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2023 has gotten off to a good start, with both stocks and bonds regaining some of the ground lost last year.  Continued strength in jobs growth and improvement in inflation data combined to ease investor’s fears that a painful economic recession is inevitable.  The bond market, in particular, benefited from expectations of a slowing economy and lower interest rates in the future.

We never know what’s going to kill a bull market.  So many events, most of them impossible to predict, can change investor sentiment very quickly and cause the markets to fall.  The end to the latest bull market in 2022 had many causes.  The war in Ukraine caused energy prices to jump and caused fears of the war spreading; global inflation spiked to 40-year highs; once high flying investments like crypto currency and many big tech stocks, plummeted.  The Federal Reserve, in an effort to get a handle on inflation, raised interest rates very quickly from levels near zero, causing the worst losses in the bond market ever.  Equity markets experienced extreme volatility as investors tried to make sense of a very unpredictable future.

Economic pain continued during the third quarter as we churn through a bear market in the equity and fixed income markets.  So far, this bear market has followed the script of past bear markets pretty closely.  Both stocks and bonds rallied during July and August, leading some pundits to declare the bear dead and cheering on the new bull.  To quote Mark Twain, reports of the bear’s death have been greatly exaggerated.  Renewed selling in September has shown that the bear market still has some bite.

Global equity markets continued their sell off during the second quarter as economic conditions around the world deteriorated.  An aggressive Federal Reserve raised the Fed Funds rate to pre pandemic levels, causing more drops in bond prices.  With inflation continuing to rise, the Fed seems willing to risk a deep recession to get rising prices under control.  Stocks entered bear market territory during the quarter, with a 20% pullback from their highs.  The yield curve inverted during the quarter, signaling that a recession is likely.  Most economists have stopped talking about whether a recession is likely and are now discussing how bad the recession will be.  In fact, we could very well already be in a recession now, as GDP contracted in the first quarter.  A repeat of this in the second quarter would meet the definition of a recession.  While a recession is not a certainty, it is looking more likely than not that we will see one.

A lot happened during the first quarter, and most of it was bad. Stocks had negative returns, despite a 10% rally the last two weeks of the quarter, as fears rose about slowing economic growth. The bond market also had negative returns as interest rates spiked due to rising inflation. The Russian invasion of Ukraine added a new level of uncertainty to the markets as economic sanctions and fears of spreading hostilities spooked investors. In this letter we will discuss inflation, the war, and Covid, which together create the Three Headed Monster that is affecting the economy and the markets.

During 2021, the U.S. economy continued to improve after last year’s contraction, taking the stock market along for the ride.  Stocks benefited from the growing economy, low interest rates, and strong corporate earnings.  The bond market gave back some of their gains from 2020 as interest rates rose from levels near zero.  The stock market is ending the year at record highs, which is interesting given some serious issues that we are dealing with as an economy.  Rising inflation, the ongoing pandemic, a shortage of workers, and supply chain problems are among the issues that could derail economic growth in the new year.

Volatility in the markets increased during the third quarter as fears rose that soaring Covid cases could slow the economic rebound we have been experiencing for the past year and a half. Consumer confidence numbers took a nosedive in September, and with consumers accounting for two thirds of U.S. economic activity, worries have risen that we are facing economic headwinds. In addition to the potential of a slowing economy, the increasing fear that inflation might be getting out of hand has also weighed on investors. It is an interesting time right now and economic and market uncertainty is climbing.

The economic recovery in the U.S. since the lockdown of 2020 has been quite remarkable. Last year’s recession was short but very severe. While we can always debate the level of Government stimulus necessary in times like this, there is no denying that flooding the economy with money helped bring us back to growth. The question now is when to end the stimulus and how to ween the economy off Government spending.

Despite an increase in volatility, stocks ended the second quarter with solid gains as the global economy continued to recover from the Covid pandemic. The bond market recovered some of its first quarter losses with a nice rebound during the second quarter. Strong corporate earnings across the board and rising consumer confidence continue to fuel stock gains, and consumers are on a spending binge after last year’s lockdown. While most economists expect this growth to slow down sometime in 2022, right now optimism abounds.

The one thing that is currently causing anxiety among investors is the threat of rising inflation. Inflation has been low for such a long time that many have forgotten what terrible economic damage can be caused by rapidly rising prices. The risk to the bond market is fairly obvious. Rising inflation leads to higher interest rates, which leads to lower bond prices. Bonds have benefited from forty years of dropping interest rates, but with rates effectively zero, we are likely to see rates move higher as economic conditions improve.

Equity markets have gotten off to a strong start in 2021, reaching record highs as the U.S. economy continues to recover from the pandemic. Stocks benefited from ongoing vaccination efforts as well as from government stimulus money being distributed to individuals, businesses, and local governments. The bond market, which benefited last year as interest rates dropped to near zero as the economy slowed, declined as interest rates rebounded with the improving economy.

We are in a very interesting time right now. The U.S. economy is recovering, but it is not an equal recovery across the board. Lower wage industries, who bore the brunt of the economic slowdown last year, have been much slower to recover. Likewise, minority and female employment remains more depressed and slower to recover. As of now, the economic recovery continues to be dependent on fiscal and monetary support. We need to see a broader recovery to allow economic growth without the use of government help.

If you are like most people we know, you are very glad to be reaching the end of this year. During the past year we have experienced a global pandemic, massive social unrest, a contentious political atmosphere, an economic recession, the largest quarterly drop in GDP in history, and an end to the longest running bull market in American history. While there is no guarantee that things will be better in the upcoming year, sometimes the expectation of better times, along with an effective vaccine against Covid, can lead to better outcomes. The U.S. stock market defied the carnage of 2020 by rebounding after the lockdown, helped by the largest post-election rally since 1932. Bonds also posted gains as interest rates plummeted due to severe economic contraction. It was a very strange year indeed.