Newsletter - 4th Quarter 2022

RECAP

Both stock and bond investors are happy to turn the page on 2022. Despite their early fourth-quarter rally, stocks ended the year much as they started, with the bear market fully intact. The S&P 500 finished the year lower by over 18%, while the Russell 2000, an index comprised of U.S small-cap stocks, lost nearly 21%. The technology-heavy Nasdaq 100 composite was the worst-performing of the major U.S. indices posting over a 32% decline.  2022 was a challenging year for stock investors, with equity markets posting their 2nd worst decline in the past 40 years. The environment was even more difficult for bond investors, with the Bloomberg Aggregate Bond Index ending the year 13% lower. This marked one of the worst years for the U.S. bond market. 

Even though bonds fared better than stocks for the year, investors in balanced portfolios did not receive the typical diversification benefits of bonds as they did in prior equity bear markets. This resulted in balanced portfolio returns posting their worst year since 2008.  As investors enter the new year, they can take solace in the notion that markets may have already discounted much of the negative sentiment surrounding the economy, inflation, and the Fed’s interest rate policy.

While yearly results were disappointing, the 4th quarter provided some noticeable market improvements compared to where the 3rd quarter ended. During the quarter, the S&P 500 and Russell 2000 recovered roughly 7.6% and 6.2%, respectively. The Nasdaq 100, on the other hand, finished the quarter flat due to the headwinds faced by the technology sector. The U.S. bond market recovered some of its prior quarter losses, with the Bloomberg Aggregate Bond Index finishing up 1.6% for the last three months of 2022.

For 2022, it seemed that the Federal Reserve and the markets were at odds with one another. As inflation hastened earlier in the year, the Fed faced playing catch-up with its interest rate policy. 

The Fed acted by delivering 4.25% of rate increases over a 10-month period which is now the most aggressive hiking period in history. Although the Fed’s rate policy helped to combat inflation, it also contributed greatly to recession concerns in the midst of a slowing economic backdrop. 

The tug-of-war battle between the Fed and the markets seemed to subside in the fourth quarter as the Fed’s efforts finally began to show inflation slowing, with the November annual reading coming in at 7.1%. This gave ease to the markets that the Fed was close to bringing inflation under control and that the pace of rate hikes may very well ease for subsequent meetings.

As we enter 2023, many risk factors remain for investors, particularly the continuation of rising interest rates and the speculation of it, how long, and how deep of a recession the U.S. and global economy could see in 2023.

INFLATION & THE FED

In their efforts to use interest rate increases to lower inflation, the Fed raised interest rates twice in the fourth quarter of 2022. In November, rates increased by 0.75% for a target rate range of 3.75 – 4.00%. Then, as planned, the Fed again raised rates at the December meeting. However, because inflation started to show potential signs of slowing down in the months prior, the Fed raised it by only 50 basis points for a target rate range of 4.25 – 4.50%. This marked a 4.25% total rate increase in 2022, the fastest upward cycle of interest rates in history.

Results for U.S. inflation peaked in the fourth quarter, and headline and core Consumer Price Index (CPI) readings showed significant year-over-year declines to close out the year. The annual U.S. inflation rate for the 12-month period ending November 2022 was 7.1%, down 2% from June’s 12-month high of 9.1%. This denoted progress in the Fed’s fight to slow the rate of inflation down.  (Source: usinflationcalculator.com)

The labor market remains a key factor in how the Fed will adjust its attack on inflation and when and how fast it will change policy. Job growth remained strong in November, keeping the unemployment rate at 3.7%. At their December FOMC meeting, the Fed predicted a rise in the unemployment rate, looking at 4.6% by the end of 2023. Later in the month of December, the unemployment rate moved to 3.5%.

(Source: Bureau of Labor Statistics)

US ECONOMY

U.S. economic growth started the year on a fragile footing, with real GDP showing a slight contraction in the first half. Calls for a formal U.S. recession were, of course, challenged by many economists as the metrics of consumer spending, personal incomes, and industrial production conflicted with this assessment. The 3.2% 3rd quarter real GDP reading helped to alleviate concerns of an official recession further. As of its most recent estimate, 4th quarter GDP growth is expected to reach 4%, according to the Atlanta GDPNow forecast. In most environments, readings at this level would normally not coincide with a recession in the near term. 

When assessing the health of the U.S. consumer and the probability of a recession, there remains some conflict across economic data. On one hand, the U.S. labor market is still showing signs of resilience, with the rate of employment ending the year near historic lows. Wage growth also supports the consumer, as this annualized reading was close to 6% for the quarter. On the other hand, inflation is still outstripping any wage gains workers have received for the year. This can be seen in the U.S. personal savings rate, which has shown a steady decline throughout the year and for the quarter. Although the U.S. consumer is very strong when assessing the labor front, the negative wealth effect created by high inflation has eroded consumer confidence, as evidenced by the University of Michigan Consumer Sentiment Index. This gauge did show noticeable improvement from the prior quarter’s lows, with a reading of 56.8. However, this sentiment barometer is still near some of its lowest levels in decades. We will keep a close watch on these metrics to see if the Fed successfully averts an economic slowdown.

US STOCKS

U.S. equity markets started out strong for the 4th quarter of 2022, with the S&P 500, Russell 2000, and Nasdaq 100 gaining in the double digits by the end of November. Even though inflation remained elevated, the cooling CPI readings gave markets hope that the Fed would be poised to pause or at least lower their December rate decision. As the December meeting approached, the Fed’s hawkish rhetoric caused markets to give back a good portion of their gains for the quarter, with most major indexes retaining higher single digits gains to close the quarter.

