturity. In 2023 it is unlikely, we believe, that high-quality bond prices will fall as much as they did in 2022, simply because the Fed is closer to its terminal rate than it was a year ago. Nevertheless there is still room for yields to rise.

The second challenge is the potential for risk spreads to widen. The bond market today seems to be telling us two conflicting things at the same time. The first, based on the inverted Treasury yield curve, is that a near-term recession is likely. For much of the past six months the curve has been more steeply inverted than at any time since the early 1980s. The 10-year Treasury yield has in recent weeks traded as low as a full percentage point below the Fed funds rate, which was raised to a range of 4.25 – 4.5 percent after the Federal Open Market Committee’s December policy meeting.

We are getting a different picture from credit risk spreads, however. The risk spread between Baa corporates, the lowest tier of investment-grade securities, and the 10-year Treasury remains relatively tight: 2.11 percent today versus the three-year average of 2.26 percent. If a recession is as imminent as the yield curve tells us, we should be expecting wider credit risk spreads than we are currently seeing. Investors need to weigh the likelihood of widening spreads against the opportunity of locking in relatively attractive yields for investment-grade corporates today. We see a good argument for doing both: allocating a portion of one’s fixed income portfolio to fixed-rate corporates today while keeping some powder dry for further opportunities as and if spreads widen.

No Free Lunch in Private Markets

Private equity funds, VC managers and other stewards of the $10 trillion private investment market may make a lot of hay touting their – on paper – relatively successful experience in 2022 versus the travails of public equity and debt markets. The US Venture Capital index operated by Cambridge Associates was down by less than half of the Nasdaq Composite losses around the midpoint of last year, the last available data point. Anecdotally, private equity buyout funds have been reporting flat or slight single-digit gains to their limited partners. These apparently benign numbers come with some major caveats, however.

The first of these caveats is liquidity. Investors in most types of pooled private investment structures are locked in for as many as 10 years, with very limited interim avenues for redemptions. The second caveat is accounting conventions. The value of holdings in a VC or private equity fund do not reflect any kind of real-time market assessment; they are accountants’ book entries based on assumptions that may be one or two years old, simply at the discretion of the accountant. Consider that comparison cited above of the VC index versus the Nasdaq: both indexes house early-stage tech companies with years of cumulative losses and unproven business models. There is no reason to think the returns discrepancy between the two indexes reflects anything other than the vagaries of discretionary accounting for private VC holdings.

The third caveat, though, is perhaps the most important. The ultimate success of any of these private investment vehicles depends on two critical ingredients: first, easy access to large amounts of low-cost debt; and, second, a vibrant exit ramp for their holdings via either M&A or public markets. Neither of those avenues is looking particularly robust today – M&A activity is well below the hectic pace of the previous couple of years, and the market for equity IPOs is moribund. In recent months private equity investors have been trying to fudge their way around these constraints by essentially buying and selling among themselves – a silly game that can only last so long. As for cheap and easy debt – yep, that ship sailed at the beginning of 2022 and it’s doubtful that it will be coming back into port any time soon.

Don’t Panic, But Don’t Expect Unicorns Either

Summing it all up, our overall takeaway message is that a conventional, cyclical recession is likely to bring with it some ongoing volatility from last year’s key market trends, but as the year plays out we see a strong case for stabilization and a return to a growth trend for core risk assets. That being said, it cannot be stressed enough how important the presence of higher interest rates is in keeping a check on growth potential. As long as we remain far away from the zero interest rate policy of yesteryear – and we believe that will be for some time to come – the market will not be kind to the sort of things that soared in 2020 and 2021, whether that be cryptocurrencies, “Uber of X” venture plays or covenant-lite private debt offerings. For portfolios that stay away from those parts of the market there should be good opportunities in companies with healthy free cash flows and relatively conservative debt-to-equity ratios.

On the fixed income side, the opportunity to lock in relatively attractive yields is good for portfolios with moderate or high income needs. Investors who choose to lock in these yields should do so with the mindset of holding onto the positions through to maturity, and worry less about mark-to-market paper returns in the meantime. Interest rates will go up and down over the next two to ten years for reasons we cannot even foresee at present; what matters is the predictability of the timing and magnitude of the income stream based on the conditions prevailing when you purchased the asset.

The year ahead will no doubt present its challenges, and the twin impulses of fear and greed will always be there, ready to drive poor decisions. Patience and discipline will get us through the tough times, and help us to see both the danger and the opportunity in each crisis we confront.

