The Times They Are A-Changin’
One of our favorite Wall Street sayings is that “trends continue until they change.” In 2022, two long-term trends changed. Inflation, which had consistently drifted lower over the past 40 years, suddenly rose – partially for structural reasons and partially for temporary ones. Ditto for interest rates. The yield on the 10-year Treasury peaked at about 16% in 1981 and then fell over the next four decades to below 1% in 2021. The positive implications of this multi-decade trend for risk assets are difficult to overstate. In 2022, this trend dramatically changed, as rates shot up to roughly 4% and could go higher as the Fed continues its efforts to contain inflation by raising the cost of borrowing.
The upshot of these sea-changes in inflation and interest rates in 2022 was a bear market across pretty much every asset class from bonds to stocks to real estate. The stock market (as measured by the S&P 500) fell by roughly 25% peak to trough during the year but has partially recovered recently. As of 12/31, it was down over 18%. The tech-heavy Nasdaq was hit much harder, down 33% in 2022. Treasuries, widely described as “risk-free” because of the assurance of repayment by the federal government, had an historically bad year, with investors in 10-year Treasuries seeing a loss of nearly 17% in 2022. Higher mortgage rates have pummeled house prices. Most other forms of real estate also came under pressure. With asset prices broadly down, the good news is that expected future returns are higher. Asset prices could, of course, go lower before entering a new secular bull market, but it appears that we are now in a bottoming process that will ultimately allow asset prices to rise again. How soon, from what level, and how fast they recover is a matter of debate. The answers depend on the interplay between secular and cyclical forces and the Fed’s determination to squeeze inflation back down to around 2% from its current level of over 7%.
To understand how inflation has made such a dramatic and unwelcome turnaround in such a short period of time, it is helpful to review a bit of economic history. For the past several decades, inflation has been held in check by the twin forces of technology and globalization. Technology enabled businesses to become much more efficient and gave consumers and businesses unprecedented price discovery powers. Globalization opened vast quantities of cheap foreign labor, which enabled businesses to relocate manufacturing operations to countries offering less expensive workers. This kept the lid on U.S. domestic wages. As inflation subsided, profits rose, interest rates trended lower, and asset values expanded.