Summary
- 2022 will go down in market history as a watershed year. For the first time, both U.S. stocks and bonds fell by double digits as a result of rapidly rising inflation, and many other asset classes failed to alleviate the pain.
- The good news is that rising bond yields and lower stock valuations have resulted in higher expected returns for these assets.
- Momentum from Q4 2022 continued with declining inflation and lower peak interest rates, leading to a 5.85% gain in the S&P 500 and a rebound in sectors such as communication services, consumer discretionary, and technology.
- Leading economic indicators have fallen sharply in the last ten months, and if history is any guide, the United States should already be in a recession. Amidst headlines regarding layoffs at technology and financial firms, the labor market remains quite resilient, potentially pushing the Fed to keep interest rates higher for longer.
- The United States reached its debt ceiling on January 19, igniting a significant policy debate in the markets, as the Treasury engages in accounting maneuvers to conceal new borrowing and keep the government running until at least June or July. If Congress does not vote to raise the limit, a debt default may occur, but we do not see this as a likely outcome. Despite the uncertainty, Treasury yields and the stock market have so far remained unaffected.
2022 Review and Portfolio Implications
2022 was a difficult year to be an investor. The reason it was a particularly difficult year was because both the S&P 500 Index and intermediate-term Treasury bonds experienced double-digit declines for the first time, with the S&P 500 declining 18.1% and intermediate-term Treasury bonds losing 12.3%.1 As one might infer, rising inflation was to blame. Furthermore, in 2022, 105 of 112 Morningstar open-end mutual funds categories, or 94%, lost money.2 This level of brutality hasn’t happened since the 2008 Global Financial Crisis.
Source: BlackRock, “Student of the Market”, Janary 2023. Morningstar as of 12/31/22. All asset classes represented by Morningstar open-end mutual funds categories. Morningstar categories that have a positive return YTD 2022; Equity Energy, Energy Limited Partnerships, Commodities Broad Basket, Systematic Trend, Commodities Focus, Latin America Stock, and Equity Market Neutral. Past Performance does not guarantee or indicate future results.
In the case of stocks, higher inflation reduces certainty around earnings and cash flow, raises input costs and wages (reducing margins), and elevates the cost of raising capital for businesses, with investors demanding a higher rate of return. Bonds, on the other hand, are impacted because rising inflation typically results in higher interest rates. Bond prices fall as interest rates rise because investors seek higher yields to compete with newly issued bonds. It is an inverse relationship, and one of the few relationships in finance that is ironclad.
Diversification works because two assets in a portfolio (typically stocks and bonds) are uncorrelated or potentially negatively correlated to one another, providing ballast to the overall portfolio when one rises or falls.
If we take a look back, for example, over the period 1926-1999, the monthly correlation between U.S. stocks and bonds registered at +0.18. So, for much of history, stocks and bonds were actually positively correlated and moved somewhat in tandem with one another. On the other hand, over the period January 2000 to November 2022, the monthly correlation was -0.2%.3 Why the change you might ask? In short, the culprits were low inflation and falling interest rates.
Following a year of negative returns for both stocks and bonds, the correlation has once again turned positive. We believe that this is a new regime in which betting on bonds to bail out a portfolio in times of stress may no longer be a viable option in the future. However, that is not to say that bonds do not have a valid place in a diversified portfolio.
2023 Market and Economic Movements
Despite all of the carnage last year, the S&P 500 clocked in a positive 7.6% total return in the fourth quarter, but the market remained well below its previous high at the end of 2021, bringing the current drawdown’s duration to a full year.
The momentum that occurred in markets in Q4 2022 has continued into 2023. December’s inflation report offered a third straight month of declining inflation, with outright deflation in the headline measure. Additionally, annualized measures of headline inflation CPI are running at a pace below the Fed’s 2% target.
In response to the declining CPI (Consumer Price Index) and PPI (Producer Price Index) data, the 10-year U.S. Treasury bond yield fell over 84 basis points from early November 2022 to mid-January 2023, and the peak implied Fed Funds futures are now below 5.0%.4 In other words, the market doesn’t believe the Federal Reserve will continue to hike much longer.
As of January 26th, the S&P 500 has gained 5.85% as a consequence of decreasing inflation expectations and lower peak interest rates, and some of the worst performing sectors last year (communication services, consumer discretionary, and technology) have rebounded spectacularly in 2023.
Source: Bloomberg; Nova R Wealth
Despite the positive news coming from the interest rate and inflation corners of the market, other leading economic indicators are signaling a recession. The Leading Economic Index (LEI), which The Conference Board publishes monthly, has experienced a sharp decline over the past ten months. As can be seen in the graph below, it has fallen to a level that has only ever occurred during recessions that were already under way.
A component of the LEI Index is initial unemployment claims, which have fallen to cycle lows but are up slightly from the 2022 summer months. This seems to be at odds with reports of large layoffs from companies positioned within the technology and financial sectors. Although, it appears these individuals are just being absorbed back into the labor market and/or are being offset by hiring in the COVID-recovery sectors (e.g. leisure/hospitality).
The Fed is keeping a careful eye on unemployment data, and we anticipate that it will be a main focus of Jerome Powell's address on February 1. The market anticipates an initial 0.25% increase in interest rates in February and a second 0.25% increase in March. If the labor market continues to be robust, the market's estimate of a peak Federal Funds rate of 5.0% may be shaken. For market participants to gauge the path of the economy beyond monetary policy, earnings estimates for 2023 are now in the focus.
U.S. Debt Ceiling
Many of you may have read alarming news about the United States' debt ceiling being reached on January 19, launching what could be the most significant policy debate of 2023 for the markets. As total debt exceeds the current statutory limit of $31.4 trillion, the Treasury is engaging in a set of accounting maneuvers to mask new borrowing and keep the government running to at least June or July of this year. Extraordinary measures, which the Treasury has employed more than a dozen times in previous debt ceiling battles, include steps such as suspending new investments in various retirement plans for government employees.
If Congress flounders and fails to vote to increase the limit, new borrowing could be halted, and a debt default could occur. However, if prioritizing specific debt does not last, the Federal Reserve, according to Joseph Wang, author of Central Banking 101, could step in and act as the Treasury dealer of last resort.5 While the exact deadline is unknown, a deeply divided Congress is being pressed to act. Surprisingly, Treasury yields and the stock market appear to be unfazed.
- Morningstar Direct; Intermediate-term Treasury bonds are represented by the Bloomberg U.S. Government Bond Index.
- BlackRock, “Student of the Market” January 2023.
- “Lessons from the Markets in 2022’, Larry Swedroe. 1/16/2023.
- Bloomberg
- “Debt Ceiling Procedures [RESTRICTED FR]”, Joseph Wang. 10/4/2021. fedguy.com/debt-ceiling-procedures-restricted-fr/