Third Quarter 2022 Commentary

Inflation has increased to 40-year highs, and in response the Federal Reserve has increased rates from range of 0.0% to 0.25% to the current range of 3.0% to 3.25%. This 13-times increase in the Fed’s target rate will act to slow the economy in the Fed’s fight to bring down inflation. The big question is by how much will it slow the economy. The most likely scenario right now is these increases will bring on a recession. A recession is scary; it includes the loss of jobs and reduced asset prices, among other things. The reality is that recessions will always be a part of a naturally functioning economy. Recessions help to reinvigorate the economy, bring about new business creation, and renewed and improved labor market growth. Equity markets have reacted in predictable fashion to the Fed’s rate increases with a decline of about 24.8% through the first three quarters of the year, but this decline coupled with the rise in rates is also creating a buying opportunity in attractive businesses that had moved above what we believed was a reasonable range of intrinsic value.

The rise in rates is fueled by inflation hitting 40-year highs. There are many sources of inflation, such as, the large amount of money the government injected into the economy during the pandemic and the break-down in supply chains around the world. Another reason that gets little attention is the collapse in productivity of workers. Inflation can be measured using the difference between unit labor costs and productivity. When unit labor costs are higher than productivity, higher inflation results.

The first chart below shows both productivity (in blue) and unit labor costs (in red). The second chart shows consumer price index inflation measure. According to these charts, when productivity is above unit labor costs, inflation is low or falling (or both); when unit labor costs exceed productivity, inflation is high or rising. Unit labor costs are a function of wages and benefits, which have been rising since the pandemic. There are indications that unit labor cost pressures are receding. For example, in the September Employment Situation report, jobs increased 263,000 and wages increased 5% year-over-year, but wage growth has slowed to a 3.6% annual rate the last few months. Declining wage growth is reducing upward pressure on unit labor costs. Productivity has collapsed since the pandemic. We are now doing less with more as productivity has been negative for two consecutive quarters, coupled with high unit labor costs. We believe productivity will increase to more normal readings of about 1.5% which we believe will help bring down inflation and mitigate the effects of the recession on people by reducing job losses.  

We build portfolios to outperform when markets are behaving normally and when they are declining, not when the market is posting huge gains. Reviewing third quarter performance, we met this goal. In July, stocks increased more than 8%, a result that would generate a doubling of stocks. Our equity holdings were up a little more than 6% that month. However, in August and September, stocks declined, sharply in September, our equity holdings did not decline as much as the broader market. Thus, we succeeded in our portfolio construction goal. We believe that we will continue to meet our portfolio construction goal not only as the economy and markets struggle through the expected downturn, but also when the economy and markets stabilize and behave normally as they recover.

Outlook

We believe a recession is on the horizon, likely starting at the end of this year or early next, and because of this, we find optimism in short supply. But one thing to keep in mind is these market declines are creating buying opportunities in both stocks and bonds and some companies that we liked are now more attractively priced and within a buy range. The same is true for bonds, we are generating more income in new bonds, which will be even more attractive when rates decline in the future, which we expect they will as inflation inevitably cools. Falling inflation is likely a few quarters out, until then, we expect stocks and bonds to struggle and the creation of more buying opportunities that will benefit clients over the long-term. Some of these we will be writing about in the coming weeks.