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📝 Market Commentary for 2022-Q4
This quarter, we experienced a relief rally for a very challenging year. We look forward to a U.S. recession in 2023, a potential secular shift in the USD, and more political drama from Washington.
We conduct in-depth investment research and provide commentary on the most significant market events of the previous quarter and provide an outlook for the current investing environment.
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2022: Challenging Year For All Assets Except Commodities.
Throughout most of 2022, the global markets were plagued by uncertainty and volatility, leading to widespread losses across most asset classes. Financial assets such as equities and bonds were particularly hard hit, while commodities were the exception, producing positive returns from a U.S. perspective.
A primary driver of this market turmoil was inflation and a tightening Federal Reserve, which had been an ongoing concern throughout the year. In response to higher-than-expected inflation numbers, the central bank of the United States implemented aggressive tightening measures, rapidly raising interest rates and selling a fraction of their balance sheet. These actions had a negative impact on all financial assets, as investors struggled to adapt to the new economic environment.
Adding to the market turmoil was a spike in geopolitical tensions, notably between Ukraine and Russia. This led to a massive rally in the dollar, as investors sought the relative safety of the US currency. Unfortunately, this also acted as a headwind for most risk assets, as the strong dollar made it harder for U.S. companies to compete, and created more domestic losses for non-U.S. assets.
Q4 2022 Provides a Relief Rally.
The fourth quarter of 2022 was a welcome change of pace after a year of volatility and uncertainty in the markets. The dollar, which had been on an upward trajectory for the first three quarters, experienced a sharp decline in the final quarter of the year, providing a much-needed boost for riskier assets. This was particularly beneficial for emerging markets, which had been hit hard by the strong dollar throughout the year.
The dollar's decline was driven by a combination of factors, including an injection of liquidity by the U.S. Treasury and a step up in the selling of dollar assets by the BRICS. While the declining dollar made U.S. stocks more affordable for foreign buyers, the real demand was in metals, which both rallied around 10% during the quarter. The demand for metals also provided a boost to the stock indices of commodity-producing countries, such as Chile, Peru, and Australia.
Overall, the fourth quarter of 2022 brought some much-needed relief to investors and markets around the world. The declining dollar provided a boost for riskier assets and emerging markets, while the resurgence in metal prices helped improve the outlook for many commodity-producing countries. While challenges undoubtedly remain, the fourth quarter of 2022 ended on a higher note.
U.S. Economic Outlook Pessimistic.
Inflation surged earlier this year, leading to central bank intervention. However, it has since begun to decrease in the fourth quarter of 2022. While it is likely to continue on this trajectory in 2023, it is not expected to decline at a fast enough rate to warrant further policy adjustments. In 2022, the Federal Reserve's interest rate hike was a major focus, but in 2023, the economic recession and its effects on slower growth and weaker earnings prospects in the United States will take center stage.
On the other side of the world, despite ongoing weakness in the Chinese economy, the government continues to implement stimulus measures and has shifted away from their Zero COVID strategy. These developments offer hope for a potential recovery, however, the real estate sector remains a source of concern and tensions with the United States are unlikely to subside.
A Secular Shift in the U.S. Dollar?
The recent movement of the U.S. dollar from a technical perspective could have far-reaching implications for the global financial system, as the U.S. dollar is the global reserve currency. One economic theory that is relevant to this situation is Triffin's Dilemma, which was proposed by economist Robert Triffin in the 1960s. This theory highlights the conflict that arises when a country that is responsible for providing the world's reserve currency also needs to run trade deficits in order to meet the demand for its currency.
As the world's reserve currency, the U.S. dollar must be continually supplied to the world in order to facilitate international trade. However, when the country's domestic economic needs are at odds with its international monetary responsibilities, reserve currency countries have historically sacrificed their currencies to save their own economies.
Despite the recent weakness of the U.S. dollar, it is important to remember that it remains the world's reserve currency and currently has a huge short interest. This means that the dollar can potentially regain strength rapidly when perceptions of geopolitical risk increase. However, long term the dollar’s strength may be challenged as the US economy deteriorates and the BRICS form a competing currency.
The Debt Ceiling Debate…Again
The U.S. government is currently at a standstill as the debt ceiling has been reached and discussions to raise the limit are becoming increasingly contentious. In the past, these debates have often been viewed as a political spectacle, with both parties engaging in a battle before eventually reaching a compromise. However, it is crucial to recognize that the failure to raise the debt ceiling could have catastrophic effects on the global economy. Previous debt ceiling debates, such as the one in 2011, have also resulted in a decrease in the creditworthiness of the United States. While the likelihood of this outcome is low, the potential impact is severe.
Fiscal intervention has become a significant factor in this economic cycle, with the U.S. Treasury providing liquidity by purchasing treasuries on the open market. Additionally, the Japanese central bank's purchases of JGB have further increased global liquidity, which likely contributed to the rally seen in October.
As the economic cycle continues, it will be intriguing to observe the government's use of other fiscal interventions, as monetary policy options have become limited.
Current Outlook and Positioning
In my view, the trend of decreasing inflation is likely to continue into 2023. However, the rate of decrease may not be significant enough to prompt any adjustments in monetary policy. The Federal Reserve is expected to remain vigilant in its efforts to bring inflation back to its target rate of 2%. This outlook presents an opportunity for bonds, particularly those with shorter maturities, as a favorable investment. Credit may also be an attractive option, but there may be potentially better opportunities to acquire higher credit at yields as a recession and potential defaults are possible in the near future.
If the U.S. Dollar continues to weaken on a secular basis, this could create opportunities for higher returns on foreign assets, particularly in emerging markets. Equities in Latin America and certain Asian countries look particularly attractive. From an economic sector standpoint, energy remains the most appealing, with industrials and materials continuing to show promise. The healthcare segment also appears to be a favorable option.
We continue to hold a steady allocation to commodities and precious metals, within each strategy's risk parameters. These assets can act as a hedge against volatile inflation and currency fluctuations, which can be beneficial during this times of geopolitical uncertainty. Overall, there are various investment opportunities available in the current market climate, but it is important to remain flexible and nimble during these uncertain times.
Written by Joseph Lu, CFA®
Joseph is the founder and a managing director of Conscious Capital Advisors, as well as a CFA® Charterholder.
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