2022 Market Recap and 2023 Outlook, Bernhard Koepp, C.J. Lawrence 1/10/23 


In this video, Bernhard Koepp gives a market recap of 2022 and an outlook on markets and global economies for 2023.

Hi there. This is Bernard Koepp at CJ Lawrence. Happy New Year. Well, we’re happy 2022 is over. In terms of the markets, it was certainly not a good year. If you go through the various indices, the S&P 500 was down 18.1%. If you were in the tech-heavy NASDAQ, you were down 33%. If you were in bonds, you didn’t do any better. If you were more into government-type bonds, the Aggregate Bond Index was down 13%. If you were in corporate bonds, you were down almost as much as the S&P 500, about 18%. Even things that typically tend to be somewhat of a counterbalance to bad markets, like gold, were not up. Gold was slightly down and rallied towards the end. I’ll get into that later. 

It was really a type of market where there is almost no place to hide. The only sector or segment of the market that was actually up significantly for the year was energy stocks, and those were up 48% for the year. If you go down all the other sectors:  Communication Services, which is the Facebooks and social media type stocks, those were down 39%, same with consumer discretionary stocks. They were down 39%. Technology in the broader sense was down 30%. Even things that you would think are a good inflation hedge, like real estate, were down 27% during that year. Financials, with interest rates going up, should have had a better outlook for net interest margins, banks for instance, but they had a pretty terrible year, down 13%. Industrials is actually down 6%, not bad. They rallied at the end of the year.  Consumer staples, not terrible, down 3%. Healthcare was a good place to hide, but also down about 3%. 

I think it’s a good idea to return to our assumptions and thinking going into 2022. A lot of the thinking amongst economists and portfolio managers at the beginning of 2022 was related to the reopening of the economy. If you remember, the Fed was talking about temporary supply chain problems that were creating inflationary pressures. We certainly believed those as well, and I think the entire market or the community of strategists were thinking, “Okay, once we get out of the problems of the pandemic shutdowns, we will get back to some normalization of supply chains.” Well, that was about to happen, and we had January and February happening where inflation was starting to come down a bit. But then the big, unexpected event was the Ukraine war. I think there is almost nobody that I know within the Wall Street community that predicted that we would actually have that war. Once Putin invaded Ukraine, it was a game changer in terms of how we think about supply chains and how we think about inflation.  The whole playbook for investing had to change at that point. If you were not in the types of stocks or investments that did well within a higher inflationary environment, you got killed. 

After February, most of us began to do a massive sector shift inside our portfolios to the stocks that have pricing power and are a better hedge against inflation. Companies that have pricing pressure tend not to be in technology stocks and things like that, but in energy, materials, and things like that. These are basically commodity-driven types of investments. For many years, those types of investments and sectors were kind of un-investable. If you think about the oil sector, nobody wanted to touch it for many years. The weight of the energy sector in terms of its ups and downs over the years was significant.  

If you go back to the 1980s, energy was 25% of the market. That came down over the years so that in 2017/2018 it was roughly 6%. Even in 2020, the Energy Sector went down to only 2% of the S&P 500.  It was like a non-sector. This was due to multiple factors. One of the factors certainly was a shift of thinking in terms of renewables. There was a whole movement to invest in companies that were ESG, which is environmental sustainability and governance type exposure. Certainly, the oil sector was not a place where you wanted to be in that sense. Everybody was thinking that the energy sector is going away because we’re moving from fossil fuels to other things. Well, that notion changed when the Ukraine war started. Interestingly, if you look at the weight of the energy sector in the S&P 500 now, it’s doubled from two years ago. Now it’s about six%. It’s still low for us to perform.  If the energy sector continues to be the only game in town, unless you have significant weight in the energy sector, you’re not going to do well. But longer-term, you must be thinking about what in the portfolio will be your inflation hedge, and certainly part of that equation is energy. 

It is important to consider the other sectors. Technology, there’s a lot of debate about technology and how the share of technology within the market or the S&P 500 will go forward. If you look at weights again, back in 1980, technology was only about 12% of the Index, quite low. If you go through the heady periods of the 1990s and the internet boom, we went to 21% of the market in 2000. That was the peak of the internet bubble that burst after that. Then we had a little bit of a steady decline after that, but once we got beyond the Great Financial Crisis, technology continued to take market share within the market and specifically, the S&P 500. We went to 29% of the market in technology in 2021. And if you remember, this was why it was such a great place to be during the pandemic, to be in big technology stocks. We rapidly shifted to digital transformation within the economy in a short amount of time.  And, during the pandemic, the only way you could really operate was if your business was in the Cloud. At our little company, we converted 100% to the Cloud, meaning we don’t have physical servers in our closets here anymore. All the processing and functions that we do are housed in data centers that are run by companies like Microsoft or AWS or Google Cloud. These are the things that really kept us going during the pandemic. We did about 10 years’ worth of cloud computing revenues within two years during that pandemic period. That is why technology as an investment during the pandemic was so terrific. If you had exposure to technology in the 2020-21 period, you made a lot of money. 

