The year 2022 will be remembered as one of the most difficult for investors in many years. Normally when the stock market struggles investors find refuge in the bond market. Last year was one of the few where both stocks and bonds had significant losses. From the classic 60% equities 40% bonds allocation, there was a 17.5% loss, the worst year since 1937 and the third worst year in history. The U.S. bond market had its worst year in history with a 13% loss. The 19.45% loss for the S&P 500 was the seventh worst year since the 1920’s. The NASDAQ was down 33% last year with bellwether Apple down 27% (off $1 Trillion from it’s high), Amazon down 50% and Tesla down 65%.

With 2022 in the history book, what about 2023? The stock market has only fallen back to back years four times: the Great Depression, World War II, the 1970’s oil crisis and the 2000 dot com bubble. In every case the second year fall was deeper than the first year. When you consider last year’s market peak resulted in the most expensive market in history, one should not be surprised if 2023 is very challenging.

At Old West we spend the vast majority of our time researching individual companies, doing deep dive quantitative and qualitative analysis. Having said that, macroeconomic factors and events cannot be ignored, and actually create tremendous opportunities as well as challenges.

After years of low interest rates and little inflation, the big challenge for the Fed will be how to control inflation without damaging the economy. It has been over forty years since the Fed has been put in this predicament, and studying the time period of 1965 to 1980, you learn that inflation can be very stubborn and difficult to control.

Arthur Burns was the Fed chair from 1970 to 1978, and he is best remembered as the Fed chair who was influenced by politics and public opinion in his inability to stamp out inflation. Average wholesale prices rose 4% from 1968 to 1972 and 10% from 1972 to 1978. The year-over-year consumer Price Index rose to 11% in 1974, fell back to 6% to 9% the next four years, and then rebounded to 11.4% in 1979 and 13.5% in 1980. It took the appointment of Paul Volcker as Fed chair in 1979 to raise the Fed fund rates to 20% in 1980 and finally control prices. By 1983 the C.P.I. was back to 3.2%.

Is the current Fed chair more like Arthur Burns or Paul Volcker? Time will tell, but my hunch is Jerome Powell will not give in to political pressure and public opinion, and he will have the resolve to clamp down on inflation. Powell, who was at one time a partner at private equity firm Carlyle Group, does not need this job, was recently re-appointed for another four year term, and will be primarily concerned with his legacy and doing what’s right for the country. Perhaps my view is a bit Pollyannish, but Powell is well aware of the persistence and stickiness of inflation. The Fed has created three massive bubbles this century, so it remains to be seen if they have the ability to raise interest rates and drain liquidity from the system without causing a severe recession.

Stock market bulls believe inflation is quickly subsiding and the Fed will soon stop raising rates and eventually begin reducing them. A counter argument would be the other half of the Fed’s dual mandate, maintaining full employment. There are currently 10.7 million job openings in the U.S., not far off the record high and nearly two times the number of unemployed people looking for work. A survey of small business owners showed 46% are unable to fill job openings, double the historical average. This will add to wage pressure which will add more fuel to the inflation fire.

A deflationary force that might come into play in 2023 is the state of the American consumer. I keep reading that Americans have trillions in savings, but those trillions might be in the hands of a subset of people. A recent U.S. Bureau of Labor statistics survey found that 41% of Americans are having difficulty paying for essential household expenses versus 29% one year ago. Also, credit card balances rose 15% year-over-year recently, the biggest increase since the 2001 recession. The personal savings rate recently hit a 17 year low of 3.1%. With the consumer being the driving force behind the American economy, a stretched consumer might negatively affect corporate earnings in the coming year.

Interest rate cycles last 20 to 40 years, and rates bottomed in 2020 when the ten-year treasury hit 0.54%. That was the end of a long bull market in bonds that began in 1981 when the ten-year peaked at 15.3%. We are more than two years into a bond bear market as the ten-year has risen to 3.6%. The U.S. has a $26 trillion economy, and we currently have $31.4 trillion of government debt, giving us a 122% debt to GDP ratio. The debt to GDP ratio was 34.7% in 1980 and 55% in 2000. With the recent increase in interest rates, the U.S. government interest expense on its debt is up 87% year-over-year. This will increase the borrowing pressure on the U.S. Treasury to fund this expense, not to mention the fiscal onslaught of spending including the recently passed $1.7 Trillion omnibus spending bill. The need for capital to fund spending is not unique to the U.S. European Union countries have outlined greatly expanded borrowing needs for 2023, as has Japan and China. All of this borrowing will keep upward pressure on interest rates in the coming year.

To tie all of this together, I do expect the Fed to continue raising interest rates to get a handle on inflation which may dramatically slow the economy and negatively affect corporate earnings.

For the past decade, trillions of dollars have poured into the stock index funds and investors have done very well with passive investing. There may have been a sea change the past year where active investing comes back in favor. Our portfolios are full of companies selling at large discounts to their intrinsic value with bright prospects, regardless of the macroeconomic risks I have discussed in this letter.

Joseph Boskovich, Sr.
Chairman and Chief Investment Officer