Pitfalls & Pitch Calls: A recession or a new hope in 2023?

This article first appeared in Wealth, The Edge Malaysia Weekly, on December 26, 2022 - January 08, 2023.
Pitfalls & Pitch Calls: A recession or a new hope in 2023?
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Amazon was the darling of the stock market in 2020 and 2021. The online e-commerce giant was riding on the Covid-19 stimulus cheques that the US government sent to locked-down Americans. Many of them were sitting around without much to do but shop online. As the cheques were cashed, Amazon’s share price rose more than two times from the low in March 2020 to the high of the summer of 2021.

The strong demand clogged the supply chains of many factories. Dearer goods followed. The US Consumer Price Index (CPI) is a gauge of how much prices changed for a basket of goods and services. It was a mere +1.3% in December 2020 from the December before. By the end of 2021, it had risen more than five times to a whopping +7%.

US Federal Reserve chairman Jerome Powell is mandated to ensure there are jobs for Americans and the prices they paid at the stores were not too high. He began to raise the fed funds rate, the key interest rate that all other interest rates, such as those of housing or business loans, are based on. A higher fed funds rate means less money for the consumer to spend or for the businessman to expand.

Powell thought the rising prices were only temporary, like the monsoon rain. Supplies would come back as factories reopened and people went back to work. Rising prices, like flood water, would recede in time. But this time, it didn’t. Workers with cash from the support given during the Covid-19 pandemic weren’t ready to get out of their sweat pants. 

Then, Russian President Vladimir Putin decided to invade Ukraine. The monsoon flooding got worse. Powell stopped using the word “transitory”. Inflation, as it turned out, was getting away from him. He needed to get the rising flood water under control. If the high interest rate went on to crush consumer demand, stop new hirings and jumpstart a recession, he would accept that as what was needed to stop the monsoon floods.

Long Covid or post-lockdown recovery?

Looking at past US recessions, the previous Fed chairs almost always caused a recession with their control of the fed funds rate. Recall that a higher interest rate, among others, means less money to hire new workers to expand the business. 

History shows that in good times, the number of people without work starts small and then rises before a recession begins. This has happened 13 times in US history. Each time there was a boom, the unemployment level stopped falling, flattened and started to move up. And a recession followed soon after. 

Applied to the present day, layoffs have been announced by quite a few industry leaders such as Amazon, Goldman Sachs and FedEx. It would be a good idea to watch the US unemployment level in 2023 for signs of the start of a recession. 

Investors are not waiting to find out. Those who believe history is like a merry-go-round have sold their shares. The S&P 500 is down more than 15% (over 20% at the lowest point) this year due to “flood mitigation”, that is, rising interest rates. During past recessions, share prices fell an average of one-third, or 33%. Simply put, stocks have fallen almost halfway to the point where investors will start looking to pick up some bargains for their retirement portfolios. 

The concept of price-earnings ratio (PER) is a measure of a listed company’s value, its share price against its earnings. Using the concept of PER to gauge whether stocks are expensive, compare the PER of 23 times in March 2022 and now. After share prices have fallen 15%, the PER is now just below 20 times. The PER is lower, suggesting a bargain.

Share prices have fallen. What about earnings? Business profits move up in a growth year, and down in a recession year. And a recession may be coming in 2023. This means earnings will fall. If prices fall and earnings fall soon afterwards, the PER stays the same, suggesting that the stocks are not cheap at all. Share prices have only fallen ahead of earnings. 

What to expect in 2023

Investors should expect companies’ earnings to fall in 2023. They will fall for two reasons. First, the strong US dollar. Second, the high prices of materials and rising wages.

High interest rates mean higher mortgage payments. They also mean higher deposit rates. Investors outside the US looking for higher returns have been flocking to the US dollar to earn a higher return. This thirst for the greenback has pushed the exchange rate higher. For example, the US dollar strengthened against the ringgit by almost a fifth, or 20%, from 4.00 to 4.75 (the low in 2022) as the greenback has been the darling currency of investors this year. 

This has had a bad effect on US companies with profits earned outside the country. When the company accountants bring the profits back, they are exchanged for fewer US dollars. The companies on the S&P 500 derive an estimated one-third, or 30%, of their earnings from outside the US, while those on the technology-focused Nasdaq have an estimated half, or 50%, of their earnings from outside the country. These overseas profits will shrink due to the strong US dollar. On the other hand, a weaker greenback means the profits will shrink less.

High prices of materials and higher wages means the rising flood levels are getting worse from the clogged supply chain and the invasion of Ukraine. US companies’ profits will fall because they now pay more for materials and labour. The earnings estimates of US companies are not fully showing that profits in 2023 will be eaten up by higher input costs. Though, to their credit, some companies have cut back on hiring and a few have announced layoffs to keep profits stable. Similarly, if Russia and Ukraine manage to talk peace and supply chains clear up, their profits will fall less.

For investors looking for a bargain, patience pays well. Investors should look for lower earnings followed by lower share prices in 2023 before concluding that stocks are like grapes during a vineyard harvest. For a better retirement, do the hard thing, which is nothing.

If, on the other hand, the best things happen in 2023, the flood levels drop and peace comes to Europe, then the grapes will be ripe. That would be the time to put more into your retirement portfolio. 

My best wishes of hope and joy to you for 2023.

Michael Lai is executive director of wealth advisory (wealth management) at OCBC Bank (M) Bhd