This is our last weekly commentary of 2022, so it seems like a good time to reflect back on the year that has been. Next week we will go charging head-on into the year ahead, and whatever things good, bad and otherwise that may entail. Not too many investors will be sad to bid goodbye to 2022, but we will duly note that it could have been worse, on many levels.

Every year has its own bespoke words and phrases that attempt to capture and bottle the essence of the twelve months just passed. Here are our three contributions.

#1: Zeitenwende

The most important story of the year began on February 24, when Russian troops poured over the border into Ukraine and ignited the biggest land war on European territory since 1945. Not only did the invasion almost immediately change set beliefs about Russia’s military prowess, which proved to be far inferior to the requirements of the task at hand, but Ukraine’s brave resistance reshaped the military and political contours of Europe and its allies. The German word “Zeitenwende” means “turning point,” referring to Germany’s reversal of decades of determined non-intervention in regional military affairs to supply desperately needed resources in support of Ukraine’s efforts. The map of NATO expanded to the border of Finland and Russia, exactly the opposite outcome from what Vladimir Putin expected would happen when the divided West of his imagination failed to unite in response to his bellicosity. Europe’s dependence on Russian energy, though still a problem, proved not to be a dealbreaker for the imposition of meaningful sanctions including most recently those implemented last month against Russian crude oil.

The war in Ukraine is sadly far from over, but by now it is fair to say that it has been a very bad year for Putin. In fact it has been a bad year for autocrats generally and a relatively, and surprisingly, good year for democracy. Jair Bolsonaro lost his bid for a second term as Brazil’s president. Xi Jinping, though consolidating his power for another term (at least) as China’s “great helmsman” was forced to pivot abruptly from his inane zero-Covid policy when mass protests broke out systematically across the country this fall. Even in the US, the midterm elections mostly resulted in a victory for moderation over some of the most extreme elements of our still-troubled political discourse. Perhaps this year will eventually come to be seen as a “turning point” in more ways than one – only time will tell.

#2: Crypto Winter

There are no doubt many phrases that could encapsulate the reversal of trends in so many asset classes this year, most of which can be traced directly back to the end of easy money and the beginning of the Fed’s campaign to bring down inflation from its highest levels since the 1980s. But the complete meltdown in cryptocurrencies stands out for a number of reasons. Recall that it was just one year ago when this asset class, which has never convincingly demonstrated that it has a genuine use case outside of shady dealings on the dark web, seemed poised to go full-on mainstream. Fortunately for those of us who resisted the hype of crypto evangelists at their fervid peak twelve months ago, the crypto takeover of “tradfi” (traditional finance) was forestalled by its collapse. That is fortunate because the fall of cryptocurrencies could have been a whole lot worse for many more people had the asset class become a bigger part of the financial holdings of systemically critical financial institutions. The spectacular fall of Sam Bankman-Fried and his FTX empire in November was likened to a “Lehman moment” for cryptoworld – the difference being that there were enough linkages between Lehman Brothers and other major institutions to nearly bring down the entire financial system. That didn’t happen with crypto winter.

The easy money conditions that gave life to 2021’s darlings – crypto, meme stocks, “Uber of X” technology moonshots – are very unlikely to be coming back any time soon. It is entirely possible that crypto winter could be followed by a spring of sorts for digital currencies – but those are more likely to be of an ilk driven by central banks than by video game-playing dudes in cargo shorts.

#3: Polycrisis

Polycrisis is a word that gained considerable traction in 2022 thanks in part to its liberal use by Adam Tooze, a Columbia University professor and the publisher of Chartbook, a newsletter widely read by economists and other denizens of the financial marketplace. It refers to the parallel existence of many problems at the same time, which does seem to be applicable to the world we inhabit. The daily challenges presented by sticky inflation and high interest rates contend for our attention with other unfolding crises such as climate change and demographic ageing, which in turn fade into the background when simmering geopolitical tensions boil over.

We will have much more to say about the polycrisis theme in our upcoming annual outlook next month. For now, though, we would like to remind you of something we used to feature at MV Financial in our marketing materials: the Chinese character for “crisis” is a compound made up of the characters for “danger” and for “opportunity.” Yes, there are many crises we are facing today, and there is danger contained therein. But there are also opportunities. We believe we have seen some evidence of that this year, including in some of the events we have described in this commentary. From the danger of Russia’s aggression came the opportunity for strengthening the alliance of democratic nations so often accused of being divided and soft. From the danger of high inflation came a necessary repricing of risk and return in financial markets. The ride is not always smooth – but we continue to believe there is always a way to see the path towards a solution even in one’s darkest days.

