Chairman’s Letter, Q4 2022

How high will the Fed have to raise interest rates? How long will they have to stay there? Will an economic slowdown suffice or will the US fall into deeper recession?




January 1, 2023

The 2023 economic outlook for the US is locked in. The Federal Reserve’s goal is to push the rate of inflation back down to 2% over the next few years. It will do this by keeping money expensive enough and for long enough to restrain economic activity.

The questions: How high will the Fed have to raise interest rates?  How long will they have to stay there?  Will an economic slowdown suffice or will the US fall into deeper recession?  

Right now, most forecasters expect interest rates to rise at least ½ point higher and stay at that level all year. The economy is mostly expected to suffer a mild recession. These all seem to be reasonable expectations with which to forecast this year’s sluggish economic trajectory. 

What could go wrong? 

First, economic growth could prove more persistent than expected. Not only did the economy expand much faster during the second half of 2022 than the first, but also the economy will receive additional support next year as federal government spending surges. The $1.7 trillion U.S. government funding bill for 2023 increases defense spending by 10% and discretionary spending by 6%. At the same time, social security, and disability benefit checks to 70 million recipients will rise by 8.7% starting this month. In fact, the increase in recipients’ disposable income will be even larger because Medicare insurance premiums, which are deducted from these checks, will decline this year because the hikes implemented in 2022 turned out to be considerably higher than needed. Add in lower fuel costs, and the consumer which is 70% of the economy, has a bit of a tail wind.

Second, Inflation could moderate quicker than expectations, and economic activity might moderate sufficiently, particularly where the greatest excesses are causing problems. This would stop interest rate increases sooner than expected, and lead investors to speculate on lower interest rates sooner than current consensus.

So, what should one watch going forward? Focus on the labor market. To get inflation in check, Fed officials need to drive wage inflation down to a range of 3% to 4%. The common wisdom is that unemployment needs to rise to the point that people are more focused on keeping their jobs than demanding pay increases. This seems like a good bet to us given recent trends. Those nasty interest rate increases are doing their job.

In ‘modern finance’ bad news for Main Street (job losses) is good news for Wall Street. As long as the news doesn’t get too bad, then the phrase “goldilocks recovery in 2022-3” will be the new narrative. This would be the positive surprise that few are considering now.

Right now, investors want bad(ish) news, so interest rates won’t go higher. This “investor class” is focused on interest rates, not long-term business considerations. This perverse scenario usually happens when people have been a little careless with money. Lately, because money was free.

What about my stocks?

Financial commentators must live with their pronouncements.  History can be a cruel tool. One year is no measure of a company’s nor an advisor’s success, and this past year is no exception. What happens in any given year can look horrible—in retrospect. It’s the future that counts, and in that, it comes down to the company you pick. 

Cruel historical pronouncements:

Steve Jobs was fired from the company he founded. When Steve Jobs died, Apple was ‘doomed’. Today the company is valued more than $2 trillion.

In 2007, Yahoo tried to buy Facebook for a $1 billion, and they were lampooned as fools. It went public 5 years later at $140 billion valuation. Yahoo is MIA. Today, Facebook is at the same value as 2016, yet its profits are 4x what they were back then. Today, the hatred of Meta (actually, mostly just Zuckerberg) is almost as thick as pea soup. The grave diggers are dancing, yet the company continues to be in the top 5 of profitability and is investing to keep that fortress of profitability. Commentators’ dim views of its vision are reminiscent of what got Steve Jobs fired.

Speaking of vision, Amazon was a stupid idea that never made any money. Even after having fallen 51%, in 2022 its still worth about 1 trillion dollars. Amazon will report record profits and revenues in 2023 and its being valued at less than it was in 2019 and its profits are 2X what they were that year. Today people worry the company will only grow 14% this year.

Amazon Web Services (AWS) was thought a stupid idea. Today AWS is the largest and most profitable supplier of computer power in the world with revenues greater than $80 Billion last year. Good thing Jeff Bezos doesn’t take advice from stockbrokers and journalists. 

Movie streaming was a stupid idea when Netflix ditched Cassette tapes. At the end of 2021 it was estimated there were 1.2 billion streamers in the world. Once again, the common narratives of pontificators were slightly off…

Why the defensive ramblings? Because the companies you own, are being valued lower than the end of the previous year. We warned this could happen, we did not forecast it, nor for the most part did we act on our concerns because: 1. We, like most everyone, are lousy at calling tops, bottoms, or prices 1-year forward, and 2. We felt that the long-term future of the companies you own are better than average. 

I am happy to report that the companies you own have collectively improved their combined profitability by 40% since 2020 and 4% in the past year. So, things have slowed a bit from incredible growth, but by no means is it a disaster. Despite this good business outcome, stocks on average are down 20% last year. One might say that some pessimism is baked into the new years cake?

Investors can be impatient; some try to dodge in and out in anticipation of some event. Others, skip from one hot sector or innovation to another. It can be great fun to watch—from afar. The past few years have seen crazy behaviour; marijuana, crypto, NFT’s, meme stocks, Elon Musk—all have come or are coming to their ‘meeting with Jesus’ moment. We do not do that stuff.

In the end, you own an interest in a business that has been and will continue to be valued over time based on profits, and the good news on that front is there is little evidence that temporary stormy economic data will affect the long-term might of the businesses you own.

Last year, I said I would not be surprised if investors finished on a sour note. I will go out on a limb and state that I would not be surprised if investors finished this year on a more positive footing. Its not a forecast but one should always consider the fact that good companies tend to appreciate overtime.