Fourth Quarter 2022 Economic Review and Outlook

The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.

Warren Buffett, 1990 Chairman’s Letter to Shareholders

The economic tea leaves suggest that 2023 could be another challenging year for both stocks and bonds. However, the outlook is more balanced given that equity valuations are much lower and bond yields much higher.

While 2022 was a rough year for investors, there is hope that the Federal Reserve will be able to achieve a “soft landing.” While inflation is still running well above the Federal Reserve’s 2% target, it appears to have peaked and has fallen faster than many expected. In addition, while the real GDP decreased at an annual rate of 1.6% in the first quarter and 0.6% in the second, it recovered in the third, growing 2.9%; and the Fourth Quarter 2022 Survey of Professional Forecasters from the Philadelphia Federal Reserve calls for continued growth in the fourth quarter, though at a lower rate of 1.0%. The labor market also continues to be quite strong, with unemployment ending November at 3.7%.

This was the first year that both the S&P 500 Index and long-term Treasury bonds (20-year maturity) experienced double-digit declines. The closest to that was in 1969 when the S&P 500 lost 8.5% and long-term Treasury bonds lost 5.1%. In addition, global diversification didn’t help, as both the MSCI EAFE and emerging market Indices also experienced double-digit losses, which were fueled by high levels of uncertainty and the U.S. dollar’s appreciation.

The VIX, the market’s measure of volatility and thus uncertainty, spent most of 2022 trading well above the range of 13-19 that is considered average. In fact, there were nine episodes when the VIX breached 30 – reaching a peak of 37.5 on March 8th. VIX levels above 20 are not only considered high, but they have been found to be predictive of high volatility over the next month. Because investors and thus markets dislike uncertainty, volatility has been negatively correlated with equity returns – when the risk of negative outcomes increases, investors demand larger risk premiums, driving P/E ratios down.