Going into 2022, that was somewhat reversed. We basically gave back most, no, all of the return of the previous year. And once the inflationary mindset started taking hold and the Fed started aggressively raising interest rates to fight inflation, multiples of these big technologies kept coming under pressure. These businesses haven’t slowed that much. If you look at companies like Microsoft or AWS, the Cloud business has maybe slowed to about 30%, and they used to grow at about 40%. But that’s still significant growth.  

In terms of profitability and growth, these companies are still exceptional businesses. They were terrible stocks in 2022, down in some cases 30 to 40%, but in terms of growth, again, these were exceptional businesses. Although they were a drag in 2022, we have to be very careful going into 2023 not to abandon all of them, but to be patient. We need to let the revaluation, or the multiple compression that we’ve gone through in this market due to higher interest rates and inflation, play out. Once that cycle has taken its course, we can go back to stable evaluations and multiples going forward.  That is hopefully when these businesses can still shine. 

Moving on to other sectors, Healthcare is very important. There’s a lot of talk going into 2023 that Healthcare is the anchor sector. Healthcare has both defensive and offensive characteristics, growth characteristics. For a long period of time, the big Pharma companies were kind of out of favor and had very low multiples because there wasn’t much going on in their drug pipelines. However, that’s changed quite a bit. Recent announcements on things like Alzheimer’s at Biogen and developments at companies like Eli Lilly and Pfizer that were very successful with the vaccines and started developing other mRNA type compounds for other uses are very interesting.  Because there is a lot going on in Pharma and Biotech, we like Healthcare going into 2023. 

In October and November 2022, there was an interesting kind of watershed moment that affected almost all the asset classes. Gold went down 11% into October and then something happened in October and November and gold started going up 11% after that, almost breaking even for the year. The same happened with the dollar, which peaked around the same time in November and then sold off 10% versus the Euro after that. The dollar is important if we think about corporate earnings, especially US corporate earnings in the S&P 500. Lots of the corporate earnings of large companies in the S&P 500 have lots of their revenues abroad. If the dollar weakens, that is very supportive for S&P 500 earnings in 2023. We want a weakening dollar to have a more constructive view of earnings growth going into 2023. The Euro has appreciated versus the dollar from that October-November period by about 10% and continues into 2023. 

If we look at yields, Two-year Treasury yields peaked in October-November and that gives us a clue why that November period was this kind of a watershed moment for markets to bottom or have a different flavor to them. Two-Year Treasuries peaked at 4.8% at the end of October and today they’re at about 4.20%, a significant decline. The same goes for the 10-Year Treasury, which peaked at 4.29%, also in that October-November period, and is now at 3.5%, substantially lower. However, that means we have an inverted yield curve, which is usually not good and is a predictor of recessions to come. We will return to that.  What happened in that October-November period is that we had a substantial decline in inflation. Inflation in the US peaked at 9.1% in June, and by November, it was down to 7.1%. That’s when the market started reacting in a more positive way, both the bond market and the stock market. That is when the extreme inflation phenomena that we haven’t seen since the 1970s was finally moving to the rear view mirror.  It’s interesting to note that the S&P 500 was pretty brutal going into the October-November period last year, down 23%. We had basically three straight quarters of negative returns, and then in the fourth quarter, things looked a lot better, up 6% or 6.5% off that October low. The same happened with the Dow. The Dow has a lot more value type stocks, so more energy industrials and things like that, and that’s actually done a lot better off of that low.  

Into November, the Dow was down 16% and then actually rallied to today, up 22%. That sets up an interesting environment for the current year. Let’s look at our forecast. The thinking around the fourth quarter was, “Oh my god, doom and gloom for 2023.” We had all kinds of events happening. The upheaval in the UK with Prime Minister May making some policy mistakes, which almost brought down the UK GILT market. There were policy missteps that almost brought things down. These black swan events occur with extreme moves in interest rates, inflation, or markets. That’s something we watch. 

What is our base case now for the US economy? We look to our former colleague Ed Hyman, the number one ranked economist, now at ISI, who’s using -1/2% for GDP growth for 2023. That’s not bad. That is a shallow recession going into this year. We are still tracking positive GDP going into the first quarter. The latest employment data showed that the unemployment rate went down to 3.5%. A 3.5% unemployment rate is nowhere near a recession. Given what we’re seeing in the data, whether it’s housing or labor, there is a highly likely chance that we will have some sort of recession in the second half of the year, but at this point, it looks pretty shallow. 