We wish each and every one of you a healthy, happy and joyous New Year.

The year 2022 is winding down to a close. In the world of financial markets that primarily means one thing: predictions, predictions, predictions. Everybody has an opinion about what 2023 will bring to stocks, bonds, oil, the dollar, cryptocurrencies and everything else under the sun. The vast majority of these predictions will turn out to be way off the mark, for the simple reason that nobody knows which of the many threats and opportunities out there, known and unknown, are going to be the ones that matter and which way they will drive asset prices. Who was baking a global pandemic into the cake in December 2019? Or a Russian invasion of Ukraine in December 2021?

Predictions Are Silly, But We Still Make Them

Despite the high probability of being wrong, though, there is a reason why we all persist in prognosticating about the year ahead – and yes, that “we” most certainly includes us at MV Financial and the “Year Ahead” outlook we publish every January. That reason has much less to do with outcomes than it does with process. Making a prediction forces us to organize many strands of disparate and often contradictory information into a coherent argument supported by logical reasoning. It also, collaterally, necessitates that we identify (as well as we can based on what we know at the time) the risks that could produce alternative outcomes to our base case.

We will have more to say about the particulars of our 2023 outlook in our report next month. Meanwhile here is one development we see as highly likely, thanks in part to some of the spectacular bust-ups of 2022. Due diligence, that plodding and time-consuming exercise of determining the characteristics of an asset ahead of making an investment decision, is due for a comeback. In the past couple years there seems to have been a conspicuous absence of due diligence, including among some of the world’s supposedly smartest investors (hello, Sequoia Capital and Temasek), as an alternative evaluation process called FOMO – fear of missing out – ruled the roost.

From “Uber of X” venture capital plays (X being whatever imagined industry sector was about to experience an Uber-like disruption) to cryptocurrencies to the nosebleed price-to-sales ratios of companies in the ARKK Innovation Fund, the name of the game was to get in quick before you miss the boat. “Have fun staying poor” was the taunt made to anyone arguing that an investment in any of these shiny baubles required a compelling real-world use case and careful analysis of the fundamentals. The FOMO mentality will never go away completely, of course, but we think it is on its way to the back seat while good old fashioned due diligence retakes the wheel.

When The Tide Goes Out

It was Warren Buffett who purportedly said that when the tide goes out it’s easy to see who is swimming naked. The “tide” in this case, of course, is the reversal of the easy monetary policy that held sway for the better part of twelve years. A lot of things can make some kind of sense, if you squint hard enough, when interest rates are zero or even negative. Throw in a bunch of stimulus money and bored people punting on Reddit memes while working from home, and it’s easy to see how the mania of 2021 happened. But now even Japan, the ur-practitioner of negative interest rates, has started to move back towards something approaching sanity. The Bank of Japan’s decision this week to allow the 10-year Japanese Government Bond to fluctuate by as much as half a percent (as opposed to one-quarter of one percent) may be baby steps, but the market seemed to get the message.

It is very unlikely that we will see a return to the strange worlds of ZIRP and NIRP (zero and negative interest rate policies, respectively) any time soon, if in fact ever. This implies a structurally higher cost of capital that should set a higher bar for yea or nay on any given risk asset. At the same time, the stunning amount of outright fraud that accompanied the collapse of erstwhile crypto “genius” Sam Bankman-Fried and FTX Capital (again, hello wise investors Sequoia and Temasek) should give one pause before credulously buying into the next charismatic dude playing video games while pitching a can’t-miss thing.

So what does this translate into, investment strategy-wise? Not necessarily, we think, into one category or another like value versus growth or international versus domestic. Strong and sustainable cash flows, a value proposition that makes sense, a sensible ratio of debt to equity – all the boring stuff that comes up during the due diligence process, on a case-by-case basis. That, we predict, will matter again in 2023.

We wish each and every one of you health and happiness in whatever holiday you and your loved ones are celebrating this season.

There was a curious dynamic playing out in the stock market during Wednesday’s Federal Open Market Committee confab. The Fed speaks – market goes down. Journalists ask questions – market goes up. We took the liberty of illustrating this odd dynamic in the chart below, showing the intraday trading patterns around the key events of the FOMC official statement and subsequent press conference.

