Commentary | 4Q 2022
“Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
- Milton Friedman
In the fourth quarter of 2022, the stock market, as represented by the S&P 500 Index, generated a positive return of 7.6%. For all of 2022 the Index returned -18.1%. While almost all sectors of the market experienced poor performance there was a substantial difference in the returns experienced by growth stocks versus value stocks. In the last quarter, the S&P 500 Growth Stock Index returned 1.5 % while the S&P 500 Value Index returned 13.6%. For all of 2022 growth stocks produced a return of – 29.4% while value stocks returned – 5.2%. The favorable relative performance for value stocks over the last twelve months represented a significant reversal of a long-term trend favoring growth stocks.
Small cap stocks produced slightly better returns than did large cap stocks. The S&P SmallCap Index produced a return of 9.2% in the fourth quarter and -16.1% for all of 2022. Within the small cap sector, value stocks performed better than did growth stocks. Small cap growth stocks returned 7.0% for the fourth quarter and -21.1% for the full year. Small cap value stocks produced an 11.2 % return for the quarter and -11.0% for the full year.
The 18.1% decline in the market for all of 2022 took place while inflation was approximately 7.0%. The decline in real asset values was more than 25%. In the last 100 years the market has produced an average annual return of 6.5% above the rate of inflation. The nearly 31 percentage point spread provides a more complete picture of the magnitude of the losses experienced by investors in the last year.
The stock market’s steep decline in 2022 reflected the pessimism and confusion experienced by investors as the Fed tried to reduce the rate of inflation by raising interest rates and slowing economic growth. During 2022, the measured rate of inflation was greater than the Fed’s announced target of 2.0%. At the end of 2022, inflation was running at an estimated 6.5% on a year-over-year basis. The end-of-year rate was below the peak of approximately 9.0% reached at midyear.
The Fed raised the Fed Funds rate from nearly 0.25% to approximately 4.25% at the end of 2022 as it sought to reduce the rate of inflation. While the rate of inflation has declined, it remains far above the 2.0% target, and the Fed intends to raise rates further in 2023. As a result of the Fed’s actions, the yield curve has become inverted, an indication to many that a recession will eventuate. The one-year rate on Government obligations stood at 4.75% at year-end, which was above the 3.6% rate on ten-year obligations.
The policies driving inflation higher have been in place for some time. Rising inflation became inevitable after 2008 when the Fed increased liquidity to stabilize capital markets when markets were thrown into chaos as defaults on sub-prime mortgages escalated. The Fed increased the monetary base from $900 billion to approximately $5 trillion during the 2008/2009 period. The Fed was attempting to reduce the money supply prior to the shutdown of the US economy in 2020 in response to the COVID-19 pandemic. The shutdown generated a sharp decline in real GDP and a substantial increase in unemployment. The Treasury ran large deficits as it tried to provide economic stimulus by supplying direct cash payments to individuals and corporations. The Fed was called upon to increase liquidity once again, and as a consequence the monetary base increased by more than $3.0 trillion.
The effort to lower the rate of inflation has reduced the rate of growth of real GDP and clouded the outlook for corporate profits. In the first two quarters of 2022, real GDP declined. Current estimates call for real growth to resume in the fourth quarter at a rate below 2%. The current consensus forecast for economic growth in 2023 is for the growth rate for the full year to be below 1.0% on a year-over-year basis. There remains a significant probability of negative real growth in the first half of the year.
Measures of economic activity show no clear trend. While unemployment is low, the labor force participation rate is below the February 2020 level. New jobs are being created, but total employment has increased by less than 1% in the almost three-year period since February of 2020. Retail sales have increased at a rate below that of the rate of inflation for much of 2022, and disposable personal income has declined in 2022. The overall rate of inflation has declined, but the rate of increase in food prices stands near a twenty-five year high.
Corporate profits for all of 2022 are likely to have increased at an approximately 3% to 5% rate on a year-over-year basis. The consensus forecast for 2023 calls for a 4% increase on the same basis. If these forecasts are accurate, nominal corporate profits will have increased at less than the rate of inflation in 2022, and at a rate only slightly above the anticipated inflation rate for all of 2023. If these forecasts prove to be accurate, there will be no increase in real corporate profits over the two-year period.
The price-to-earnings ratio for the overall market has declined in line with the outlook for weak economic growth and a slow increase in corporate profits. The PER for the S&P 500 declined from 23 times trailing twelve-month earnings in early 2022 to approximately 20 times at the end of the year. The end of year PER was close to the long-term median for the measure.
For the market to generate returns equal to or above the long-term average in 2023, the process of reducing the rate of inflation to below the Fed’s 2% target must be eliminated or reduced as a source of downward pressure on real economic growth and corporate profits. The Fed has been alone in the effort to reduce inflation. The pressure to increase liquidity will arise as a matter of course as the Treasury continues to incur large budget deficits. The Congressional Budget Office estimates Federal budget deficits will average $1.6 trillion per year for fiscal years 2023 through 2032. Deficits of the estimated magnitude will put pressure on the Fed to help provide liquidity once again. The consequences will be the same as they were in the past when the Fed stepped up to fund the Treasury’s deficits; inflation will increase and interest rates will rise eventually.
A return to economic conditions characterized by moderate inflation and stable economic growth requires lower deficits than those forecast by the CBO. Favorable sustainable stock market returns will require a change in economic policies.
Sources: S&P Dow Jones Indices, US Bureau of Labor Statistics, CBOE, Bureau of Economic Analysis
The information contained in this commentary represents the opinion of Affinity Investment Advisors, LLC and should not be construed as personalized or individualized investment advice. The analysis and opinions expressed in this report are subject to change without notice. The information and statistical data contained herein have been obtained from sources, which we believe to be reliable, but in no way are warranted by us to accuracy or completeness. This report includes candid statements and observations of economic and market conditions; however, there is no guarantee that these statements, opinions, or forecasts will prove to be correct.