Financial markets in 2023: Aggregate demand and inflation.

• Author: Rhoads, Russell

Last year, our financial forecast for 2022 mentioned that there was a "significant chance of a negative return." Unfortunately, we were right about that. The stock market has lost about $10 trillion from this time last year. Surely, everyone has felt the loss in their savings and 401(k) plans, but it is shocking to see the largest negative return since the crash of 2008, with the market dropping more than 20%. As we predicted, value stocks outperformed growth stocks, but this is cold comfort since both were down and "outperformed" only means smaller negative returns.

Fixed income has also had a very rough year. Corporate bonds are down about 15% and U.S. Treasuries have had negative returns of between 6% and 12%, depending on the term to maturity. Of course, the negative returns are due to more than doubling interest rates. Interest rates on three-month U.S. government debt is up 419 basis points (from near zero to 4.22%), while 30-year government debt is up 191 basis points (from 1.88% to 3.89%). Yes, the term structure is "hump-backed," with short-term rates rising to roughly 12-month debt (4.67%) and then declining for long-term maturities.

In short, there is no place to hide. Unless you put your wealth in cash last November, you lost. Of course, on a real return basis, that cash is worth less than it was a year ago.

The returns from the previous five years make 2022 especially painful. When we gave this report last year, the stock market was at historic highs. The value of all common stock was $49 trillion, 32% above where it was in 2020. Certainly some of this stunning return was due to recovery from the damage done by the pandemic, but not all of it. Between 2016 and 2021, we saw a compound growth rate of 15.9%. This was one of the strongest fiveyear periods in U.S. financial history, which was remarkable given that we had two very different political administrations, a politically divided country, a pandemic, trade wars with many countries and growing inflation, not to mention supply-chain bottle necks.

Then it all fell apart and no, we are not talking about cryptocurrency or FTX. We are talking about the value of American firms.

What will happen next?

First, the Federal Reserve has raised interest rates, specifically the federal funds rate, six times in 2022 (see Table 1).

This is obviously in response to increasing inflation. Given that the growth rate for inflation has, maybe, possibly stopped increasing (or at least the rate has stopped...