To fully appreciate this chart, it is important to understand who is doing most of the trading here. More precisely, what is doing the trading, because it is not a bunch of humans watching the TV and then barking buy and sell orders into a phone like a scene from Trading Places. No, the action here is being done by very sophisticated trading programs employing state-of-the-art artificial intelligence. This high-powered AI basically digests all the verbiage – both from the press release and from the spoken words of Jay Powell and the assembled journalists – and spits out trade orders in real time. Essentially, the trader bots are looking for specific words and phrases that tell them whether the vibes in the room are hawkish or dovish, and then selling or buying accordingly.

Nothing New Under the Sun

Consider the FOMC press release. This came out at precisely 2:00 pm on Wednesday afternoon and, as you can see, the trader bots hit their sell buttons in unison. What was the trigger here? Most likely, it was this phrase: “The Committee anticipates that ongoing increases in the target range will be appropriate…” Remember the excitement in the market last week when the inflation report came in cooler than expected? Many investors hoped that a softer inflation outlook could bring down the Fed’s expectations for its terminal rate; i.e., where they expect rates to be when they stop tightening. A press release that did not contain the two words “ongoing increases” would have been consistent with that hope. But there was the phrase – and sure enough, even though the magnitude of the target rate increase this time was 0.5 percent as opposed to the 0.75 percent cadence of the past four meetings, the terminal rate expectations in the accompanying Summary Economic Projections were indeed higher.

This should not have been a surprise, though, because Powell and his colleagues have been unrelentingly clear in their messaging about this. Yes, it was appropriate to dial the rate hikes back from 0.75 percent, but rates are going to keep going up, and then staying elevated, until there is compelling evidence that inflation is on its way back down to the two percent target rate. This has been the message ever since Powell’s speech at Jackson Hole back in August. There was nothing in the FOMC press release to suggest that conditions have gotten worse – they haven’t, and it really does seem like inflation has passed its peak. But two consecutive CPI reports (October and November) do not rise to the level of “sufficiently compelling.” Once again – and we have seen this dynamic all through this tightening cycle – the market simply got out ahead of its skis.

The Press Games the Refs

The press conference itself really illustrated how this AI-powered trading dynamic works. When Powell walked up to the lectern and started in with his opening remarks – which, again, sounded like nearly every speech the man has given for the past four months – the trader bots went into another funk (shown in the above chart). Then the journalists started asking questions.

Now – these are some of the most prominent financial journalists for major press organs like CNBC, Bloomberg and Marketplace. They are all extremely fluent with the language that drives short-term trends in securities markets – any one of them could tell you what “ongoing increases” means to investor sentiment, for example. And their questions reflected this fluency; they used terms like “loosening financial conditions” (referring to rising stock prices and falling bond yields), “pivot” (a course reversal in which the Fed starts cutting rates as soon as it gets to its endpoint in the tightening cycle) and “recession fears” (which has a very specific meaning in Fedspeak, i.e. stopping its tightening policy in order to avert a potential economic downturn – this was what the Fed did throughout the middle of the 1970s, and it was not a good policy).

You can see how stock prices are bouncing back and forth pretty wildly during this section of the press conference but mostly lurching higher. Again, it’s those words – and the journalists know full well what they are doing when they lace their questions with these trigger phrases – trying to coax out something newsworthy from Powell that will move markets and give them something juicy to write about. It makes for a good game, perhaps, but in the end it is all little more than clever effervescence. In the end Powell would not be moved – he stayed on message, and the doves were nowhere to be seen.

Looking Ahead

Our main message to you is pretty much what it always is – these short-term gyrations are best ignored for portfolios with long-term financial objectives. We think the FOMC’s current expectations for a terminal Fed funds rate – with the median rate at 5.1 percent based on this week’s Summary Economic Projections – are pretty close to where things will actually wind up. The economic slowdown question does loom large as we look ahead to 2023. But, as we have noted repeatedly in recent commentaries, the data points that we have in front of us today are inconsistent. A number of indicators suggest that the cooling period is underway (most recently US retail sales, which came in softer than expected in the November report issued yesterday). The labor market is still perplexingly strong (though this is also a lagging indicator). The Treasury yield curve is inverted and positioned for a recession, yet credit risk spreads are still relatively tight. There is a lot to pay attention to in the coming weeks, before the Fed meets again on February 1 next year. Meanwhile, patience and discipline remains the best advice we can give. Too bad there’s not an AI-powered trading bot that keys off those words.

