Summary of Key Points:
- One of the worst years on record has drawn to a close. Both equity and bond markets ended the year the way it started
- December’s performance less than reassuring as bond yields were rising again
- A slower economy next year is all but certain, a recession is not. On the positive side, if we should see a recession, it should be milder than the 2007-08 and 2000-01 recessions
An extremely difficult year in the financial markets ended with a thud for U.S. stocks. After a 14% rally in October and November, the S&P 500 Index dropped 5.8% in December to close out the year with an 18.1% loss, its largest annual decline since 2008.
Foreign stock markets held up much better in the fourth quarter. Developed international stocks gained 17.3% - one of their best quarters ever – and Emerging Market stocks were up 9.7 %. For the full year, developed international stocks outperformed the U.S. market by nearly four percentage points, dropping 14.5%.
A major headwind for non-U.S. stocks was the strength of the U.S. dollar (DXY Index), which appreciated 8.3% for the year, reducing dollar-based foreign equity returns one-for-one. However, in the fourth quarter, the dollar dropped 7.7%, providing a boost to EM and international equity returns for U.S. investors to end the year.
Turning to the fixed income markets, core investment-grade bonds (Bloomberg U.S. Aggregate Bond Index, aka the “Agg”) had a solid fourth quarter, gaining 1.9%. But this was still the worst year for core bonds in at least 95 years, with the Agg dropping 13.0%. The key driver, of course, was the sharp rise in bond yields; the 10-year Treasury yield ended the year at 3.9%, up from just 1.5% a year prior. High-yield bonds had a strong fourth quarter, up 4.0%, but were down 11.2% for the year. Floating rate loans were the best segment within the bond markets, down less than 1% for the year.
As shown in the chart below, 2022 was only the third year since 1926 that both U.S. stocks and core bonds declined, and the only year that both asset classes lost more than 10%.
Macro Outlook for 2023: Economic Slowdown with a Chance of a Soft Landing
For investors (not economists), the difference between a flat economy and a mild recession next year is a distinction without much difference. What we care about is the impact on corporate earnings and valuation multiples — the latter being a function of earnings, interest rates, and market sentiment (investor psychology).
Inflation and Federal Reserve monetary policy remain the financial markets’ key macro focus. In the fourth quarter, major central banks across the globe continued raising short-term interest rates. Tighter monetary policy curtails “aggregate demand” — consumer and business spending – which in turn reduces inflationary price pressures.
The good news is that the October and November U.S. inflation reports showed a sharp fall in headline consumer price inflation (including food and energy prices). Various measures of core inflation (excluding food and energy) have flattened on a year-over-year basis, but at around 5% to 6% are still far above the Fed’s 2% target.
The less-good news is that consumer services prices are generally stickier (that’s an official economic term) than goods prices. And as the chart below shows, core services inflation is still rising. Fed Chair Jerome Powell has recently cited this as a particular focus of the Fed.
Speaking of the Fed, as expected, at its December 14 meeting, the Federal Open Market Committee (FOMC) raised the fed funds rate by 50 bps to a target range of 4.25% to 4.50%. It also forecasted 75 bps of additional rate hikes in 2023. This is more than the markets expect.
While we know that the ability for anyone to predict what the Fed will do next year — including the Fed itself — is nothing more than a guess, we think the following quotes from Jerome Powell are worth highlighting as they at least reflect his/the Fed’s current outlook:
- “The inflation data received so far in October and November show a welcome reduction in the monthly pace of price increases. But it will take substantially more evidence to have confidence that inflation is on a sustained downward path.”
- “I would say it’s our judgment today that we’re not in a sufficiently restrictive policy stance yet, which is why we say that we would expect that ongoing hikes will be appropriate.”
- “The historical record cautions strongly against prematurely loosening policy. We will stay the course until the job is done.”
- “The labor market remains extremely tight.”
Each quarter the FOMC publishes its forecasts for inflation, GDP growth, unemployment and the fed funds rate. Continuing the negative trend for the year, the December revisions were for lower GDP growth, and higher unemployment, core inflation and interest rates in 2023. While we’d never expect the Fed to actually forecast a recession their latest forecast of 0.5% GDP growth in 2023 is about as close as it gets.
Wages are a function of the supply and demand for labor. As Jerome Powell said, the U.S labor market remains very tight. The 3.7% unemployment rate in November is still near all-time lows. The ratio of Job Openings to Unemployed workers – one measure of labor supply vs. demand – is still near all-time highs, at 1.7 job openings per unemployed worker. As shown in the chart below, there is a strong positive relationship between this ratio and wage growth (wage inflation). As with other inflation metrics, we may have seen the peak in wage inflation but still have a long way to go to get to the Fed’s targets.
