Covington Investment Advisors, Inc. Blog

As we reflect back on a tumultuous 2022 and begin to look forward to 2023 we are not only preparing for our new year outlook but also what topics are on everyone's minds, including our own, over the holidays. We have listed the notable questions and what our take is on each one, both a short answer and a more nuanced view. So if the economy comes up in those lively holiday conversations hopefully these provide some interesting discussion material.

1. “Are we in a recession? We have had two consecutive quarters of negative GDP growth this year, isn't that a recession?”

Short answer:Not yet. 

Long Answer:  Although two quarters of falling GDP meets the definition of a “technical recession”, from an economic perspective weakness has to broaden out to a wider range before it meets the criteria for an official recession. The National Bureau of economic research (NBER) makes the official call on whether the economy is in a recession. To do this they use 6 economic indicators which are more expansive than just GDP which can be impacted by large swings in trade and inventory data (which we have seen this year). ..

At Covington our primary focus has been meeting our clients’ financial goals and secondarily to make a difference in our community. Meeting our clients’ financial goals has enabled us to participate in a number of community efforts for the betterment of the human experience. On November 11^th, 2022, I had the privilege of hosting a ribbon cutting ceremony at the newly established Laurel Highlands Workforce & Opportunity Center celebrating the Center’s successful operations and its first class of cohorts studying to become Medical Assistants. The Center is located at 310 Donahoe Road, Greensburg, PA 15601. Feel free to visit the website at https://lhwoc.org for more information.

Patrick Wallace (middle) cuts the ribbon at the Laurel Highlands Workforce & Opportunity Center ribbon cutting ceremony. ..

More Pain To Endure

There is no doubt that this has been one of the most difficult years in recent memory for many investors. Nearly every equity index has fallen below the definition of a traditional bear market, a decline of 20% or more. Equally difficult has been the performance of the bond market which is supposed to insulate portfolios from market volatility. Even commodities, which started the year strong with heightened geopolitical activity, have begun to roll over. Crude oil has fallen -25% during the third quarter of 2022 and -35.7% since its March peak. Under restrictive Fed policy to mitigate heightened inflation, we will have to endure the pain until the Fed completes their mandate of price stability.

What has been behind the weakness in the market is above average inflation and a major shift in Fed policy. Nominal GDP has been very strong, up 8.5% in the first quarter and up 6.6% in the second quarter. After inflation though, real GDP is trending negative. Inflation, as measured by the Consumer Price Index, has come down from its peak of 9.1% in June of 2022 but still remains up over 8%, well above what the Fed considers its “neutral” rate of around 2.5%. In response to stubbornly high inflation, the Fed Funds rate has been increased five times so far in 2022 to a range of 3.00% to 3.25%. We anticipate two more hikes before year end which will leave the Fed Funds rate at a target of around 4.5%. We anticipate Fed policy may be able to transition sometime in early 2023 depending on the inflation data...

Inflation data continued to surprise to the upside with last week's CPI reading shocking markets and lead the Federal Reserve to announce another 75bps rate hike yesterday. The fed funds rate is now in the target range of 3% to 3.25%. In our opinion inflation has likely peaked but remains elevated enough that a quick dovish pivot by the central bank is not in the cards. You'll remember from our note last year (here) that when the Federal Reserve begins tightening policy and raising interest rates it is essentially the economic equivalent to a punch bowl being pulled away at a party. While we were not surprised that the Fed was tightening policy we have been surprised by the speed of policy change. For perspective, at the beginning of the year markets were pricing in a federal funds rate at sub 1%, now futures markets are pricing in a rate above 4% for 2023.

So now that we have embarked on a changing policy journey, where does it end?The truth is I don't think even Chairman Powell knows the answer as to what the terminal rate will be in a year. Like mentioned previously the market sort of does this for him by pricing in the terminal rate years ahead using futures contracts. Still, the procedure for central banks has always been more of a guess-and-check process where they begin raising rates until something in the market forces them to reverse course. On our chart today I plot some of these events and you can see they are wide ranging as far as which area of the market is most affected and ends up defining the tightening period. But one thing is common amongst them: most are pockets of excess where prices became irrational. Also notice how many of these are relatively illiquid or obscure with many taking place in emerging or debt markets...

