“History has demonstrated time and gain the inherent resilience and recuperative powers of the American economy.” - Ben Bernanke
Happy New Year to each one of clients and their families. With the New Year’s ball having dropped to usher in 2023, we can now say that one of the most interesting years for investing in recent memory has officially concluded. Looking back, it’s impossible to pinpoint a time when such specific economic and market conditions came together at the same time. Now is a great time to reflect on what made 2022 so unique:
- Broader stock markets entered an unexpected bear market throughout the first three quarters of 2022, and yet stabilized in September throughout the rest of the year.
- Despite stock market volatility, economic indicators have been showing signs of economic strength. US GDP grew 2.6% in the third quarter, unemployment has remained near historic lows, and consumers and corporations have retained large cash buffers and relatively low household debt.
- Strong economic factors have given the Federal Reserve confidence to raise federal funds rates at a faster pace than any dating back to the 1980’s. However, they have shifted to slowing rates in the most recent meeting.
- Once resilient so-called FAANG tech giants, Meta, Amazon, Apple, Netflix and Google, that drove broader market gains lost $3.4 trillion in market value. The Wall Street Journal cleverly called these stocks ‘de-FAANGed’.
- Fixed income had a rare year in which it was more volatile than equity.
- Markets also grappled with macroeconomic trends, including the conflict in Eastern Europe, an energy crisis, and strict lockdowns in China.
- Less developed products and markets, including cryptocurrency, NFTs, and SPACs, have not yet proven to be a ballast to the volatility experienced by traditional financial markets
With the performance over these last 12 months, some investors are optimistic about the future potential for markets in 2023. In this letter, we’ll deep dive into the markets over the past year and discuss potential 2023 outlooks.
As mentioned in our introduction, Q4 2022 signaled a slight turnaround in recent trends for the stock market across most stock categories, with universally positive returns for most of the equity styles – a welcome treat to end the year.
However, year-to-date returns have been incredibly unpredictable, so despite return upticks in Q4, overall the stock market didn’t post many gains year-to-date. The bright spot was in large-value stocks that managed to end the year with positive returns.
Below, you’ll find the performance of various domestic equity categories over the past 3-, month, 12-month and 3-year periods.
Despite growth stocks historically trumping value’s returns, in the past year value has outperformed growth stocks.
Unsurprisingly, most sector indexes have performed similarly. Some bright spots over the previous year, as indicated in the chart to the right, have been Energy, which has largely outperformed most other sectors. Additionally, sectors that we consider ‘defensive’, including consumer defensive, healthcare, and utilities, have performed generally better than their most sensitive counterparts, such as technology and communication.
Energy’s outperformance has been a large story in 2022, driven mostly by economic conditions. Oil and natural gas prices skyrocketed as inventory plummeted from pandemic lows faster than expected, especially given lower investment in production and the Ukraine conflict.
A question often on fund managers and investors minds when analyzing past market performance data is the likelihood that a bear market will continue. One angle financial market participants can consider is past performance of a broad market index such as the S&P 500 year-over-year to identify trends. When assembling these returns, we can see that negative performance in two consecutive years is actually an abnormality.
Interesting to note that even in recent financial crises, such as 2008, did not see consecutive years of negative returns.
The previous year was a uniquely volatile performance for fixed income categories, regardless of product or sector. This has left investors optimistic about potential future returns for fixed income in 2023, specifically with current short-term yields reaching near term highs.
Coincidentally, these short-term assets performed the best over the past year, and the shorter duration assets you held in your portfolio, the better you performed. For example, we saw long-term treasuries posting 29% losses, whereas floating rate bonds – the shortest duration issues – only posting less than 1% losses.
In terms of credit rating, the spread between government (U.S. Treasuries), corporate, high yield and mortgages was relatively tight, indicating that credit rating was not as important of an indicator as duration. However, it is worth noting that Treasuries outperforming high yield by over 1.5% indicates a tilt towards more investment grade bonds. If investors are concerned about economic risks, they will continue to gravitate towards these investment grade products in 2023.
This volatility is important because typically fixed income is an investor’s and fund manager’s ballast to volatile equity markets. In years where equity has underperformed, typically uncorrelated bonds, asset backed securities, etc. would reduce the draw down. However, given performance in 2022 you’d be surprised to find that bond markets actually had an even more volatile year than stocks, which, for the first time in decades, reduced their effectiveness as a ballast.
This unusual behavior was driven by a number of factors, including recession concerns, but could also be attributed to the Federal Reserve’s actions in increasing their target federal funds rate, and signaling that rate increases would continue into the future, drove yields higher. Investors could buy Treasury inflation protected securities (TIP), but may have been better off with shorter term bonds, regardless of whether TIPs or not.
The graph above depicts the total return for stocks and bonds since 1871. Any data point to the bottom left axis are years when both stocks and bonds were negative. As shown, it a rare occurrence for both stock returns and bond returns to be negative, happening only three other times since 1871. Not only that, but 2022 trumped these years in volatility of returns.
This isn’t to say that the trend of stocks and bonds remaining volatile won’t continue. However, these specific market conditions meant incredibly unique circumstances, especially with the Federal Reserve tightening as fast as they are. As indicated by Bloomberg graph on the next page, rates rose at a rate not seen in years, and are continuing to slow despite recent Fed decisions to lower the rate at which to raise rates.
With these high rates, some investors are adding fixed income positions, specifically short duration income, to their portfolios, with the expectations that prices will increase in 2023.
Alternative assets, including commodities, metals, asset backed securities, and other financial products had mixed performance in 2022.
Commodities such as grain, corn and soybeans skyrocketed in early 2022, but largely fell to close the year near where they started. Alternatively, precious metals (such as silver and gold) surged in Q4, bringing prices back to year-start.
Given market fluctuations in 2022, it seems to be an interesting opportunity for financial market participants to take advantage of any market dips. As previously mentioned, using times like this as a jumping in point for investments has historically paid off for investors.
Consider overweighting large cap stocks in suitable portfolios in accordance with individualized investment policy. Also consider contributing funds to mid and small cap stocks proportionally and in accordance with your investment policy procedure. In portfolios with large-cap stock exposure, revisit allocations to international stocks, such as Emerging Market funds, as large-cap funds may already have sufficient international risk for your portfolio. Increasing exposure to emerging markets may be suitable for some portfolios, but its also possible for there to be risk in developing countries in the near future.
Your fixed income strategic allocation will vary based on disbursement needs; however, at a high level short-duration may continue to be the most important fixed income factor contributing to performance as it has been over the previous year. Consider prices for non-investment grade funds may be less attractive at the current moment versus investment grade funds (Treasuries, high-quality corporate) and think about including these funds in your portfolio, if they are a suitable investment.