Economic Environment

We enter the year with an economy that is slowing but still growing at a reasonable pace. It would not be surprising to see fourth quarter GDP for 2022 top 3%.

Rising interest rates and declining liquidity are applying the brakes to the US economy.

Short-term rates have gone from virtually 0% to over 4% in record time.

The Fed is draining cash from the economy at a rate of $95 billion every month.

A recession seems to be an almost universal consensus; however, a less dire outcome is still possible.

Supply constraints caused by lockdowns and travel restrictions are resolving. Throughput at ports and transportation hubs continues to improve.

Lower commodity prices and shipping costs are combining to relieve cost pressures on many goods. Overseas shipping prices are below one quarter of their COVID peaks.

The availability of chips is improving; some surpluses are reported.

Massive fiscal and monetary stimulus in response to COVID stoked demand, and that, combined with supply constraints, fostered record inflation.

Higher interest rates and declining liquidity are designed to temper consumption and inflation; however, the US consumer has proven to be surprisingly resilient.

Recently, lower savings rates (2.2% in October) and rising debt (credit card debt up 16.9% in November) suggest that the durability of the consumer may be reaching a limit.

All their public statements insist that rates will remain higher for longer, but convincing the public that they will stay the course is also a tool to combat inflation. Any suggestion to the contrary would be immediately discounted by the markets.

Inflation is showing clear signs of a bating. The annualized run rate of the “all items” CPI index for the past three months stands at 1.8%. Much of that is attributable to improving energy prices.

By not rolling the proceeds of maturing bonds held on their balance sheet, the Fed is draining large amounts of cash from the financial system.

By their own estimates, monetary tightening can impact the economy with a delay of between 18 and 24 months. The strong medicine is just about to hit.

Ifinflation and/or the economy slow down sharply in 2023, the Fed may be forced to take its foot off the brake.

One uncomfortable scenario: inflation comes down, but not to 2%,while unemployment begins to creep up.

Stock declines in 2022 would appear to reflect the higher discount rate attributable to rising rates, but earnings estimates may still be high.

A sustainable rise in stock prices requires growth in earnings. Markets may anticipate such an eventual development with some lead time.

Recent strength in the dollar has helped moderate the cost of commodities but also dented earnings from overseas operations. A reversal in the dollar could support non-US earnings but also increase the cost of imports.

Unemployment stands at a record low of 3.5% and has yet to move up in response to monetary tightening. Many employers still report difficulty in filling openings with qualified workers.

Wages have been increasing at rates above 4.5%, yet the participation rate remains at a low 62.3%, suggesting a plentiful supply of workers who could re-enter the workforce if motivated to do so.

At the same time, the baby boomers have been retiring in droves since COVID, so the supply of experienced workers will be impacted by departures.

Workers at the low end of the payscale have benefited the most from wage inflation, which has improved their participation in a consumer economy, provided all the gains are not siphoned off by inflation.

Wage inflation will remain a key component of overall inflation, especially in the services sector.

National figures on housing are reacting to sharp increases in mortgage rates.

30-year mortgages are hovering between 6.5 and 7%, down from their very recent highs but up sharply from their historic lows in 2021.

Nationally, existing home sales were down 35.8% YOY in November, and single-family construction was down by a similar amount.

However, many high-growth zip codes in the Southeast, Texas, and Arizona have proven more resilient.

The real estate market is not nearly as over-heated, or as over-leveraged, as it was in 2008.

SPACS, IPOs for profitless companies, and cryptocurrencies thrived in an environment defined by excess liquidity, forgivable loans, and ultra- low rates. In an environment of tight money, things like quality earnings, proven assets, and sound management may be more highly valued.

For most of this century, stock indexes have generally out performed stock pickers. In a tougher environment, security analysis could make a comeback.