Investment Overview: 4th Quarter 2022

The economy

High inflation and geopolitical pandemonium marked a 2022 that left investors reeling from market losses as they now approach 2023 with trepid anticipation. Equity markets posted their worst performance since 2008. Fixed income markets, after more than a decade of mostly up years, also took a hefty tumble. 2022 was indeed atypical, as the benefits of diversification did not quell portfolio volatility nor portfolio losses to any meaningful degree.

Although markets reacted negatively, the economy held up remarkably well in 2022 despite an aggressive Federal Reserve that raised its Federal Funds Target Rate seven times to a 15-year high. U.S. third-quarter GDP came in at a positive 3.2%, reversing two straight quarters of economic contraction. Strong labor markets persist, with an unemployment rate at a historically low 3.7%. Consumer spending, possibly buoyed by excess savings during COVID-19 lockdowns, remains heathy for the time being.

Elevated inflation is of paramount concern and is front and center in the minds of investors and consumers alike. Mercifully, recent reports indicate some cooling. The ubiquitous Consumer Price Index (CPI) came in at 7.1% for November, down from a 9.1% peak in June. Moreover, the Federal Reserve’s preferred inflation metric, core Personal Consumption Expenditures (PCE), decreased to 4.7% year-over-year in November, off of previous readings of 5.1% and 5.2% in October and September, respectively. The core PCE Index excludes volatile food and energy prices. Core PCE at 4.7% is of course well above the central bank’s 2% long-term target, but any progress in the battle to tame inflation is certainly welcome news.

Despite some signs of optimism, it remains apparent that economic cracks are beginning to form as Fed rate increases take effect. The Conference Board’s Leading Economic Index has fallen for nine months in a row, and the ISM Manufacturing Index has now shown contraction for the second consecutive month. Higher mortgage rates are also rapidly cooling the hot pandemic housing market. Moving forward, most economists predict that the Fed’s efforts to fight the highest inflation in four decades will eventually result in a recession. According to The Wall Street Journal, a recent survey indicated that more than two-thirds of the economists at 23 large financial institutions that do business directly with the Federal Reserve are betting the U.S. will have a recession in 2023.

Although a consensus opinion for a 2023 recession appears to have been established, the more important question is likely to be its longevity and severity. While certainly debatable, we feel the most likely scenario calls for a relatively mild recession. The Fed may not ultimately pull off its goal of engineering a “soft landing,” or bringing inflation under control without causing a recession, but current measures by our central bank appear to be making headway. Also, structurally low unemployment and slowing but still reasonable credit growth should prevent a drastic economic contraction. The same recessionary outlook for the United States cannot be restated for Europe and its periphery, though. Although we wish for the best, energy and food price volatility is likely to disproportionately disadvantage our Western allies in the months ahead as the Russian/Ukrainian war rages on.

Fixed income

Bond investors suffered one of the worst years in a generation as strong inflationary pressures emerged, then intensified, eventually prompting aggressive central bank policy action reminiscent of the Paul Volker era of the late ‘70s and early ‘80s.

While pressures were present to start the year, the Russian invasion of Ukraine exacerbated the inflationary backdrop already alight from supply chain bottlenecks and pent-up demand from COVID-19 lockdowns.

In response, the 10-year Treasury Bond went from 1.5% at the start of the year, peaked at 4.2% in October, and finished the year yielding 3.9%. In fact, the 10-year Treasury Bond witnessed its biggest annual increase in over 40 years — or as far as data goes back to 1977. With rising rates came significant losses for fixed income investors, with the Bloomberg U.S. Aggregate Bond Index losing over 15% for the year.

While supply chain issues are abating, wage pressures and economic fallout from the continuing war are likely to persist. In short, the fight against inflation appears far from over, despite the Fed pushing its target rate from close to 0% to an upper range of 4.5% while initiating quantitative tightening, or the shrinking of the Fed’s balance sheet and removal of liquidity from markets. Fed officials signaled in December that they plan to keep raising rates to between 5% and 5.5% in 2023.

The Fed’s hawkish policy action has also led to yield-curve inversion, or shorter-term rates rising faster and higher than longer-term rates. The 2-year Treasury has had a higher yield than the 10-year bond for most of the past six months. While not a certain predictor, an inverted yield curve is often associated with a recessionary period.

Treasury yields of selected maturities for recent time periods are displayed below (data from Bloomberg).

Total return numbers for various fixed income indices over the past quarter and 12 months are below (data from Bloomberg).

Equities

Stock markets experienced an overall positive fourth quarter but ended the year with a thud after regaining footing in October and November. All major equity indices ended the year down, with U.S. markets snapping a three-year winning streak and most indices booking their worst yearly performance since 2008. Investors shifted to a risk-off attitude as a new reality of higher rates, stubborn inflation, and prospects for a global recession set in.

2022 will be remembered not only for its woeful returns, but also for the extreme divergence between the returns of the major benchmark indices. While the blue-chip Dow Jones Industrial Average was down a little less than 7%, the S&P 500 and technology-heavy NASDAQ indices were down 18% and a whopping 33%, respectively. The tech selloff was so extreme that many analysts likened it to the bursting of the tech stock bubble more than 20 years ago.

A preponderance of the divergence can be explained by the demise of the historically low-rate environment that many investors came to expect over the last decade. Skyrocketing interest rates disproportionally hammered tech-sector stock valuations for two reasons. One, higher rates and bond yields gave investors safer options to generate more attractive returns than before, making riskier plays like tech less alluring. And two, the longer-dated future cash flow streams of many tech companies are more sensitive to higher rates as those cash flows are discounted back to the present.

On a brighter note, international stocks outpaced their domestic counterparts for the quarter despite ongoing unease with the war in Ukraine and declining economic growth. For the quarter, developed international stocks increased 17% on better-than-expected earnings and a dollar selloff that resulted in the translation of international returns at more favorable exchange rates.

Slowing economic growth, rising input costs, and higher interest expenses are pressuring corporate profit margins. According to FactSet Research, analysts expect companies in the S&P 500 Index to report their first year-over-year decline in quarterly earnings since 2020. Fourth-quarter profits are projected to decline over 4%, a sharp reversal from the more than 31% growth logged a year earlier.

Clearly the key debate going forward is whether earnings estimates have been lowered enough given the increasingly uncertain macro backdrop — and secondly, once a bottoming of earnings has been reached, when might a recovery occur? Although stock price levels adjusted meaningfully in 2022, volatility will likely continue as the market attempts to answer these questions.

Below is a table displaying various equity index returns for the past quarter (data from Bloomberg).

Sector returns

Fourth-quarter sector returns were largely positive as value sectors regained leadership while growth lagged. Energy was the top performing sector followed by Industrials, Materials, and Financials as a troubling inflationary backdrop boosted commodity prices and interest rates and, accordingly, the earnings of associated companies. More defensive value sectors also experienced a strong quarter, with Health Care and Consumer Staples both up over 12% as investors may be preparing for an impending recession by finding solace in safer stocks. 

Higher interest rates and inflation, while helpful for the aforementioned sectors, dampened enthusiasm for others such as Utilities and Real Estate. Nevertheless, returns for those sectors were still up 8% and 4%, respectively. Higher interest rates certainly affected the relative attractiveness of companies with long-duration cash flows evidenced by the lagging performance of the Information Technology, Communication Services, and Consumer Discretionary sectors.

The following table details S&P 500 sector total returns for the quarter (data from Bloomberg).