Contributors: Andrew Walker, Bruce Ensrud, Matt Stockman
THE SHORT STORY
If it felt like 2022 was a rough year in markets, that’s because it was. Thanks to the Federal Reserve’s aggressive rate hiking cycle to combat inflation, we witnessed the worst year ever for bonds and the 7th worst for stocks. China’s reopening and data showing moderating inflation led the markets to find their footing in the fourth quarter to create a strong finish to the year. Interestingly, despite a strong dollar, international markets outperformed the US in 2022.
As inflation subsides and we near the end of the Fed rate hike cycle with a still healthy economy, we see conditions forming for a bear market bottom and we ultimately expect markets to finish the year higher. In this environment, prudent asset allocation and risk management will be increasingly important as we believe that markets will be harder to navigate due to heightened volatility and an increased focus on fundamentals and valuations. While there remains upside risks to inflation, downside risks to economic growth (recession), and tail risks with Russia and China, these are not part of our base case.
Where We’ve Been – 2022 & Q4 Review
If it felt like 2022 was a rough year in markets, that’s because it was. Thanks to the Federal Reserve’s aggressive rate hiking cycle to combat inflation (and Russia’s invasion of Ukraine), we witnessed the worst year ever for bonds and the 7th worst for stocks. Further highlighting the dismal year is a) the fact that, across all 112 asset classes, 94% had negative returns and b) the fact that some darling market stocks like Meta (formerly Facebook), Netflix, Amazon, and Alphabet (formerly Google) produced returns between -39% and -64%.
Despite the reality of markets last year, we are encouraged by a few opportunities that this market turmoil has presented to us.
- For the first time in many years, attractive interest rates can be earned on cash (over 4% in most cases).
- Similarly, interest rates on bonds are also attractive. Bonds with short maturities of 6 months are in many cases offering over 5% interest rates. Perhaps more importantly, with rates being well above zero now, the risk-return relationship that we see in bonds is much more healthy today.
- Depressed stock prices offer long-term investors a compelling opportunity to dollar-cost-average new dollars into the market at favorable valuations.
The market appears to be finding its footing as things started to improve towards the end of the year. Market returns were generally favorable during the fourth quarter, as China reopened and slowing inflation data led the market to believe that rate hikes would soon end. This expectation that the Fed would end rate hikes soon resulted in the dollar (finally) showing some signs of weakness. This contributed to especially strong returns in international markets. In fact, international markets finished the year with better returns than US markets.
| Market Category | Market Index | Q4 2022 | YTD 2022 |
|---|---|---|---|
| US Large Cap | S&P 500 | 7.6% | -18.1% |
| US Small Cap | Russell 2000 | 5.8% | -21.6% |
| International Developed | MSCI EAFE | 17.4% | -14.0% |
| Emerging Markets | MSCI Emerging Markets | 9.7% | -20.1% |
| US Bonds | BB US Aggregate | 1.9% | -13.0% |
| US Dollar | DXY* | -7.7% | +8.2% |
Where We’re Going – 2023 & Q1 Outlook
There are 3 things that we expect to see in markets in 2023:
- Persistent Volatility
- Moderating Inflation
- Bear Market Bottom
Persistent Volatility
The last 10+ years in markets have been unique compared to long-term history. One could describe markets since the Global Financial Crisis as having low interest rates, low inflation and low growth coupled with maximum accommodation and maximum liquidity. These conditions have led to abnormally low volatility and have encouraged additional risk taking or TINA, the acronym for “there is no alternative” (to owning more equity, given the alternative yielded ~0%). We believe that reversing some, but not all, of these conditions may produce higher structural volatility across multiple asset classes. Additionally, these shifts may also mean that investors expecting the playbook of the last 10 years to be the same for the next 10 may be disappointed (in other words, the “growth” stocks that faired so well in the environment of the last 10 years may not be the leaders going forward).
Moderating Inflation
Inflation will continue to be top of mind in 2023. While it is unlikely that inflation will fall straight to the Fed’s target of 2% (especially due to the persistence of inflation in the services sector), that is not what is required for a market bottom or for the Fed to pause. We simply need the path to resolution to be illuminated. So, while inflation has already moderated substantially (soft landing, anyone?) and may moderate more fully in the years to come, its pivotal moment in market sentiment may be closer at hand.
Longer-term, we expect aging demographics, trends towards deglobalization, and the move to green energy to result in inflationary levels moderately higher than they were over the last decade (although lower than where they are today).
Bear Market Bottom
Since 1950, the average pullback of 20% or more has lasted roughly 14 months. While this is merely an anecdote, our 12-month-old bear market is likely closer to its end than its beginning. Furthermore, markets tend to bottom after the Fed is done raising rates. Given the Fed is near the end of its hiking cycle, and that any recession is likely to be mild (thanks to strength in the consumer and the labor market), we are optimistic that we will finish the year higher than we began.
Summary
As inflation subsides and we near the end of the Fed rate hike cycle with a still healthy economy, we see conditions forming for a bear market bottom and we ultimately expect markets to finish the year higher. In this environment, prudent asset allocation and risk management will be increasingly important as we believe that markets will be harder to navigate due to heightened volatility and an increased focus on fundamentals and valuations. While there remains upside risks to inflation, downside risks to economic growth (recession), and tail risks with Russia and China, these are not part of our base case.
Thank you for allowing us to partner with you as we navigate the ever-changing market. We appreciate your continued trust.
If you have questions or would like to dive deeper into this quarter’s outlook, please reach out to our investment team. We’d be happy to set up a virtual coffee to talk more.
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The Bloomberg U.S. Aggregate Bond® Index, or the Agg, is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. Investors frequently use the index as a stand-in for measuring the performance of the U.S. bond market.
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