Investors experienced losses across most major asset classes, sectors and industries in 2022, with energy stocks once again outperforming almost all other segments of the market.
Inflation prints are moderating as a combination of slowing demand and supply chain improvements combined with tighter financial conditions are pushing prices lower.
Bonds posted one of their worst years ever in 2022; however, a potential peak in rates mid-year could create the opportunity for better performance in 2023.
A tumultuous year for stocks and bonds
2022 will certainly be a year to remember, but for all the wrong reasons, at least from an investing perspective. The third worst year for the S&P 500 since 1980, and the worst year for the Bloomberg U.S. Aggregate Bond index since its inception in 1976, it was a year in which investors could find little to cheer about it – and few places to hide.
The challenge of investing in bonds, knowing that rates were likely to rise, was offset in part by concerns about lofty valuations in the equity markets, driven by years of low borrowing costs, buybacks and a pull forward of activity for many growth stocks during the pandemic. The low-rate environment which dominated the decade prior to the pandemic created meaningful concentration in high growth, low profitability companies, and a massive unwind of this trade resulted in sharp declines for major indexes, particularly the S&P 500 and the NASDAQ in 2022.
International, developed and emerging markets stocks had underperformed the technology heavy U.S. indexes through the post-GFC period, but this valuation advantage was drowned out by a U.S. dollar that shot higher as the Fed raised rates. Even the relatively higher exposure to value sectors in these indexes did little to aid performance, especially for U.S. investors after the currency translation was factored in.
So what did well? Energy stocks soared as demand came roaring back and the Russian invasion of Ukraine coupled with the decision by OPEC+ to continue to limit supply created a new floor for energy prices; within the S&P 500, energy stocks closed the year up over +60%. Traditionally defensive sectors also performed well, with relative outperformance for utilities, health care, consumer staples and health care over the benchmark.
Value stocks outperformed growth stocks globally, and the Dow Jones Industrial Average, which had been deemed irrelevant by many investors over the last several years, closed down less than -7% in a year where interest rates rose at the fastest rate on record. Within the fixed income market, relative outperformance was delivered by shorter duration bonds, and by municipals, which tend to be better insulated from interest rate changes given the tax advantages afforded by their structure.
Interestingly, despite growing concerns about covenant light issuance and the pressure that companies with weaker balance sheets will face when refinancing, high yield corporate bonds soundly outperformed investment grade corporate bonds for the year – a trend that we expect to reverse should a recession occur.
The Fed solidifies its plans to tame inflation
The overwhelming consensus view coming into 2022 was that inflation was going to be a formidable force for central banks, politicians, economists, investors, consumers and business owners. The liquidity injected into the system in response to the sharp decline in economic activity in 2020 and limited outlets for the distribution of that liquidity created an influx of investment in goods and in financial assets and created upward pressure on prices for inputs and investable assets in 2020, 2021 and into 2022. The Fed’s response has been swift and significant, and reaction to the Fed’s policy changes dominated the narrative this year.
One could argue, and many do, that the Fed acted too late; however, the data indicates that inflation is improving. In fact, October and November headline and core CPI prints came in lower-than-expected and are beginning to reflect the trend down in PPI that began several months earlier. (To be fair, the producer prices popped first, so this lag is consistent with historical trends.) The positive surprise in both cases buoyed markets briefly, but looking past the data points, investors are not worrying about inflation remaining near peak levels, but are beginning to worry about the decline in prices. The Fed’s efforts to tighten financial conditions is intended to bring inflation back to its target rate of 2%, and the only lever it can pull is on the demand side.
In fact, it is the evidence of demand destruction that has created pops in the equity and bond markets over the last several months, as investors interpret this evidence to imply that the Fed will move from restrictive policy to accommodative policy, from hiking to a pause and, eventually later in 2023, to a pivot.
Our view is that the Fed is not yet ready to rely on relative improvement and is instead set on meeting the absolute goal of bringing inflation back to target. The evaluation by the markets that the Fed will act on this relative improvement is creating a disconnect in the equity markets but even more so in the bond markets, as the yield curve remains deeply inverted, implying that the Fed will cut rates sooner than what is being telegraphed.
The Fed understands that while the numbers are improving, inflation needs to be stamped out before it can claim victory, and its credibility hangs in the balance. A pause is likely at some point this year, but not before enough has been done to transmit a true reset in prices throughout the U.S. economy.
Will the bond market have its day in the sun in 2023?
A slow, methodical reduction in prices certainly has implications for the broad economy. However, among all the aspects of 2022 that were extraordinary, the performance of the bond market must be considered near the top of the list. As mentioned earlier, bonds have struggled against the backdrop of Fed action, and investors who remained invested in bonds over the post-GFC decade were rewarded for their acceptance of low yields with historic drawdowns.
Coming into 2023, however, our view is that there will be opportunities for bond investors – even if we are not yet at peak interest rates. Despite indications of slowing economic growth, and the potential pressure on lower quality issuers, credit fundamentals have been strong and should have the ability to absorb economic headwinds next year. One would anticipate that defaults could tick up given the economic outlook; couple a slowdown with higher costs and lower margins, and refinancing will be more difficult.
As the Fed reaches its terminal rate, however, volatility in the market should decline, and investor demand should support credit spreads offering strong relative yield. Coincident with a peak in fed funds rate by mid-year, spreads could widen more but rebalancing towards the front end of the curve should lend support and keep spreads from moving too far too fast.
In short, the Fed pausing or ending the hiking cycle would cause the curve to normalize and steepen, and in our view, this would be driven by the front end of the curve. As a result, active duration management along with a prescriptive approach to assuming credit risk represents the next phase in investing in this quickly changing environment; however, in the near-term, limiting duration and credit risk remains the pragmatic approach.
The written financial and economic data are obtained from FactSet, the Federal Reserve, the Bureau of Economic Analysis, the Bureau of Labor Statistics, Bloomberg, ICE, and YCharts as sources but not limited to such. The accuracy and completeness of the financial or economic data are believed to be reliable but has not been independently verified.
Please feel free to reach out to your SVB Private Wealth Advisor for a deeper discussion regarding the points above, or a review of your current plan to ensure it remains aligned with your long term needs and goals.