Economic growth spiked coming out of the pandemic trough in 2021 with the aid of aggressive fiscal & monetary support. Late in 2021 that growth began to cyclically slow down leading to volatility in the first half of this year followed by sizable rallies and selloffs. The selloffs have been exacerbated by geopolitical shocks, tightening monetary policy, and inflation. The rallies have been characterized by optimism that these sources of contention are showing signs of dissipating amid record low sentiment in equity pricing. At the center of these contentions is inflation. High inflation is typically an offshoot of strong economic activity and loose monetary policy. Symmetry implies that a slowdown in economic growth should coincide with a peak in inflation which would be a welcomed respite for investors allowing the Fed to lighten up on rate hikes. This “dovish pivot” was the root of the 17% rally in the S&P 500 in mid-June through mid-august, but the crux of this optimism is that slowing economic growth risks a recession and the inflation we are experiencing now is unique in many ways. In response to this Fed chairman Powell’s recent comments at Jackson hole sent equity markets lower after this dovish pivot never materialized. On the contrary Powell's speech was short, but explicit in relaying the central bank’s commitment to fighting inflation even at the risk of recession...

Inflation data continued to surprise to the upside with last week's CPI reading shocking markets and lead the Federal Reserve to announce another 75bps rate hike yesterday. The fed funds rate is now in the target range of 3% to 3.25%. In our opinion inflation has likely peaked but remains elevated enough that a quick dovish pivot by the central bank is not in the cards. You'll remember from our note last year (here) that when the Federal Reserve begins tightening policy and raising interest rates it is essentially the economic equivalent to a punch bowl being pulled away at a party. While we were not surprised that the Fed was tightening policy we have been surprised by the speed of policy change. For perspective, at the beginning of the year markets were pricing in a federal funds rate at sub 1%, now futures markets are pricing in a rate above 4% for 2023.

So now that we have embarked on a changing policy journey, where does it end?The truth is I don't think even Chairman Powell knows the answer as to what the terminal rate will be in a year. Like mentioned previously the market sort of does this for him by pricing in the terminal rate years ahead using futures contracts. Still, the procedure for central banks has always been more of a guess-and-check process where they begin raising rates until something in the market forces them to reverse course. On our chart today I plot some of these events and you can see they are wide ranging as far as which area of the market is most affected and ends up defining the tightening period. But one thing is common amongst them: most are pockets of excess where prices became irrational. Also notice how many of these are relatively illiquid or obscure with many taking place in emerging or debt markets...

Inflation data continued to surprise to the upside with last week's CPI reading shocking markets and lead the Federal Reserve to announce another 75bps rate hike yesterday. The fed funds rate is now in the target range of 3% to 3.25%. In our opinion inflation has likely peaked but remains elevated enough that a quick dovish pivot by the central bank is not in the cards. You'll remember from our note last year (here) that when the Federal Reserve begins tightening policy and raising interest rates it is essentially the economic equivalent to a punch bowl being pulled away at a party. While we were not surprised that the Fed was tightening policy we have been surprised by the speed of policy change. For perspective, at the beginning of the year markets were pricing in a federal funds rate at sub 1%, now futures markets are pricing in a rate above 4% for 2023.

So now that we have embarked on a changing policy journey, where does it end?The truth is I don't think even Chairman Powell knows the answer as to what the terminal rate will be in a year. Like mentioned previously the market sort of does this for him by pricing in the terminal rate years ahead using futures contracts. Still, the procedure for central banks has always been more of a guess-and-check process where they begin raising rates until something in the market forces them to reverse course. On our chart today I plot some of these events and you can see they are wide ranging as far as which area of the market is most affected and ends up defining the tightening period. But one thing is common amongst them: most are pockets of excess where prices became irrational. Also notice how many of these are relatively illiquid or obscure with many taking place in emerging or debt markets...

More Pain To Endure

There is no doubt that this has been one of the most difficult years in recent memory for many investors. Nearly every equity index has fallen below the definition of a traditional bear market, a decline of 20% or more. Equally difficult has been the performance of the bond market which is supposed to insulate portfolios from market volatility. Even commodities, which started the year strong with heightened geopolitical activity, have begun to roll over. Crude oil has fallen -25% during the third quarter of 2022 and -35.7% since its March peak. Under restrictive Fed policy to mitigate heightened inflation, we will have to endure the pain until the Fed completes their mandate of price stability.

What has been behind the weakness in the market is above average inflation and a major shift in Fed policy. Nominal GDP has been very strong, up 8.5% in the first quarter and up 6.6% in the second quarter. After inflation though, real GDP is trending negative. Inflation, as measured by the Consumer Price Index, has come down from its peak of 9.1% in June of 2022 but still remains up over 8%, well above what the Fed considers its “neutral” rate of around 2.5%. In response to stubbornly high inflation, the Fed Funds rate has been increased five times so far in 2022 to a range of 3.00% to 3.25%. We anticipate two more hikes before year end which will leave the Fed Funds rate at a target of around 4.5%. We anticipate Fed policy may be able to transition sometime in early 2023 depending on the inflation data...

