February 21, 2023 Letter to Clients

Goodbye (and Good Riddance) to 2022 

The past three years have been a remarkable and challenging period of change for the world and subsequently the markets and economy, with last year having proven to be one of the most rapidly evolving economic and financial years in recent history. We’re confident in saying 2022 is a year investors hope will not repeat anytime soon.  It was a year of turmoil that followed 2021’s economic reopening and easy money- with big (and arguably overinflated) gains for stock market investors. With 2022 having decades-high inflation and an aggressive response by the Federal Reserve, last year proved to be an extremely challenging year for investment returns. Undoubtedly, the big question being asked by investors now is if 2023 will be a continuation of last year or can we expect something different. 

Inflation and Recession:  The Balancing Act Continues  

The good news is that inflation has peaked. The unwelcome news is that it could be a while before we see it return to normal, or even more moderate levels.  As we write this letter, January’s consumer price index (CPI), shows that inflation grew at a 6.4% annual rate, slightly higher than expected but lower than some had feared.  This means the Federal Reserve (Fed) is highly likely to continue their rate hiking campaign, which in turn will bring some market volatility ahead.  

Last year we wrote it was our belief that the US had already entered a recession, given that economic statistics are backward-looking and an announcement that we have entered a recession typically comes after we have already been in one for two quarters.  Looking ahead to this year with the Fed continuing to raise rates, pushing borrowing costs higher, this was expected to slow the labor market and cool growth, fueling the risk of an economic downturn.  Going into 2023, it remains to be seen if the Fed can pull off a soft landing, in which the economy slows but does not plummet. Yet another scenario is presenting as a possibility; that neither a soft landing or economic contraction occur and that growth simply continues on….which could be a problem as well. If growth and the job market continue running too warm for inflation to slow, the Fed will be forced to respond more aggressively than expected this year.  Clearly it remains to be seen how things progress and if the economy can cool off just enough to tame inflation and stick that soft landing.  

 Fixed Income: Outlook on Bonds 

Fixed income may be known for its stability, but bond markets can have bad years just like equities- cue 2022.  It is uncommon for both equities and bonds to decline together- so uncommon in fact that it has only been observed 2% of the time since 1926.  As we entered last year it was common knowledge that inflation was running hot, but few expected it to persist for as long as it has.  After a year of dramatic interest rate increases in an attempt to cool inflation, it is almost hard to remember that rates were zero to start that year. In hindsight, this stance by the Fed appears to have been a mistake and recognizing they were behind the curve, having been playing catch-up in the form of consistent and significant rate increases since. These aggressive rate hikes, the most aggressive since the early 1980s, were hugely consequential for bonds given that their prices move opposite interest rates- as rates rise, bond prices fall.  In other words, the value of a bond an investor owns will fall as new bonds are issued at higher coupon rates.  Those newly issued bonds are delivering bigger interest payments, making existing bonds less valuable.  The relationship between interest rates and bond prices serves as a reminder that fixed income investing can be a tricky business, because it wasn’t that long ago that we were faced with a completely different fixed income investing challenge; interest rates were at historic lows making for lackluster bond yields which left many retirees seeking to meet their target portfolio returns through other means, such as stocks and other investments.   

While impossible to know what’s in store for 2023, the good news is the likelihood of bonds doing as poorly as last year is unlikely.  The Fed is likely to continue to raise rates throughout this year, however far less dramatically or rapidly than in 2022. With yields now higher, bonds may begin behaving like bonds again- meaning they will serve as a ballast when stocks fall, unlike in 2022 when both were falling simultaneously.  The bottom line is bonds continue to play an important role in a diversified portfolio and given that yields are looking more attractive than they have in quite some time, fixed income investors may once again be able to earn sought-after returns through a well-constructed portfolio, holding both bonds and high-quality dividend paying stocks, something that was difficult during the low interest rate environment not so long ago.  

Equities:  Being Selective and Managing Risk  

In our last letter, we discussed that going into 2023 we saw the increased need to employ a more tactical approach to stock and bond selection. Last year, the falling valuations, stock prices and market selloff were less about deteriorating fundamentals of businesses and more about how markets react to rising interest rates.  The good news is that many of the various sectors maintain strong fundamentals. The flip side is that should economic weakness begin to manifest, it has not yet been factored into equity prices, leaving room for additional market weakness.  If the outlook for slowing growth begins to unfold, we can expect to see corporate earnings begin to deteriorate, which is a fundamental reason for market weakness and would warrant a more guarded investment approach.  At the present time we see a need to position for a decline in the economy and reduce exposure to areas such as consumer discretionary, industrials, and financial services and be constructive in the best-in-class companies in sectors such as consumer staples, biotech, digital media, and information technology to name a few.  Individual attractive opportunities continue to be present, such as government defense contractors for example, and we continue to seek out and identify those areas to round out our fundamentally driven portfolios.  

Timeless, sound investing principles will always be our approach over following trendy whims. Our market and economic outlook will evolve as the year progresses, new data becomes available, and new events unfold and when appropriate, we will be prepared and ready to shift focus to more cyclical and “recovery” sectors.  

SECURE 2.0 Act: Required Minimum Distributions  

On December 29, 2022 the Consolidated Appropriations Act of 2023, collectively referred to as SECURE 2.0 Act, was signed into law with the intent to assist individuals reach savings goals and provide more flexibility upon retirement. Although there are over 90 provisions to the plan, we wanted to bring attention to one that is particularly meaningful for those who are approaching or are already in their early 70s.  Required Minimum Distributions (RMDs)- The requirement to begin taking RMDs from Traditional IRAs and workplace plans has increased from age 72 to age 73 in 2023.  If you wish further explanation of RMDs and/or are turning 73 this year, please feel free to contact our office to discuss.   

As challenging as last year’s market was, we do know that difficult market and economic conditions pass… and they do always pass. While we are maintaining a cautious and defensive approach at the present time, we will continue to seek out opportunities for portfolio growth.  As the year unfolds, we will adapt as necessary while keeping true to our goal of investing in an intelligent manner designed to meet our client’s needs for both the short- and long-term.  


Steve LePage