Transcript:

Hello, everyone, and welcome. And on behalf of AB, I’d like to wish you all a belated welcome to 2023. And on behalf of the capital markets, I would like to bid a good riddance to 2022, which on the back of rising bond yields and falling valuations generated one of the worst combinations of market returns in four decades. At the center of it, the story that we all know too well by now, the Fed’s pursuit of fighting historically high inflation through aggressive tightening, which was magnified in the beginning of 2022 by Russia’s invasion of Ukraine and pushed higher still by the impact of rising home prices and rents, generating the returns that you see here.

However, there was another story inside of this chart. I’ve talked for some time about two inflection points. Both would matter to markets, the first being when the Fed would acknowledge or markets would realize that they were nearing the end of their tightening cycle. In the third quarter, we got a little bit of a head fake where markets thought the Fed would turn its attention to growth only to be strongly rebuked by the FOMC, resulting in the round trip in returns that you see here. However, in the fourth quarter, that nearing-the-end-of-the-path message was confirmed, generating very strong returns. Now, the Federal Reserve clawed back some of that on two important points: one, that the terminal rate would likely be higher than expected, and two, that it would stay there for a longer period of time. Nonetheless, fourth-quarter returns across assets were very solid.

So how should you think about 2023 as an investor? Well, the story of 2022 was one of how high the Federal Reserve would raise rates and, in turn, what the magnitude of the negative impact on bonds and valuations would be. The story of 2023 has shaped up to be the question of what impact those higher rates for a longer period of time will have on growth and therefore earnings. Put another way, the story of 2022 for equity investors was how high and its impact on the P in P/E; 2023 is about for how long and its impact on the E in P/E. Which leads us to our first important disagreement in markets: How large will the hit to earnings be? Interestingly, if you had looked at earnings estimates at the beginning and the end of last year, they would basically look unchanged. But the story’s in the path, particularly in the back half of the year, as expectations were radically reduced.

Today, those expectations are broad in terms of what the market expects, but many expect it to fall much further. And so one way to think about it is to go back to our choose-your-own-adventure chart. Remember when this was created at the beginning of last year? It was to try to dimension the wide range of S&P forecasts for 2022 by focusing on the driver of that range, the P, or earnings multiples rather than earnings themselves. As it turns out, that’s what transpired, is earnings finished where they started and valuations contracted significantly. Now, as you consider the S&P’s price level in 2023, instead of the horizontal line, focus on the vertical, because that’s where almost all of the initial action’s going to be. And what’s going to drive that? The second big disagreement: the ultimate path of inflation this year.

As a reminder, when we came into this inflationary period, it was first on the back of goods prices driven by COVID, a radical change versus history, as our economy is largely services-based. Remember then? You get a Peloton and you get a Peloton and you get a Peloton. That was replaced earlier this year by Russia’s invasion of Ukraine and the impact on the so-called headline components—food and energy—ultimately then again giving way to shelter or housing-related inflation. Now, as the first two have fallen away and shelter is expected to do the same later this year, we’re now left with the final corner that the Fed is talking about, which is services outside of housing—things like medical care, transportation, food away from home, etc.

And why should you care about that? Because this is a potentially sticky form of inflation. As history says, it’s tied to wages and jobs. And since wages and jobs are very strong, the Fed believes that the only way to tackle the potential for inflation coming from here is to reduce consumption by slowing the jobs market and in turn slowing growth in earnings. Hence, our two big disagreements, the path of inflation and earnings, are tied to each other. Which leads to the two main questions I receive: One, what should I watch? And number two, what should I do? What should you watch? Well, from an inflation perspective, inflation’s been coming down for the past few months, and so clearly we’re going to want to watch the path of inflation.

One thing that Fed watchers are also looking at is the nearer-term inflation numbers—not the last 12 months, but the last three. And you can see that that’s a little more sharply down. It’s those replacement numbers that are going to make a big difference as older months are replaced by newer months. This is our choose-your-own-adventure inflation chart, if you want to see how that works out. If we take assumptions about what monthly readings might look like over the next six months, you’d get a sense of how quickly the path of inflation would come down. So watch that month-over-month switch. And also, of course, because it’s the Fed’s goal, keep an eye on the jobs market. One, how many jobs are being added versus the baseline amount needed to absorb new entrants? Too big of a gap between the two will keep the Fed tight. And number two, you don’t necessarily have to reduce jobs. You can also reduce job openings. Today, there’s a very large number of open jobs, so look at both of those to determine whether or not we’re making headway.

And what should you do? The first thing that I would tell you is to first look toward 2024. Because while there’s a great deal of disagreement about the path in 2023, the market believes inflation is coming down quickly and rate cuts will happen this year, while the Fed believes inflation will take much longer to come down and expects no rate cuts this year. They are much more aligned as we get into the following year, 2024, where both expect normalizing (aka the world before COVID), growth and inflation, and they expect multiple rate cuts by that time. Why that should matter to you as an investor is because in a normalizing world complete with falling rates, that lends itself to higher bond returns, multiple expansion and modest earnings growth and, therefore, of course, strength in equity markets.

Today, it seems as though everyone is trying to be a market timer because we’re trying to guess when it’s good to get in, and that’s a very difficult proposition. So I would instead ask for you to imagine a point that might be two years out as we make our way to our normalization rather than trying to guess the entry point. And there’s a bit of a warning as well here, because the second inflection point that I mentioned earlier is when the Fed first begins to talk about when it might cut rates. And when that happens, markets could move quickly. In other words, there are opportunities for investors today, but we need to be careful not to market-time ourselves to a point where, as my grandpa would say, all the good getting’s been gotten.

Now the devil’s in the details when it comes to portfolio construction and there are areas that we consider more attractive, and we will continue to share those details with you as we go. But at a high level, for thoughtful investors, I believe that this is an opportunity to put together a portfolio with meaningful return expectations over a two-year horizon. As always, thank you for joining. My best to all of you for a healthy and happy new year, and we will see you next quarter.