Third Quarter 2022 Write-Up

The end of the third quarter of 2022 marked the continuing decline of equity markets worldwide.  The Dow Jones Industrial Average lost 20.9% year-to-date, the Standard and Poor’s 500 Index was down 24.8% and the Nasdaq Composite declined 32.4%. Despite a brief rally in late July and August predicated on the false hope of a Federal Reserve pivot on rate increases, September brought the sobering realization that the inflation problem is real, and that the Fed was going to address it.  Increasing interest rates will be the Fed’s primary blunt tool to reshape inflationary expectations.  

 In July 2020 we wrote: 

The debt issued to fight the pandemic will restrain economic growth over a long period.   The IMF estimates that the world’s twenty richest countries have earmarked 3.5% of their GDPs to the pandemic crisis, more than they spent at the nadir of the Great Financial Crisis.   It further estimates that gross fiscal debt in advanced economies will expand 16% this year, to 122% of GDP.  Central banks have enacted measures to keep the cost of debt low.  The U.S. Treasury yield curve is barely visible, with short-term rates at close to zero, and longer-term rates in the “why bother” range.  The 2-year now yields 0.15% versus the 0.65% yield of the 10-year note. 

The world has changed dramatically since then.  Today, the benchmark 1-, 2-, 3-, 5- and 7-year Treasuries all yield above 4.0%.   Since that 2020 letter, for comparison, the 2-year now yields 4.27% (up 4.12 percentage points) and the 10-year note yields 4.09% (up 3.44 percentage points).  In 2020, the Fed was trying to modulate market rates, by manipulating short-term and longer-term interest rates by setting a low primary rate and buying longer-term Treasuries, respectively.  This was similar to what the Fed did following WWII, by keeping interest rates low in order to let the country grow into its debt levels at a “comfortable pace.”  Aided by the industrial boom that followed WWII, the Fed was largely successful.   However, this time, on a grander scale and without an impending economic renaissance, the Fed’s efforts are off to a rocky start.  

While the Federal Reserve deserves some criticism, and goodness knows that we are always here ready to supply it, the greater fault lies in ourselves.  The American voter has consistently elected governments, both Republican and Democratic, that shunned fiscal and financial discipline.  The cumulative breadth of this malfeasance is appalling and shameful.   {Just as an inconvenient reminder to the scale of large numbers, a million seconds is 11.57 days; a billion seconds is about 31.68 years; a trillion seconds is over 31,000 years.}  Everett Dirksen, a Republican senator from Illinois, was (perhaps apocryphally) reported to have said, “A billion here, a billion there, and pretty soon you’re talking real money.”  Dirksen died in 1969.  By 1981, the national debt reached $1.0 trillion (while nominal GDP was $3.2 trillion).   In 1996, the national debt exceeded $5.0 trillion for the first time (nominal GDP $8.1 trillion).  By 2008, the debt exceeded $10 trillion (GDP: $14.7 trillion); by 2011, $15 trillion (GDP: $15.5 trillion); by 2017, $20 trillion (GDP: $19.5 trillion); by 2020, $25 trillion (GDP: $20.8 trillion).   Today, U.S. national debt exceeds $32 trillion.  In the last three years it has grown by $8.0 trillion, or 35%.  Since 2008, we have twice had annual budgets that exceeded 10% of GDP.  Our current Congress does not blink at budget proposals that exceed 5.0% of GDP.  Herb Stein, an economist who worked for the Nixon and Ford administrations said, “If something cannot go on forever, it will stop.”   Herb was right.  But as citizens and parents, we have a responsibility to hold our elected officials accountable.  The current national debt of $31.2 trillion is over $93,000 per American citizen, or $240,000 per American household.

Last quarter we wrote of seven concerns that were worrying investors.  All but one are still evolving.  Covid fears have ebbed, judging by the very low uptake levels of the bivalent booster shots.  Weak Chinese economic growth is evident.  As President Xi secures his “President-for-life” role this week at the Communist Party Congress, China has suspended regular quarterly economic statistical releases.  This is not the action one would expect if economic results were good.  China will be less of a driving force for world GDP growth in the coming years.  As for negative corporate profit margin pressure, we are seeing it unevenly early in this quarter’s reporting season, as we are seeing negative expected earnings revisions.  Inflation rates are still elevated, and this is still causing real wage deflation.   Recent inflation releases still suggest that inflation will remain stubbornly high as it moves from goods to services.  Finally, decelerating consumer demand is becoming more evident as product switching accelerates and big-ticket purchases decelerate.  However, the larger banks (JPMorgan, Wells Fargo and Bank of America) still report solid consumer finances.  A recession is still widely expected in the next year.

While our country’s challenges are manifest, and there is an abundance of bad news and uncertainty in the markets, we remain optimistic in the long-term.  Bear markets are the price paid for better long-range equity returns.   The reversal in interest rates means that fixed income securities are becoming investable again after a long period of unacceptable returns.  Recessions give strong companies opportunities to accelerate market share growth and improve competitive positioning.  And finally, the U.S. economy is the best machine for human advancement ever developed.   This too shall pass.  But it might take time.

Sincerely,

Your Team at Baxter Investment Management