Memo on Interest Rates, Inflation, the Economy and Bonds – ValueWalk Premium

Memo on Interest Rates, Inflation, the Economy and Bonds

If you are investing, you read so much gloom and doom. The recession, the inflation, the coming market crash, the job losses, the hardship, the war, supply chain this, energy issues, climate change, higher interest rates etc…Then I step outside it feels like a very different world. Restaurants are packed and can’t hire enough people. Hotel room prices are still crazy expensive, if you can get one. I’m still trying to reconcile what I’m reading and what I’m seeing. Maybe that’s the lag effect economists are talking about, the time gap between decision and effect. The shock will probably come at mortgage renewal, or the day you need to change your car. With great credit, you can finance a new car at 9%.

Q4 2022 hedge fund letters, conferences and more

There’s a lot of talk about recession. With rates where they are at, it’s hard not to think there won’t be a slow down. If there’s a recession, the key question is how deep and for how long? But I’m puzzled at the recession guessing game. During a recession, unemployment goes up and economic activity drops. And right now we have a very tight labor market. And yet the World Bank predicts that GDP will grow 1.7% in 2023.

Interest rates have risen a lot in 2022. 7 times in fact, that took the Fed Fund target rate from 0.12% to 4.25%. Inflation is the root cause of rising interest rates around the world. The goal is to crush inflation back down to 2%. Inflation is trending down but there’s still work to do. The good news is that the December CPI advanced at a 6.5% annual clip, matching the economist’s consensus, down from 7.1% in November and a high of 9.1% in June. It was the sixth consecutive month of slowing annual inflation. With weaker inflation, interest rates are expected to go up a little bit more in 2023.

Fed Fund Rate 2022

Fed Fund Rate 2006-2022

You can argue that central bankers should take a pause on the rate hike, but policy makers have suggested it’s better to overtighten since it is easier to loosen policy than to tame inflation. If they take their foot off inflation’s throat too early, it can come back roaring to life, like we saw in the 70s. If Powell follows through what he’s saying, he’s going by the Volker playbook of the 1980s.

If investing teaches you anything, especially in a year like 2022, it is that low-probability events sometimes materialize. Many funds had a very disappointing year in 2022, some well known names had drawdowns of 50% or even higher. A megacap like Amazon was down 50%. Yes that Amazon, the one that tries to deliver packages to your house the same day, not the rainforest, which I’m sure is not doing too well too.

For the newer generation of investors, 2022 was the year they realized that stocks can go down. Everyone knew that.  But to actually live it, the pain of a loss, to see your money melt away, that’s the real lesson. 2022 was the year where everything stopped working. Whatever worked for the last 15 years, stopped working. The link between equity and bonds broke. Normally when stocks are down, bonds go up. Bonds provide the buffer in case of panic. That’s why the 60-40 portfolio is popular. But that stopped working too, because normally was the keyword, and nothing is normal anymore. That 60-40 portfolio was down 16% in 2022.

What worked in 2022? Energy, commodities, mining. But that’s not exactly conservative. Commodities are very volatile. Take oil, a WTI barrel of oil is trading near its 52 week low, around $79 a barrel. down from $123 back in July.

Here’s the key returns of some of the main indexes:

  • S&P: -19.24%
  • Dow: -8.8%
  • Nasdaq: -33.63%
  • TSX: -8.5% (consists of a lot of energy, mining, commodities)
  • MSCI World Index: -17.7%
  • Emerging Markets: -22%
  • Bloomberg U.S. Aggregate Bond Index: -13% (dernier rendement négatif remonte à 1994, -2.9%)
  • US 10-yr went from 1.5% to 3.9%
  • Investment grade: -13%
  • High Yield: -12.7%
  • REITS -29%
  • Portefeuille 60-40: -16%
  • Amazon: -50%
  • Apple: -26.6%

According to the Financial Times, the market value of companies traded across all global stock exchanges dropped approximately $25 trillion in 2022.

Source: JPMorgan

A lot of talk about a potential soft landing this week. We saw equity and bonds rallying this week. With the 10-yr Treasury Bill dropped from 3.9% to 3.5% since the year started. What does a soft landing this even look like? Look at the returns above. That doesn’t sound like a soft landing to me. Risk assets got decapitated. As for what will happen, I’ve no clues. Nobody has any idea what the earnings will look like. Without that, how do you even make predictions. However valuation looks more reasonable. The S&P 500 ended 2021 selling for over 21x earnings but was trading for just 16.7x (forward) as of December 31, 2022. Essentially at its 25-year average of 16.8x.

The main question is the bond market right? It’s usually right. Almost always correct—especially the 2-yr Treasury note. Well what does the US Treasury market tell us about the path of rates? We have an inverted yield curve (short-term rates are higher than long-term), which suggests problems in the economy and that rates will fall. Right now there’s a gap between where the bond market says interest rates are heading, and where the Fed says they’re going. The bond market is saying that we are the top of monetary tightening, and towards the end of 2023 it will start easing. Markets are expecting interest rates to be cut by the end of the year, down to 4.5%, while Fed officials see rates holding above 5% with no reduction until 2024.

Look I know the bond market is usually right, but I think we are destined for failure if the Fed tries to tighten and immediately loosen. Unless there’s a crash or some massive liquidity event that breaks the system, I don’t see it happen. Inflation is still too far off its target of 2%.

The good news is that you have a restoration of decent fixed income yield after 15 years of ultra-low interest rates. Fixed income is finally competitive. You can get a safe 4%-5%. We haven’t seen that in a very long time. On the other hand, the the days of “free money,” in the form of ultralow interest rates are gone, maybe for quite some time.

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