Last year was difficult, as the economic realities of a post-COVID environment and the war in Ukraine resulted in an inflationary environment not witnessed in over 40 years. The U.S. Federal Reserve and other central banks countered by aggressively raising interest rates, shrinking the money supply, and deleveraging balance sheets. This significant shift in monetary policy pressured asset prices just about everywhere. Both equities and bonds reached bear market territory in the same year for the first time ever. In U.S. equities, the S&P 500 index lost nearly 20% for the year, while the technology-heavy Nasdaq 100 index declined 33%. Bonds did not fare any better and experienced their worst year on record. The Barclays Aggregate bond index was off 13%; prior full-year losses had never exceeded 3%. Other asset classes faced a similar fate. Real estate declined in excess of 20%, cryptocurrency Bitcoin collapsed 76%, and even gold disappointed. Good riddance to 2022!
|Index||YTD 2022||Q4 2022|
|S&P 500||U.S. Large Cap||-18.1%||7.56%|
|Russell 2000||U.S. Small Cap||-20.4||6.23|
|Russell 2000 Growth||U.S. Small Growth||-26.3||4.13|
|MSCI EAFE||Developed International||-14.4||17.3|
|MSCI EM||Emerging Markets||-20.0||9.70|
|Bloomberg Barclays||U.S. Core Bond||-13.0||-1.8|
We should point out that as painful as 2022 was across asset classes, the intermediate and long term has been very good to portfolios, in particular those with U.S. equity exposure. Before 2022, the S&P 500 had returned 90% over the prior three years and 113% over the prior five. The question for 2023 is whether we continue with the dislocation witnessed last year or revert to the more productive periods of years past.
Inflation remains a headline issue in 2023, but we believe price pressures are set to ease meaningfully throughout the year. The rapid increase in interest rates ushered in by the Fed throughout 2022—from 0% at the beginning of the year to over 4% currently—provides a powerful, albeit lagging, force against inflation. Generally, higher interest rates stunt economic growth and increase the cost of borrowing funds. This in turn dampens demand for goods and services and limits price increases.
More specifically, the current bout of inflation was triggered by a sharp rise in prices for goods, which then broadened to include higher prices for services. Easing supply shortages, lower consumer demand (consumer confidence is near all-time lows), and excess inventories should all contribute to a slowdown in goods inflation. Case in point, Tesla recently reduced prices on its electric vehicles by as much as 20%. We expect prices of other durable goods to follow.
Services-based inflation tends to be stickier but could also improve as the year unfolds. Inflation tied to housing—the biggest component of services inflation—is set to slow significantly as home prices and sales cool meaningfully as a result of higher borrowing costs. In addition, easing labor conditions should keep downward pressure on wage growth, which tends to drive inflation for other services.
Fortunately, we have begun to see some progress on inflation. The most recent Consumer Price Index reading in December was 6.5%, down from June’s high of 9%. We expect future readings to show further moderation, although it is uncertain how long it will take for inflation to hit the Fed’s 2% target.
While inflation is set to moderate further, our primary concern for 2023 shifts to slowing economic growth and/or a recessionary environment. As mentioned above, higher interest rates come at an economic cost by restricting growth. And as the Fed prioritizes price stability over economic expansion, the outlook for corporate profits, and therefore asset prices, becomes more uncertain.
Indeed, global conditions today and those anticipated in the coming months are similar to those that have signaled economic recessions in the past. Leading economic indicators like the yield curve (inverted) and the Services and Manufacturing Purchasing Managers indexes (both under 50) are suggesting significant slowing ahead. This is intentional as the Fed wants to dampen demand, but the question is, to what extent is growth compromised?
Although economic downturns are never desirable, there are reasons to believe that this may be a shallower decline than many. Household and corporate balance sheets are in good shape, and other than inflation, there are no other significant economic imbalances that we can point to. In addition, with unemployment levels near 50-year lows, the labor market’s strong current position could help buffer future weakness.
Recession, soft landing, hard landing: whatever ensues in 2023, we must recognize the difference between the economy and markets. Take, for instance, the height of the COVID-19 health crisis in 2020–2021. Equity markets rallied on the recognition that eventually a health solution to the coronavirus would be achieved, the economy would reopen, and profits would return. Conversely, in 2022—despite a modestly expanding economy, healthy corporate profits, and a strong labor market—financial asset prices suffered under the weight of tighter monetary policies, surging inflation, and the Russia-Ukraine war.
As 2023 begins, it seems as if everyone expects economic growth to falter and corporate profits to decline. The recession “call” is pervasive, and it feels like this potential recession may be the most anticipated one we can remember. When, or if, it finally arrives, the market may already begin looking ahead to the eventual recovery. The market does not always move in lockstep with the economy. It’s a forward-looking mechanism.
History supports this perspective. There have been 11 years since 1950 in which the S&P 500’s earnings declined by 10% or more. Still, in just 2 of those 11 years did the S&P 500 produce a negative return. Negative but well-anticipated economic news does not necessarily portend negative returns. However, we should point out that during those 11 years with declines in earnings, the median drawdown was -14% throughout the year. So while 9 of the 11 years ended with positive returns, the paths for markets were typically rocky. To be sure, 2023 could unfold in a similar fashion.
Amid another potentially turbulent year in 2023, we certainly empathize with clients’ concerns and understand that periods of heightened uncertainty can be unsettling. However, our experience has taught us to lean into our investment process during difficult times and look past near-term macro clouds to identify investments that perhaps have been unfairly penalized. Volatility, as we are experiencing today, often provides us an opportunity to reposition portfolios for enhanced future performance.
To this end, our “wish list” of new investment ideas is fuller than it has been for many years. Interestingly, while U.S. equities continue to offer opportunities, other asset classes are looking promising as well. Fixed income is an area that we have not preferred over the last 10 years, given the ultra-low interest rate environment. However, given the shift in monetary policy, higher rates, and the subsequent decline in valuations last year, bonds are beginning to offer reasonable return opportunities. One standout is U.S. Treasuries. Currently, 6-month T-bills (backed by the full faith and credit of the U.S. government) are yielding almost 5%. Given the relative safety of these instruments, the risk/return profile of these is particularly compelling. Ultimately, we believe that bonds may once again begin to play their more traditional role of diversifier in portfolios where fixed-income exposure is warranted. They would be a welcome addition to our investor toolkit going forward.
We hope everyone had an enjoyable and safe holiday season. We are here to answer any questions you may have on our outlook or your accounts. Please do not hesitate to reach out.
John, Cam, Lauren, and Team