Cautious But Opportunistic For 2023
Hello and Happy New Year!
As always, we like to share with you our outlook for the coming year. We ended 2022 pretty much where we started: cautious, conservative and committed to protecting our customers’ assets while looking for opportunities. Looking ahead to 2023, we expect a challenging, volatile first half, followed by a stronger second half if the Fed can get inflation under control. As such, we will maintain our defensive investment posture, looking for opportunities to put more of our client’s cash to work ahead of an upturn in the markets.
Our goal, as fiduciary investment advisors, is to take less risk than the market while out-performing the market over time. As of late December 2022, the stock and bond markets were both in the red, but thanks to our large cash positions and defensive stock portfolio, our clients fared much better than the Standard & Poor’s 500 index.
We aim to buy quality companies at the right price. We look for strong earnings, solid balance sheets and adept management. Ninety percent of our companies pay strong dividends.
These kinds of companies generally did relatively well in 2022 amidst continuing supply-chain blockages, labor shortages, the war in Ukraine and the biggest inflation spike in 40 years. Heading into 2023, we expect inflation will continue to be the key factor driving the economy, stocks, bonds and, of course, the Federal Reserve.
After holding the short-term federal funds rate near zero for more than two years, the Fed raised it seven times in 2022, to between 4.25% and 4.5% in December. The Fed is expected to continue raising this rate until it hits 5.1%, according to the latest median forecast of Federal Open Market Committee members. If inflation comes in lower than expected, the Fed could stop sooner and the markets likely would rally. If it comes in higher than anticipated, the opposite could happen. We expect a somewhat higher terminal federal funds rate, around 5.5%.
The Fed’s rate hikes, along with some supply-chain improvements, helped lower the year-over-year inflation rate from 9.1% in June to 7.1% in November. That was the “easy” part of taming inflation. Getting it down further will be harder and stickier.
To calm markets and bring down longer-term rates during the pandemic, the Fed pumped trillions of dollars into the financial system by purchasing U.S. Treasuries and mortgage-backed bonds. It paid for them by creating reserves, which are deposits held by banks at the Fed. This is another term for printing money. This process, called quantitative easing or QE, increased the assets on the Fed’s balance sheet from about $4.1 trillion in January 2020 to almost $9 trillion in March 2022.
QE, combined with near-zero short-term rates and massive fiscal stimulus, created far more demand than Covid-hobbled companies could supply, and the result was rampant inflation.
Getting that money out of the system, called quantitative tightening or QT, will be a lot harder than putting it in. The Fed has been passively reducing its balance sheet by not using the proceeds of bonds that mature to buy more bonds. As of September, it has been letting up to $95 billion a month (only about 1% of its assets) mature without reinvestment. Going any faster, or actually selling bonds, could disrupt the bond market and financial system. Reducing reserves on commercial bank balance sheets could impact their ability to lend.
The Fed is likely to keep raising the funds rate until it’s higher than the inflation rate, which is why we see it topping out around 5.5%. But getting there will involve some pain and discomfort, probably a recession.
If inflation was a fever, the summer spike sent it to 104 degrees. We’ve brought it down to 101. But we need to get it back to normal. That could happen sometime around mid-year, which will pave the way for a healthier second half.
To that end, we are looking for so-called defensive companies that will hold up in a challenging environment; many we already own.
We continue to like energy. We own ExxonMobil and Chevron, and recently bought some Conoco. The U.S. cannot convert to green energy overnight, and in the meantime, there is no way for companies to increase their U.S. reserves. With China emerging from Covid-19 lockdowns, demand for oil, gas and coal will surge. Like it or not, we see oil prices going up over the next five years. Chevron and ExxonMobil don’t correlate directly with energy costs, but they do over time.
Defense is another sector that should hold up as the United States supplies more weapons systems to Ukraine and replenishes its own depleted stock amid geopolitical tensions in Russia, China and Taiwan. We own Lockheed and would consider buying Raytheon, which is supplying missiles to Ukraine, at a better price.
Even in a recession, people need to maintain their health, which is why we continue to own pharmaceutical stocks such as AbbVie, Eli Lilly, Pfizer and, in some portfolios, Johnson & Johnson. AbbVie’s not a household name but many of its products are. They include Humira (for Chrohn’s disease), Botox and Celexa and Lexapro (for depression). Pfizer benefitted from its Covid-19 vaccine and Lilly has a wonderful patent portfolio. J&J has a diversified pharma base and develops medical equipment.
Financial stocks generally benefit from rising interest rates because the rate they can charge on loans goes up faster than the rate they pay depositors. A lot of them have wealth management businesses that are fairly stable. Although investment banking has suffered, some trading desks are still doing well. Our top holdings in the financial sector are J.P. Morgan and Goldman Sachs.
We also like commodities and companies related to the commodity cycle, such as Caterpillar and Freeport-McMoRan. We expect there will be a lot of construction, whether it’s in the United States or Ukraine, over an extended period.
We think we can maintain these defensive positions if the market corrects significantly, and if the market rallies, we will participate in the rebound.
We started 2022 with about 40% of our portfolios in cash. Although that position has gone up and down, that’s about where we are today. Most of that cash is in short-term Treasuries; some are yielding more than 4%, which is higher than the 10-year Treasury yield. Some people see this anomaly in the “yield curve” as a harbinger of recession.
To recap: We expect the Federal Reserve will continue raising the federal funds rate to about 5.5% by mid-year and keep it there for a while. Consumers, who make up about two-thirds of the economy, are becoming stressed. Credit card balances increased 15% year over year in the third quarter, the biggest increase in more than 20 years.
We anticipate a recession next year, but not one serious enough to spur a rate cut in 2023. Fed Chairman Jerome Powell does not want to make the mistake former Fed Chair Arthur Burns did in the 1970s. To tame inflation, Burns raised interest rates so much they caused a recession, but then cut rates too soon, and inflation stormed back.
We expect further retrenchment in stocks during February through May, followed by a strong second half. The companies we own are relatively well insulated from volatility. At some point in 2023, we expect to put more cash to work. And we are prepared to change our individual stock and bond outlook as the economy dictates.
As fee-only registered investment advisors, our goal is aligned with yours: to preserve assets while participating in the market’s long-run advance.
As always, please do not hesitate to reach out to Bruce or Leon with any questions, comments or concerns.
We wish you a Happy New Year, and as always, thank you for your confidence and trust.
All the best,
Bruce and Leon
Nollenberger McCullough Investment Advisors
Performance - Trust - Experience
Bruce Nollenberger
415-287-5100
brucen@nollmac.com
Leon Wiatrak
415-956-8700
lwiatrak@nollmac.com
Nollenberger McCullough Investment Advisors
100 Shoreline Highway Bldg B, Suite 380
Mill Valley, CA. 94941
415-956-8700 or 415-287-5100
Nollenberger McCullough Investment Advisory
Performance -Trust - Experience