More broadly, rising wages correspond to higher unit labor. The latest monthly wage data suggest a deceleration of wage inflation. But the Fed will want to see a material and sustained downward trend before declaring victory. The Fed’s hope is that tighter monetary policy will reduce the number of job openings (demand), relieving the pressure on wages without causing a big increase in layoffs and unemployment. That’s a possibility given the unprecedented number of job openings relative to unemployment, but it’s not our base case.
A significant bright spot in the otherwise awful inflation picture this year has been the stability of medium- and longer-term inflation expectations. In contrast to the early 1980s, as shown in the chart below, 5-to-10-year inflation expectations this year have remained in a 2-3% range.
Inflation is not just a U.S. problem. Nearly all the other major global central banks are also continuing to hike interest rates to fight inflation in their countries. For example, both the European Central Bank (ECB) and the Bank of England hiked their policy rates another 50 basis points (0.5%) in December. The ECB hawkishly stated, “We decided to raise interest rates today, and expect to raise them significantly further, because inflation remains far too high and is projected to stay above our target for too long.”
Along with persistent core inflation, the 2023 growth outlook has worsened for the U.S. and most of the globe. In our recent commentaries, we’ve highlighted two widely followed economic indicators that are published monthly: the Purchasing Manager Indexes (PMI) and the Conference Board’s U.S. Leading Economic Index (LEI). Both measures continued to deteriorate in the fourth quarter, signaling an economic slowdown in 2023.
The LEI has a long track record of “calling” recessions. In addition to the magnitude of its recent decline, it has fallen for nine consecutive months (and likely will again in December). This has never happened without an ensuing recession. Having said that, our caveat, as always, is that no economic indicator is 100% foolproof and there is a first time for everything.
A third consideration for slower growth is an inverted Treasury yield curve – meaning short-term yields are above longer-term bond yields. An inverted yield curve is unusual and usually (but not always) a leading indicator of recession. The timing from inversion to onset of recession has been highly variable.
Finally, as we’ve noted before, more important than whether the Fed is raising or cutting the fed funds rate is whether the policy rate is at a “restrictive” or “accommodative” level. This year has been the Fed’s most aggressive rate hiking cycle since 1980. At the current fed funds target rate of 4.25%-4.50% compared to inflation expectations of around 2.5% and the Fed inflation target of 2%, one can argue the rate is now in restrictive territory, with the full negative impact on the real economy still to come in 2023 due to monetary policy’s well-known lagged effects.
A counter argument is that with current inflation readings still well above 4.5%, the after-inflation (real) fed funds rate is still negative and therefore not yet restrictive. After the December rate hike, Fed Chair Powell said, “We’re not in a sufficiently restrictive policy stance yet.” If that’s the Fed’s view, it reinforces the likelihood they will continue to raise rates in 2023, albeit at a much-reduced pace than in 2022.
There are some economic positives:
First and foremost, the labor market remains strong, enabling consumer income and spending growth; monthly job growth (nonfarm payrolls) has also remained solid, increasing by 263,000 in November; weekly new unemployment claims (a leading indicator for the labor market) remain low, though they are ticking higher.
Households also still have huge “excess savings” stemming from the pandemic – about $1.5 trillion (down from $2.3 trillion) that can support additional spending even as the Fed tightens. Business balance sheets are also generally in good shape, with many firms having refinanced their debt at low rates prior to this year’s sharp rise. More broadly, there don’t appear to be any major, systemic, economic/financial icebergs lurking under the surface, e.g., unlike in 2007-08 with the housing/mortgage derivatives market.
To the above list of macro positives, we’d add a significant new development in the fourth quarter: the unexpected and sudden abandonment of China’s highly restrictive zero-COVID policy. Zero-COVID has been the key driver of China’s economic slump the past two years. But now the most repressive measures – mandatory testing, quarantines, community lockdowns and travel restrictions – are being revoked.
The reopening of China’s economy for domestic consumers should be a catalyst for a growth rebound in 2023. (Chinese households have built up trillions of dollars in savings since the pandemic.) However, the impact over the next few months will be quite negative as a wave of infections engulfs the country (likely in the hundreds of millions) and as uninfected individuals restrict their activity to try to avoid the contagion. China’s COVID vaccination/booster rate, particularly among the elderly, remains far below other Asian nations. According to Capital Economics, in other countries that exited similar zero-COVID approaches it took three to six months for economic activity to pick up.