More Pain To Endure

There is no doubt that this has been one of the most difficult years in recent memory for many investors. Nearly every equity index has fallen below the definition of a traditional bear market, a decline of 20% or more. Equally difficult has been the performance of the bond market which is supposed to insulate portfolios from market volatility. Even commodities, which started the year strong with heightened geopolitical activity, have begun to roll over. Crude oil has fallen -25% during the third quarter of 2022 and -35.7% since its March peak. Under restrictive Fed policy to mitigate heightened inflation, we will have to endure the pain until the Fed completes their mandate of price stability.

What has been behind the weakness in the market is above average inflation and a major shift in Fed policy. Nominal GDP has been very strong, up 8.5% in the first quarter and up 6.6% in the second quarter. After inflation though, real GDP is trending negative. Inflation, as measured by the Consumer Price Index, has come down from its peak of 9.1% in June of 2022 but still remains up over 8%, well above what the Fed considers its “neutral” rate of around 2.5%. In response to stubbornly high inflation, the Fed Funds rate has been increased five times so far in 2022 to a range of 3.00% to 3.25%. We anticipate two more hikes before year end which will leave the Fed Funds rate at a target of around 4.5%. We anticipate Fed policy may be able to transition sometime in early 2023 depending on the inflation data...

With the dramatic compression in valuation multiples this year we can now start to plot the current positioning of the market versus historical averages to gauge whether or not equities are attractive. On the graph above I have the forward 12 month P/E ratio of the S&P500 which currently stands at 17.6x and represents a level of 4,029. Overlapped on the chart I have 5, 10, and 15 year average multiples along with corresponding S&P 500 prices...

Last fall we advised you that we were expecting an adjustment period for the capital markets [see blog here]. An adjustment to slowing economic growth, decelerating corporate earnings, higher inflation, and new Federal Reserve policy measures. Market valuation models are adjusting to these new circumstances. Ultra-low interest rates, massive fiscal and monetary initiatives elevated valuations beyond actual long-term earnings potential. Under the Fed’s efforts to contain inflation, valuations will now align to actual long term economic growth expectations which remain attractive. The economy is still expanding at historical trend line GDP growth of 3% and corporate earnings are more representative of expectations at 8%.

..

The situation with Russia/Ukraine remains fluid but we wanted to follow up our note on the ‘Turmoil on the Eastern Front’ from the beginning of the invasion. In that note we showed the historical playbook for geopolitical events, and looking back the market has behaved remarkably in line with those precedents up to this point. But we don't think the situation is completely behind us and want to reiterate that historically what happens after the initial recovery mostly depends on what conditions were like going into the crisis. In today's case that was inflation and changing central bank policy. We continue to think that will be the dominant theme as we go into the second half of 2022.

For more on the geopolitical situation please see Schwab’s latest market perspective below:..

Geopolitical tensions continue to boil with the Russian invasion of Ukraine shocking an already inflationary global commodities market. Rumors of progression in ceasefire negotiations have boosted markets today but regardless, the economic fallout from the sweeping sanctions will likely last for some time. In our last note we outlined from a high level what the market behavior was during past episodes of similar geopolitical turmoil. We also reiterated why having operating cash set aside and being able to ride out volatility is essential to long term investing. But just as important is understanding what you own and making sure the assets are fundamentally strong...

After 18 months of very little volatility a cascading series of events including the escalation between Russia and Ukraine have reverberated throughout markets causing our first 10% percent drawdown in large cap stocks since March 2020. I'm not going to try to predict the path of military actions in Europe but I can try to put into perspective what the economic impact might be from what's taking place in the region.

Geopolitical events by their nature are difficult to predict and tend to be short lived, although there are certainly exceptions.Outside of the commodities sector, Russia is a marginal player in the world economy accounting for only 1.3% of global GDP, and Ukraine makes up an even smaller portion. US exposure to Russia in terms of total trade is a very low 0.1% of GDP. The EU on the other hand sources roughly 1.5% of their total goods trade with Russia. The main exposure is that commodities are a global market with Russia accounting for about 10% of global oil production and the EU has become ever more dependent on imports for energy. EU imports have long represented over 90% of its oil consumption, while the natural gas import share has increased from roughly 50% in 1990 to also over 90% today. By contrast, the US has moved from importing over 50% of its oil & petroleum during the 2000s to being a net exporter today. So in theory the first order effect from rising energy prices should be modest to the overall US economy. Still, the second order effects of a shock to the already tight global energy market is what could be disruptive...

