Investment Commentary: January 2023

Our current view of the economy and markets is:

• Corporate earnings may be heading for a quarter or two of low growth;
• Consumers appear to be in better shape than feared heading into 2023; and
• The investment setup looks to favor low-risk opportunities such as short-term bonds and higher quality and dividend-paying stocks.

Corporate Earnings Under Pressure

Businesses began borrowing more money in 2022. This tends to happen for good reasons, such as a pickup in economic activity, or bad reasons, such as a more difficult climate to raise stock or equity capital. 2022 was a bit of a mixed bag as we had seen companies rebuilding inventory at a time when revenues were growing though stock prices were falling.

As lending volume picked up, banks began charging more interest on loans compared to their own funding costs (i.e. related to deposits).

The net effect is businesses have taken on more debt at a higher cost in a rising interest rate environment. When this happens, company balance sheets become more leveraged. As the following chart illustrates, companies have fewer short-term assets relative to short-term liabilities. This tends to eventually pressure profit margins.

Over the long run, we see corporate earnings growth essentially match the nominal growth (including inflation) of the economy. Meaning businesses tend to grow at about the same rate as the economy over time.

Since 2020, earnings have rallied arguably above their long-term trend. This combined with the idea that borrowing costs seem to be going up, leads us to believe earnings growth could be slow for a significant portion of 2023.

Consumers are in Better Shape than Feared

Many people worry 2023 will be a rough year for the economy. We see this concern play out in different ways with one of them relating to consumer sentiment. As the next chart shows, consumer sentiment reached an all-time low in July 2022. While this sounds bad on the surface, a sentiment many times improves at a rapid pace when reaching a low point. Rising from troughs is typically associated with economic growth (and not the start of a recession). As a result, 2023 may be a year when consumers begin to feel better about their economic conditions.

Some of the low sentiment may be attributed to inflation rising faster than income. This can be observed in 2022 as demonstrated by the next chart. However, as this relationship normalizes, income would rise faster than inflation with a combination of higher interest rates on investments, higher wages, and lower inflation. Generally speaking, all three of these concepts are playing out.

One area of inflation that has tended to remain stubbornly high has been related to housing (as measured by rents and owner-equivalent rents). However, we believe housing prices are extended and the growth in housing prices (and rents, etc.) will be low over the next several months, possibly longer.

As a result, we believe it’s reasonable to expect housing-related inflation measures to be part of the lower inflation story in 2023.

Further, we expect overall inflation to be lower than the Federal Funds rate sometime in the 1^st half of 2023. One of the positive implications is that short-term debt investments such as short-term bonds and many money market funds will outpace inflation for the first time in a while.

Yields Favor Low Risk

Interestingly, we already see short-term bonds providing higher yields than long-term bonds and the overall dividend yield of the stock market (as shown in the next chart).

Investor dollars tend to flow toward higher yields. The current environment indeed leads us to believe short-term predictable bonds make more sense than usual.

While it looks relatively expensive from an income standpoint, the lower dividend yield of the stock market consists of many individual stocks with both lower yields and higher yields. We believe stock investors will continue to look for stock opportunities though avoiding more speculator or expensive portions of the stock market. Instead, stock investors will likely favor higher dividend-yielding stocks or stocks with relatively attractive valuations.

Overall, we believe 2023 is positioned to be a decent year for both lower-risk bond investments and attractively priced, higher-quality stock investments.

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