Most China watchers expect an economic rebound in the second half of 2023, supported by other fiscal, monetary and regulatory policy actions by the Xi regime. China accounts for roughly 20% of global GDP, so the benefits of a Chinese economic recovery are obvious, especially for its key trading partners in Europe, Latin America and Asia.
A slower economy next year is all but certain, a recession is not. On the positive side, if we should see a recession, it should be milder than the 2007-08 and 2000-01 recessions.
Financial Markets Outlook for 2023 and Beyond
Despite their ubiquity, short-term stock market forecasts are a fool’s errand – as seen by how wrong they usually are – and not a sound basis for a successful long-term investment strategy. Instead, our portfolios are built on the foundation of a long-term “strategic” asset allocation that aligns with the client’s risk profile, financial objectives, and investment temperament.
As such, and given the inherent uncertainty about the future, our portfolios are structured to be balanced, diversified, and resilient across a wide range of scenarios, but also with the flexibility to be opportunistic when markets get out of whack (i.e., when current prices do not reflect underlying longer-term fundamentals) due to excessive fear or greed. In such cases, we act contrary to the current market mood – trying to be “greedy when others are fearful” (Warren Buffett) and vice versa.
Three factors give us some comfort for the equity markets in 2023:
- First, we believe that economic weaknesses, globally, are likely to prove short-lived and shallow because of a robust labor market.
- Second, most investors appear to be prepared by now. In the expectation of the now-unfolding slowdown, defensive stocks (especially dividend payers) have been favored in equity markets all of last year.
- Third, consensus expectations for equity market returns over the coming 12 months are very cautious, which is the complete opposite of the situation one year ago.
So, the fact that the consensus of economists may expect a recession next year doesn’t necessarily mean equities will do poorly if the market has already discounted a recessionary outcome in current prices.
In sum, as we weigh the trade-off between short-term downside risk management (playing defense) and medium-term upside return potential (playing offense) we want to shift our portfolios towards more defense right now, and we do not believe we are giving up return in doing so. If the equity market declines to levels that offer compelling medium-term returns, we will look to play more offense.
The past year has been one of the most difficult investment environments ever for the bond markets. The traditionally defensive Bloomberg U.S. Aggregate Index (“the Agg”) lost 13% in 2022 as high inflation led to a spike in interest rates. While losses have been painful, the good news is that current yields will likely translate into positive returns that bond investors have not seen in years.
When estimating returns for core bonds (the Agg) over longer periods of time, the starting yield is a good approximation of subsequent returns. The chart below illustrates the strong relationship between starting yields and subsequent 5-year returns.
At year-end, the Agg was yielding 4.7%. This provides a good base-case return assumption for core bonds over a five-year investment horizon. In a bearish macro scenario, where Treasury and Aggregate bond yields move lower, we estimate that core bonds returns would be stronger. In an environment where inflation remains stubbornly high and/or the Fed increases rates higher than consensus expectations. In this scenario, we would still expect core bonds to generate a return in the 3- 4% range.
We expect core bonds to deliver a positive return if a recession plays out, providing valuable portfolio ballast while riskier assets such as equities get hit. For example, if the 10-year Treasury yield were to decline 75 bps (to 3.10%) over the next 12 months, we estimate the core bond index would return close to 9% (from yield plus price gains).
Our core bond allocation also acts as “dry powder” that we can tactically allocate into stocks and other higher-returning assets at more attractive prices.
As 2022 has (painfully) reminded investors, we should “expect the unexpected, and expect to be surprised.” This is expressed in our portfolio construction and investment management via balanced risk exposures, diversification and forward-looking analysis that considers a wide range of potential scenarios and outcomes.
While challenging, it is critical for long-term investors to stay the course through these rough periods in the markets. The shorter-term turbulence and discomfort is the price one pays to earn the long-term “equity risk premium” – the additional return from owning riskier “growth assets” (such as stocks) that most investors need to build long-term wealth and achieve their financial objectives.
Fixed-income assets and high-quality bonds are also now reasonably priced with mid-single-digit or better expected returns. Core bonds will also provide valuable portfolio ballast in the event of a 2023 recession.
From all of us at Argent, we wish you and yours a healthy, happy, and prosperous New Year.
Certain material in this work is proprietary to and copyrighted by Litman Gregory Analytics and is used by Argent Financial Group with permission. Reproduction or distribution of this material is prohibited, and all rights are reserved. Argent Financial Group is the parent company of Argent Trust, Heritage Trust and AmeriTrust.