By Daniel McGarvey, Portfolio Analyst
2022 Market and Economy Review and 2023 Look Forward
In a year marked by high inflation, aggressive monetary policy and global conflict, the losses capital markets experienced in 2022 were unfortunate but understandable. The S&P 500 returned -18.1%, and the Bloomberg Aggregate Bond Index had its worst year since its 1976 inception at -13%. The 10 Year Treasury Rate rose from 1.63% to 3.88%, and the yield curve remained inverted for almost the entire second half of the year.
Although inflation appears to have peaked last summer, the most recent personal consumption expenditures (PCE) print of 5.5% shows that it is still uncomfortably high. Because it was sticky throughout last year, the Federal Reserve had to pursue its most aggressive tightening cycle in decades, raising the target federal funds rate by 425 bps since last March. The Fed remains intent on tackling inflation, even at the risk of a recession, and futures markets expect the effective target rate to peak near 5% by mid-2023 (as of 12/30/22). The continued deep inversion of the three-month and two-year treasury rates over the 10-year is also indicative of a coming recession.
A minimum condition for monetary policy to truly be considered “tight” is that rates should exceed inflation, so we expect that the Fed will have to continue tightening and then stay restrictive throughout 2023. The labor market is still overheated, giving them more of a runway to keep tight policy. Prior policymakers have made the mistake of loosening too early before inflation was thoroughly vanquished, and this board seems keen to avoid that error. As such, it would not be a surprise to see a 2023 recession that the Fed chooses not to step in quickly and fight against. The market only expects inflation to be around 2.33% in the next five years, indicating that investors believe the Fed will accomplish its goal (see chart below).
These increased recession odds and continually increasing rates have weighed on equities as they face the threat of lower future cash flows, which must be more heavily discounted. Some of the companies hit hardest were prior high-flyers like Meta, Tesla and NVIDIA, which all lost over half their market cap in 2022. Many other speculative corners of the financial markets had a year of reckoning as well, including cryptocurrencies, which unraveled through the FTX scandal.
After many years of higher risk easily translating to higher reward, last year was a reminder that speculative excess cannot build up forever. Contraction mainly came from the denominator of the PE ratio, and we believe that going forward, pressure could switch to the numerator. However, we are encouraged that returns can still be positive in years of declining earnings (see chart below).
The pain of losses has been felt worldwide, especially as European and emerging markets continue dealing with the ramifications of the Ukrainian invasion and devaluation of their currencies. We wish there were a peaceful end in sight for the war, but it appears the conflict could keep lingering for months to come, resulting in a rather drawn-out return to normalcy for energy markets. The U.S. Dollar also has room to strengthen from its short-term oversold condition, especially if the war persists and the Fed continues raising rates.
On the real estate front, housing showed substantial weakening in 2022, as evidenced by declining housing starts, fewer mortgage applications, and the worst stretch for existing home sales since 1999. Although they have regressed from their October peak, 30-year mortgage rates are still above 6% and unlikely to fall much further as rate hikes continue. It would not be a surprise to see continued housing weakening and lower home prices next year, although a major crash is unlikely.
A welcome development for investors was the passage of the Secure Act 2.0 in late December, which aims to boost retirement savings. Major provisions include expanding 401k automatic enrollment, raising RMD ages, increasing catch-up limits, and improving tax credits. There are a great deal of other provisions as well, many with administrative implications for employers, which our retirement team can help shed light on.
Investment Allocation
Although there were very few equity classes left unscathed last year, we finally saw the significant outperformance of value over growth that we had been expecting. We also saw outperformance of large caps over small caps and, interestingly, international over domestic stocks.
Despite recent outperformance, we still favor value over growth throughout the cap spectrum. We especially prefer high-quality dividend growers over speculative high-beta companies and are concerned about the market’s top-heaviness. We are attracted to the valuations of small caps, especially because they tend to outperform inflation, but we are still cautious because they also tend to underperform in recessions.
As was the case throughout 2022, the international space continues to offer palatable valuations but many potential headwinds. As such, we maintain our positive long-term view and cautious near-term view. The same can be said for emerging markets, especially given their outsized exposure to China amid their continued battle with COVID-19.
Bonds have become significantly more attractive recently, and we doubt that rates will move as dramatically as they did in 2022. It was largely the drawdown in bonds that made the year so uniquely challenging, and another year of such high stock-bond correlations seems unlikely. That being said, we are keeping credit quality high due to recession concerns and duration low due to continued rate uncertainty. The worst is likely behind us, but it makes sense to lock in some elevated short-term yields.
Along with treasury bonds offering higher yields than before, Series I savings bonds are offering a composite rate of 6.89% through April 2023. The rate is quite appealing, but there are various rules and suitability concerns to be aware of before considering a purchase.
We are also still in favor of holding alternative asset classes that can offer diversification and uncorrelated sources of return in times of uncertainty.
*Charts provided by YCharts, Inc. and Strategas Research Partners, LLC.
Daniel is a Portfolio Analyst at Stonebridge Financial Group and works on portfolio analysis and other related tasks. When away from the office, Daniel spends his time playing guitar, reading, and exploring the outdoors.