We believe we are in a transitory environment that will be increasingly challenging for bonds. With potential rate hikes in the future, it is important to have realistic expectations about bond returns as they are likely to be low in 2022. The image below illustrates the inverse relationship between bond prices and bond yields. Although the bond market is less volatile than the stock market, bonds also fluctuate in terms of price. You can see we have been in a 36-year bull bond market that has brought yields to record lows.

Although bonds typically provide portfolios with a safe haven from market volatility due to their low correlation to stocks, they don’t provide much protection against inflation. In fact, inflation is a major driver of volatility within the bond markets. With the Federal Reserve likely to raise interest rates multiple times in 2022 to combat inflation, investors have been concerned about a potential decline in bond performance. In fact, the Barclay’s Intermediate US Aggregate Bond Index was down -1.54% last year...

Market and Economic Observations

December 10, 2021

Covington recently presented their observations on the market and economy at our annual shooting event held at Pike Run Country Club. Please find our presentation commentary below...

Markets underwent a volatile session today on news that the WHO is monitoring a new covid variant detected in small numbers in South Africa called B.1.1.529. The new variant is purported to contain multiple mutations with increased antibody resistance and rattled markets on a thinly traded day with several of the cyclical & travel related parts of the market getting hit hardest.The development of rising covid cases is a risk to markets but the trend of the world economy recovering from covid is still intact even as new variants create speed bumps in the process. The Delta variant created a hiccup in the recovery earlier in the year but the economic risk ended up being minimal. With winter approaching I would guess that the world will continue its rolling two month cycles of rising and falling covid cases with a combination of antivirals and boosters eventually smoothing infections similar to the flu.

The WHO has said it will take weeks to understand how the new variant may impact transmission or react to vaccines. But for some perspective, South Africa still has very low vaccination rates with only 41% of the population receiving the jab. In most of the developed world vaccination rates are greater than 70%. Also, only ~ 80k tests per day are being administered in South Africa which means the sample size will need to be much larger before data is concrete. And while the new variant is worried to be more transmissible, death rates in South Africa are still very low which is encouraging . We’ll see if that holds in the coming weeks...

Last week, we had the pleasure of hosting our first board of directors meeting for the Laurel Highlands Workforce & Opportunity Center in their new building located at 310 Donohoe Road, Greensburg PA. My wife and I founded the non-profit organization to remove the barriers of structural poverty for individuals who are under and/or unemployed, or are in transition of employment. Our vision for the center is to serve as a hub of human services that will provide for the betterment of the human experience.

It is our hope to simultaneously address the labor needs of the businesses located in Westmoreland County. Our efforts will be collaborative, multi-faceted, and modeled after Bill Strickland’s Manchester Bidwell Center. To accomplish our mission we plan to leverage the talent and skills of our Board of Directors. Anne Kraybill, Executive Director of the Westmoreland Art Museum will be developing our arts program along with developing a music and video learning program with Endicott Reindl of the Westmoreland Symphony Orchestra. Dr. Christine Oldham, retired Superintendent of the Ligonier Valley School District, will be developing our curriculum and oversee our third-party childcare program. Dr. Dan DiCola will be our medical director and be developing our medical training programs. Tay Waltenbaugh will be supervising our social services programs, and Greg Daigle, while serving as our Director of the Center, will coordinate our manufacturing training programs for local businesses. Michelle Mcfall will serve as our student recruiter and Melissa Hipple will be serving the center as our medical program instructor...

Covid has disrupted supply chains in two major ways: surging demand for imported consumer goods in the west, and a decline in workers required to maintain and operate these supply chains. Over the last twenty years supply chains have relentlessly been pushed towards efficiency with the adoption of Just-In-Time(JIT) inventory management in addition to the integration of global component sources. This Evolution has dramatically increased efficiency but has come at the cost of fragility. Covid constantly flipping the on/off switch on these supply chains has exposed this weakness. Shipping is the nexus of the issue. It usually takes 40 days to transport a container from a factory in China to a store in the US. At the moment it takes 73 days meaning goods ordered today may not arrive by the Holidays. Consequently, price of shipping has jumped. Both the Shanghai Shipping Exchange Containerized Freight and the Baltic Exchange Freightos Container indexes are reading at historic highs. Just recently the port of Los Angeles announced they are going to start running at 24 hours a day to ease the cargo backlog but this won't solve the problem overnight. ..