Year In Review

The stock market opened lower this morning, reversing some of yesterday’s rally. On this last trading day of the year, exchange volume is very light as many Wall Street traders are on vacation. At the moment, it looks as though the S&P 500 Index will finish the year with a -20% return. Small-caps and emerging markets indices are slightly worse. The tech-heavy Nasdaq Composite Index looks to have fallen 33%. Despite more attractive valuations, most international stock indices underperformed in US dollar terms because the dollar was so strong. Red ink spilled over into the bond market this year. Even counting interest received, the Bloomberg US Aggregate Total Return Bond Index fell nearly 13%. Junk bond funds were down about the same. Long-term US Treasuries fared the worst, falling 30%. There was nowhere to hide.

I’m calling this the Year of the Covid Hangover. In short, supply & demand imbalances combined with massive doses of government stimulus sparked high inflation, which in turn drove alternating fears that the Federal Reserve was either behind or ahead of the curve in terms of monetary tightening. The fiscal (congress) and monetary (Fed) regimes changed abruptly and suddenly the easy money era was over. As a result, this is the worst year for a diversified 60% stock/40% bond portfolio since 1926. The S&P 500 has had only three worse years since I was born: 1974, 2002, and 2008. Sentiment on Wall Street and Main Street collapsed to near record levels and many predicted imminent economic recession.

And yet, reports of the economy’s death have been greatly exaggerated. While gross domestic product (GDP) contracted during the first half of the year, it rebounded nicely in the second half. The Atlanta Fed’s forecasting tool shows fourth quarter GDP tracking to 3.6% growth. This growth resulted from better than expected business & consumer spending. And spending resulted from a strong job market. The unemployment rate fell from 3.9% to 3.7% this year. Finally, the positive effect of all those stimulus dollars is that most households and businesses have less debt and more savings than they did before the pandemic.

Inflation was the watchword for 2022. Looking back five to ten years, economists wondered whether ultra-anemic inflation would last forever. Now they’re tempted to expect it will remain high forever. Of course, neither are true. Today’s inflation is a natural outgrowth of unprecedented—$5 trillion if Bloomberg News tallied it correctly—stimulus. The amount of money in circulation (M2) shot up 40% between February 2020 and February 2022. To give some context, post-housing crash stimulus nudged M2 up by about 30% over a four-year period.

But as I said, the easy money era is over. The stimulus spigot has been shut off and M2 is no longer growing. In fact, the Fed’s new bond-selling program called “quantitative tightening” will likely shrink M2 next year. In addition, lending rates are no longer laughably low. Bankrate’s average 30-year fixed mortgage rate doubled this year. Small Business Administration loan rates have more than doubled. All of this spells the end of high inflation. We are beginning to see signs of this: gasoline, used cars, lumber, freight, televisions, etc.

We exit 2022 locked in a horse race between the pace of moderating inflation and the pace of Fed “tightening.” Fed officials say they’ll continue to raise interest rates—though at a slower pace than they did this year—until they see “compelling evidence that inflation is moving down, consistent with its return to 2%.” They say the fight against inflation could last into 2024. In the meantime, all eyes will be fixed on the economy to gauge how well it stands up to more restrictive financial conditions.