2023 is upon us and most investors are happy to bid 2022 adieu. It’s been a turbulent year, to say the least, with inflation, aggressive rate hikes, war, and significant losses across asset classes. Correlations between equities and fixed income turned positive, and investors felt the sting of losses in equities and bonds simultaneously. The S&P 500 ended 2022 down -18%, the Bloomberg US Aggregate bond index was down -13%, and the MSCI EAFE was down -14%.
Writing this time last year, we were boasting a 27% return from the S&P 500 in 2021. We predicted COVID moving into the background, a strong US consumer boosted by savings and stimulus, an overvalued US Large Cap Growth sector, rising global inflation, and upcoming Fed rate increases. Shortly after, we saw a war begin in Ukraine, and swift energy reform sweep Europe. While we predicted a volatile and possibly negative year, the downturn in 2022 was significantly different. The most widely felt variation was that positive correlation between equity and bonds, giving us a year where both asset classes were negative. Fixed income can normally be counted on to stem losses in equities, however, with the Fed raising rates aggressively throughout the year, even shorter-term fixed income wasn’t spared the red tape.
Last year we knew the Fed was behind in raising rates, and they certainly made up for their slow pace, moving the benchmark Fed Funds rate from close to 0 to 4.5%. It seems doubtful that the Fed will pivot until the Fed Funds Rate is positive in real terms and the labor market shows meaningful signs of cooling. It’s true those numbers continue to come down, but there is still meaningful wage growth and job openings remain elevated. Not enough progress has been made to appease the Fed. We believe rate hikes will continue in 2023.
Last year’s healthy US consumer could only hold up to the crushing weight of inflation for so long. Moving into 2023, savings are running low, and borrowing has increased. Credit card balances have crept up and the average consumer is running out of steam. Wage growth has helped but has not kept up with the rate of inflation. And it’s important to note inflation is a rate. The Fed’s target is 2% inflation, but that won’t change the 7% we’ve seen as of December. Negative inflation typically comes with a severe recession, something we’re all hoping to avoid. Their goal isn’t for prices to go back, only to stop rising by more than 2% a year. Thus, the average consumer needs wage increases (the same Fed is trying to slow down) to continue if they hope to regain some of the purchasing power they had prior to 2022. Consequently, discretionary spending may be negatively impacted in 2023.
We did see COVID move into the background this year for developed countries, but China remains behind and only recently ended their zero COVID policy. The end of Chinese lockdowns may eventually boost the global economy, but there could be short-term pain as COVID sweeps through a population with little immunity. Thus, emerging market equities remain an area of concern in 2023.
International equities took a hit in 2022 after the Russian invasion of Ukraine. Inflation was already high, and energy became a concern as Russia predictably cut off oil after broad support for Ukraine. However, better-than-expected energy storage, a mild winter, and a weaker US dollar provided a tailwind for international equities in Q4. Inflation and fiscal policy remain concerns as global central banks are raising rates in tandem with the Fed in the US. It’s worth considering, however, that the MSCI EAFE index is tilted toward Large Cap Value names. Should the US Dollar’s trend lower continue in 2023, international equities could present an opportunity for investors.
Large Cap Growth companies certainly felt the pain we predicted last year. The S&P 500 Growth index was down almost -30% in 2022. Unfortunately, even after the drop, valuations remain high. Ongoing quantitative tightening by the Fed has put an end to the era of negative real interest rates. Companies that are able to grow their cash flows organically and/or have cash on hand are now at a significant advantage over those that depend on borrowing. That continues to favor the Large Cap Value sector.
Looking into 2023, we hope to discourage unreasonable pessimism and encourage reasonable expectations. Even if a recession does occur, it will be the most predicted recession imaginable. While we believe market predictions are still high, earnings estimates have moved down. Valuations are cheaper than they were this time last year, and opportunities in investments are starting to develop. The dollar, after a strong year, has begun to weaken, which could in turn benefit international equities. While equity and bond diversification hurt in 2022, we believe the negative correlation between stocks and bonds should normalize in the future. It’s true consumer and business confidence is down, however historically, the best time to invest is when confidence is low. While it’s highly likely 2023 won’t repeat 2021’s returns, there are reasons to believe it could be better than 2022.
At SIMA, our 2022 portfolio changes in favor of US Large Cap Value over Growth paid off for our clients. Moving to a shorter duration in bonds also helped fixed-income returns. In 2023, we continue to overweight Large Cap Value equities and short-term, high-quality bonds. We’ve added active management in the US Large Cap Value sector and further shortened the duration in fixed income while the Fed continues to raise rates. While 2022 was admittedly challenging, we continue to believe planning, proper asset allocation, and diversification are keys to success. Historically, clients have been rewarded by staying invested and focusing on long-term goals vs short-term market movements. So don’t give way to unreasonable pessimism in 2023 and let us help you make informed investment choices personalized to your goals.
Heather A. Voight, AIF® | Portfolio Manager
Previous market commentaries:
2022 Third Quarter Market Commentary 2022 Second Quarter Market Commentary 2022 First Quarter Market Commentary
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