The other surprise is Europe. I just got back from Europe. I spent some time with my mother in Munich over Christmas and then spent a little bit of time in Spain. It was quite clear being there that there’s a lot of economic activity happening. It’s not doom and gloom. There was this notion that Europe is going through an energy crisis. It certainly is going through an energy crisis. Prices have come up a lot because they turned off their primary source for natural gas and had to convert. That was quite a shock.  A couple of things have happened. The Germans, who have the biggest economy in Europe, have built LNG capacity to import liquefied natural gas from all over the world, including the United States. The first LNG tanker arrived in one of the ports in Northern Germany last week, Wilhelmshaven, carrying enough natural gas to fuel 50,000 homes for a year. That’s a game changer because now we have a direct flow of LNG to the biggest economy in Europe. Storage is also at an all-time high level in Europe. The weather in Europe through the holidays and winter has been unseasonably warm, which gave the Europeans some breathing room to re-establish their storage and build out their capacity. The good news is that natural gas prices have collapsed. Two months ago, we were thinking about shortages, but now we have the probability of a glut of natural gas in the spring. The Europeans have gotten their act together on the supply side and storage.  In addition, households have kept their heating to only 19 degrees Celsius, which resulted in a reduction in demand for heating.  The overall reduction in European household demand has prompted economists to revise up the expectation of GDP growth in Europe. Goldman Sachs, for instance, is now predicting that there won’t be a recession in Europe anymore. That is quite a bullish development. They are using 0.6%+ GDP growth for 2023 for the Eurozone.  That is quite remarkable. 

Let’s talk about China briefly. China has gone through its comeuppance in terms of COVID. The people had enough of the zero COVID policies, and they’ve abandoned all of that. Right now, everybody’s getting sick, but COVID will run its course, and they will reach some sort of herd immunity. There are reports that the Chinese are talking to companies like Pfizer to produce vaccines and drugs that will help if you have the virus. These are positive developments for China, which is important for global growth and supply chains. 

The tone all of a sudden here in the last two to three weeks going into 2023 has changed quite dramatically. Also, on inflation, the latest data that we got on labor shows that we can’t find enough workers in some cases in certain sectors, and the unemployment rate is so low at 3.5%. There has been some moderation in average hourly earnings, and they were actually revised down in the latest data. That kind of shows that the labor costs, which is one of the biggest components of CPI, like rents, and housing, are actually coming down. That is all good news. 

What do we think about stocks and bonds? Our thinking is that we’re going to have a positive return in stocks and bonds in 2023. There’s a lot of discrepancy when it comes to strategists and economists for 2023. We tend to have a more optimistic view, and I’ve always said if you’re an investor and if you’re saving money for the long term, you must be more optimistic. Investing is an optimistic endeavor. If you do not think the future is going to be better than the past, you shouldn’t be investing. But in terms of real data, I think we’ll see some improvement in the data, and there will be surprises, especially on the earnings side, having to do with a weaker dollar and economic activity that isn’t as bad as people have suggested just a couple of months ago. 

The outlook for earnings and valuations will be somewhat better going into the new year. Tom Lee, who was a very good strategist for many years, is very bullish. He is calling for 20% type returns for 2023. We’re not so sure about that, but I think if you think about if inflation moderates, which is happening, and we’ll get some more inflation data this week, you could certainly get to a point where equity markets and bond markets will continue to rally. Our expectation would be sort of 5-10% type returns, but it could be a lot better. 

The only problems that can happen are these so-called Black Swan events. We saw a little bit of that when you had the UK crisis with the GILTs. One of the things that hasn’t occurred yet in the global crisis that we’ve seen in the last year or so with inflation is that we haven’t really seen any credit events. A credit event is where there is intense stress somewhere in credit markets relating to certain sectors. We’ve seen that in the past in energy companies when oil prices dropped to like twenty dollars a couple of years ago during the pandemic. There was a worry that oil companies have borrowed money, their bonds outstanding. If you have some of these types of credit being downgraded, that’s a problem. 

Today, if you think through where there could be some stresses in the global economy, we can look at things like emerging markets. The strong dollar has been really tough on emerging markets because a lot of the developing countries borrow in US dollars, and if the US dollar goes up, then of course that debt service is even more difficult. And if you think about importing commodities, everything from energy to food commodities, which tend to be purchased and sold in US dollars, it makes it a lot more difficult for emerging markets. Thus, budgets within developing countries are under a lot of stress. 

Solving sovereign issues and potential black swan events or crises related to them are aspects we are monitoring closely. However, our base case for 2023 is that it will be a significantly better year than 2022. We anticipate some challenges and bumps in the road in the first half of the year until the Federal Reserve stops raising rates, which is expected to occur around March. Beyond that, we believe it sets up a promising market. 

In conclusion, we appreciate your support and thank you for watching this lengthy video. At CJ Lawrence, our focus remains on conducting bottom-up analysis of companies. We strive to find exciting investment opportunities and are pleased to have maintained our competitive position compared to other similar competitors. We have proudly maintained our Top Gun six-star ranking in the PSN database for the large-cap category throughout 2022. Although the returns last year were disappointing, we hope for improvement this year. If you have any questions, please don’t hesitate to reach out. Take care. 

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