In looking at the components that comprise the market, the dichotomy of elevated but cooling inflation led to noticeable return differences across equities. The high run rate of inflation continued to favor cyclical-oriented sectors, whose business models benefit from inflation-driven revenue growth. The sectors in this space that led for the quarter were energy, industrials, materials, and financials. Growth–oriented stocks, which tend to react negatively to rising interest rates, underperformed their value/cyclical-oriented peers as the outlook for additional rate increases hampered their return outlook. The laggards in the growth space for the quarter were consumer discretionary, communication services, and real estate stocks. 

U.S. stocks closed the year in a fairly valued range, with the S&P 500 trading at 16.7 times 2023 earnings. The trend in earnings growth has been disappointing for 2022, with the first three quarters showing a steady decline in the growth rate. With 4th quarter earnings season on the horizon, analysts expect a further deterioration in earnings but still indicate slight growth. This comes as no surprise, given the high inflation rate and the higher cost of borrowing that consumers and companies had to endure in 2022.   Despite the trend of earnings for the year, the overall growth rate for 2022 is still expected to be above 3%.

US BONDS

U.S. bonds provided a nominal positive return in the last three months of 2022. Unfortunately, the pace of Fed rate hikes and inflation left bond investors with one of the worst years of return on record.

At the beginning of the quarter, bond prices continued to be pressured by the threat of more hawkish Fed policy and higher inflation. This caused the bond market to reach its lows for the year in late October as the odds of a fourth 0.75% rate hike increased to 100%. However, after the November meeting passed, the inflation data started to show signs that the Fed’s policies may finally start to bring inflation under control. This gave markets hope that the Fed could pause or even lower its rate hike trajectory stoking a rally in bonds and allowing the bond market to recover some of its losses for the year.  Returns varied across bond sectors for the quarter. The decline of inflation expectations favored more credit-sensitive bonds as the prospects of credit downgrades and defaults waned.

High yield and investment grade corporate bonds led the bond market to post returns in the mid to low single digits. Mortgage-backed securities also outperformed the broad market by a slimmer margin in response to falling mortgage rates. U.S. treasuries underperformed for the quarter as investors embraced a risk-on sentiment.

Bond yields responded accordingly to price movements during the quarter. Yields initially rose across the maturity curve at the start of the quarter in anticipation of the Fed’s November rate hike. However, as the prospects of easing inflation gained, yields fell, with longer-term yields falling more than short-term yields creating a steeper inversion of the U.S. treasury yield curve (when short-term rates are higher than long-term rates). At the peak of its inversion in December, U.S. 2-year treasury bonds yielded almost 0.84% more than 10-year treasury issues. This is one of the largest yield differences between the two maturities in 40 years.   The yield curve has been inverted since early July, and many economists have referenced this occurrence as the foreshadowing of an economic slowdown. However, there are still some economists that believe the extent of the inversion is more a function of the Fed's aggressive rate policy.

MARKET OUTLOOK

As we look to 2023, equity analysts expect corporate earnings to decline nominally in the first half as the effects of high rates and inflation continue to strain demand and corporate profit margins.

However, if the Fed manages to tame inflation during the first two quarters, this could set the market to a higher growth rate trajectory later in the year. Additionally, when reviewing the negative equity performance we experienced last year, the markets may have already priced in this information to a strong degree.

The risk of a recession remains front and center. Many analysts fear the Fed’s hawkish moves to fight inflation at the expense of economic growth may drive the U.S. into an inevitable recession. However, at the December FOMC meeting, the Fed is still forecasting a slightly positive economic growth rate for 2023. 

Fed Chair Jerome Powell suggested that in 2023 we may not see as sharp increases as in 2022 when rates were quickly increased to jump-start the Fed’s key weapon to fight inflation. 

It is likely that at the Fed’s first meeting on February 1, 2023, they will continue to raise rates, but potentially by a smaller percentage point than we have seen in the past several rate changes. Regardless of how the Fed adjusts its tactics, it is expected to continue a tightening approach until they see a weakening in the labor market. This occurrence has usually coincided with falling wages and, with that, lower inflation.

Inflation may be cresting, particularly as energy prices decline and large companies begin to trim their workforce. These are all encouraging signs that the Fed is making headway in combating inflation. However, we also believe that there is a risk that the Fed’s fight against inflation could take longer than expected. 

Against this backdrop, we believe there are two ways markets can recover from here. The first scenario we see is that earnings and the economy manage to stay resilient in the wake of the Fed’s rate policy. The second is that 1st quarter inflation strongly decelerates, allowing the Fed to pause or even become contractionary. However, markets could be subject to additional volatility if we encounter a large breakdown in corporate earnings or a reacceleration of inflation. While we believe that a large downgrade in earnings is a less likely scenario, we do believe that China’s economic reopening could pose a threat to higher global inflation, which would force the Fed to hike rates beyond their target.

With 2022 over, there are still many obstacles to navigate in the year ahead. In the short term, the uncertainty and volatility of markets may cause investors to question their long-term investment plan. During such times, investors may be tempted to stray from their long-term asset allocation and move their investments to cash. We always caution against attempting to time the market. Investors that attempt this task tend to do so on emotion and usually execute their sales near market lows.  Conversely, when markets recover, these same investors usually buy back into the market at a much higher level from where they sold. This type of behavior runs contrary to one of the most important principles of investing: buy low and sell high. Before making any changes, we always advise that clients contact us to review their financial plan to make sure that their strategic asset allocation is in line with their long-term goals.