It’s been one of the go-to conversation starters of the year – how about those gas prices huh? Prices are higher for all manner of goods and services, but there is a special place in the heart of our petrol-besotted nation for those flashing red signs at the local Shell or Sunoco station, telling us exactly, to a penny, what the price of a gallon of the stuff is today versus what it was a day, a week or a month ago.

So, here’s a good conversation starter for today: the average price nationwide for a gallon of regular gas today is $3.29. On January 3, the first workday of 2022, the average nationwide price was…yep, $3.29. At the end of a year in which gas prices loomed large over monthly household budgets and struck fear into the hearts of politicians running for office, we are basically right back where we started from. In fact, the spot price for a barrel of Brent crude oil, a market benchmark, is actually down for the year to date.

Supply Surprises

Oil’s downward trend over the past two months is one of more counterintuitive developments we have seen this year. On October 5, OPEC+ nations agreed to a new round of production cuts in the amount of 2 million barrels per day. That was a significant enough supply cut to draw sharp criticism from the Biden White House, accusing the cartel of shortsighted profit-seeking and even interfering with the runup to the US midterm elections. In fact, oil prices fell in the immediate wake of the OPEC+ decision, with Brent crude dropping about $10/bbl before briefly resuming an upward trend (see above chart).

This week saw another potential landmine that many observers thought would send oil prices higher. On Monday the European Union’s sanctions prohibiting entry of seaborne Russian oil into European ports went into effect, along with a price cap, supported by both the EU and the G7, of $60 on any Russian oil sent by tanker anywhere in the world. These punitive measures could have had the effect of Russia sharply curtailing its supply; the country has claimed it will refuse to deal with any buyer who uses the price cap. Instead, the oil has flowed largely unimpeded, at least so far. Asia’s principal buyers of China and India already pay less than $60, effectively, for the oil they negotiate from Russian supply sources. In fact, the $60 price cap was designed in such a way to produce precisely this outcome, while avoiding dramatic supply cuts (it remains to be seen whether that will still be the case if world oil prices shoot back up to $100 and buyers attempt to hold Russia to the $60 cap).

Another positive factor on the supply side has been increased production here in the US. Domestic production plummeted immediately after the economy shut down in March 2020, and producers have been very slow to turn the taps back on. But the number of active US oil rigs is now back to where it was right before the bottom fell out: today’s active rig count of 627 is roughly comparable to the 624 rigs operating on March 27, 2020 according to data produced by Baker Hughes (cited in an article by Catherine Rampell in today’s Washington Post).

Demand Doldrums

On the flip side, demand trends are also helping to put downward pressure on oil prices. China, the world’s second-largest oil consumer after the US, is set to use less oil in 2022 than it did in 2021 according to the International Energy Association. Persistent lockdowns from China’s zero-Covid obsession have had a material impact on demand. While those restrictions appear to be loosening, it may be a very bumpy road for China as it tries to reopen – Covid cases there are surging now, natural immunity levels are weak and China’s domestically-produced vaccines are not up to the task of beating back the many new faces of the omicron strain.

Elsewhere in the world the economic outlook is turning down; the IMF and World Bank both issued new warnings today about growth prospects for next year. There is by no means any certainty that the US is headed for recession next year, and we have noted in several recent commentaries the ongoing conflicting signals from the labor market, consumer spending and elsewhere. But the Treasury yield curve is currently inverted more steeply than at any time since 1981, suggesting that the bond market is quite confident about an impending downturn (though risk spreads, which we would expect to widen appreciably ahead of a recession, have remained relatively tight). US oil demand for this time of year is as low as it has ever been in the past 20 years.

All of this could change, of course. If China manages to stay on course with its reopening that will likely provide some upward momentum for oil prices. Russia still is a wild card despite the relatively muted first few days of the new sanctions. And if the US does manage to achieve a soft landing with the Fed’s monetary tightening – which would be good news on many fronts – we would expect oil demand to turn up here as well. For now, though, you can probably expect fewer of those “how ‘bout them gas prices!” conversations at the water cooler, and a return to the usual observations about weird weather, college football playoffs (or the World Cup, take your pick!) and the traffic jams on the Beltway.