2022 has been one of the worst years for investment on record. Most asset classes performed poorly – stocks, bonds, and cryptocurrencies. Only energy benefited from the war in Ukraine and the disruption to oil and gas supplies around the world. Even so, crude oil prices are down almost 50% from their peak earlier in the year.
We are not surprised at the poor performance this year. At the end of last year I wrote: “I think that 2022 will be a bumpier year for financial markets than 2021. Inflation worries and geo-political tensions in Ukraine, the Middle East, and China will create more volatility than we witnessed in 2021”. Unfortunately, we were spot on.
As we look ahead to 2023 it’s worth reflecting on how we got here and what could happen next.
Politicians and central bankers like to lay the blame for all of our economic troubles on the war in Ukraine. It is certainly true that the war in Ukraine precipitated both an energy crisis and a food crisis driving up the price of food and energy all around the world and leading to higher inflation globally. That in turn has led central banks to tighten monetary policy to try to get inflation back under control. As a result bond and equity prices have fallen, in some cases, sharply.
A reduction in the growth of inflation and hopes that the Fed will also slow down the rate at which it hikes interest rates have helped the markets to rally from their September 2022 lows. Will this prove to be the start of a sustained bull market? We don’t think so. We think the start of 2023 could be as bad for financial markets, if not worse, than 2022.
The economic and financial troubles we are facing go back before the war in Ukraine. For decades we have been building up excessive amounts of debt through irresponsible fiscal policies under both left and right wing politicians. We dealt with the debt crisis of 2007-2009 by nearly doubling the entire stock of debt that had been created in thousands of years of human history, in only a few short years! Now we live in a world with far too much debt. There are usually only two outcomes to excessive debt: outright default or inflating it away in real terms.
Central bankers also responded to the financial crisis, and then Covid, by printing trillions of dollars, effectively colluding with governments to support bad fiscal policies by buying the bonds they issued. So much for central bank independence.
So, when Russia invaded Ukraine in February, the world was not in a happy state. It was a time bomb waiting to go off. The war in Ukraine was merely the trigger.
Many people assumed that the war in Ukraine would be over relatively quickly. It now looks set to last for years.
Ukraine is not the only geo-political trouble spot. The risk of a conflict in China is inversely linked to the performance of the Chinese economy. The worse things get in China the more likely it is that China will provoke a conflict or eventually invade Taiwan. And China is not in a happy place economically. China is in demographic decline with some estimates that its population could halve by the end of the century. At home it faces a glut of unsold real estate, which for a long time was a major driver of economic growth. Abroad, trade is likely to fall as the global economy slows down or enters recession.
Once the communist party is no longer able to justify its legitimacy through strong economic growth north of 5% per annum, they are likely to revert to nationalism to maintain control. Let’s not forget that the rationale for President Xi seeking an unprecedented third term in office was to resolve the Taiwan issue.
To make matters worse, in the wake of the war in Ukraine, the West seems intent on provoking China by moving slowly away from decades of agreed ambiguity on Taiwan’s national status and towards a position of recognising Taiwan’s sovereignty. This is not to pass judgement but merely to comment that China might, as a result, feel justified in starting a conflict with Taiwan.
Sadly, there is more geo-political risk in the Middle East. After the US pulled out of the ‘Joint Comprehensive Plan of Action’ between Iran, the permanent members of the UN Security Council and the EU, Iran has been steadily ramping up its nuclear enrichment. This comes at a time when Israel has elected possibly its most right wing government in history making a regional conflict more likely than ever. War in the Middle East will certainly not help the price of energy to come down.
So, when I look at the major asset classes, there is not much to recommend them. With inflation over 7%, and the Fed Funds rate at 4% real interest rates in the US have become more negative than before and monetary conditions looser. 10 year bonds yields below 3.5% look decidedly unappealing when governments have many more bonds to sell and when major central banks have started to sell the mountains of debt they acquired at much higher prices than today.
Stock markets look set for a lose-lose scenario in which either the world implodes and earnings collapse or the most-flagged recession in history fails to materialise and interest rates have to rise considerably higher to cool rampant inflationary pressures from extremely tight labour markets. In either scenario, equity markets have a long way to fall. If you are still clinging on to the hope that central banks will be able to engineer a ‘soft landing’ then you have clearly not followed their abysmal track record in recent years. In the crisis of 2009, P/E values bottomed out below 10. There is certainly the potential for the S&P 500 index to fall below 3000, at least a 25% drop from current levels.
Finally, the shine has come off cryptocurrencies. Crypto prices were driven higher by three factors: a political belief in a tech world free of human intervention; an emotional attachment by younger investors to an asset class that they felt was not as overvalued as other asset classes and that they could make their own; and for everyone else the appearance of an easy way to make money. Well, unfortunately, we have now seen that crypto markets are as vulnerable to human corruption as the rest of society; bonds and stocks no longer look as overbought relative to cryptocurrencies as before; and crypto has gone from being an easy way of making money to a really easy way of losing money.
So, what’s the good news? Well the good news is that, if you can afford to take a long term view, lower markets will represent a great opportunity to build an investment portfolio. I’d much rather buy at a big discount in a sale than at full price. The people who can most afford to take a long term view are our children. $10,000 invested for them at birth will compound at 10% to over $3 million when they are 60. $10,000 invested for them at age 25 will compound to only $280,000 at age 60. So, it is always better to start investing as early as possible. Those first twenty five years of compounding can make a massive difference. And, the other piece of good news is that if I’m right about the early part of 2023, it will be an even better time to be a long term investor than it is today!
Season’s greetings and best wishes for a healthy and prosperous 2023 from all of us at Invstr.
