Perspective Matters
Eleven years ago, on January 1, 2012, the S&P 500 price index stood at 1,257.60. Ten years later, on December 31, 2021, the same index stood at 4,766. On a total return basis, the index returned +16.6% annually for the decade, a total increase over 360%.
By the end of 2022, the S&P 500 price index stood at 3,839. The total return loss for 2022 was (-18.1%). The 10-year annualized total return of the S&P total return index dropped slightly to +12.6%.
While 2022 was a lousy year for equities by any measure, and the worst single year performance since 2008, but if you measure returns over the last decade, investors have done exceptionally well.
Taking this long view, we believe that, when the current market turbulence is behind us, investors will again think, “That didn’t turn out nearly as bad as it felt at times.”
In 2022, a confluence of events weakened asset prices across all markets. Markets were struck by a global economy still trying to recover from a pandemic, while dealing with unprecedented monetary policy measures and a major war in Europe. The turbulence of 2022 will carry into 2023, with implications for economic growth, interest rates, earnings, and market.
Inflation, Interest Rates, and Economic Growth
US inflation appears to have peaked in August 2022, with the Consumer Price Index (CPI) showing us good reason to believe that we are now in a downward trend.
While the downtrend is welcome news, it doesn’t mean that we will get back to the Fed’s 2% annual target anytime soon. Our forecast is that it may take two years or more for us to get there. There is still a lot of uncertainty about when and where inflaton and unemployment will stabilize. We think that the inflation will be between 3.5% and 4.5% by the end of 2023 and then drop toward 3% or so thereafter.
In response to the inflation, the Fed will continue to increase the fed funds rate until it reaches 5.0% to 5.25% at the end of the first quarter. If inflation remains higher for longer, then further increases are certainly possible.
The increase in interest rates by central banks will continue to weigh on global growth rates in 2023. There is still a strong possibility to believe that we will achieve the desired “soft landing” (mild recession) and avoid a “hard fall,” but there is still considerable uncertainty around what scenario will unfold.
Financial Markets
The biggest positive of last year’s broad surge in interest rates is that bonds finally offer “income” to starved investors. Cash and short-term bond instruments currently yield around 4.5% and even higher yields can be found in other credit sectors such as investment grade corporate bonds.
The broad-based sell-off in equity markets has left some stocks with strong earnings potential trading at very low valuations and thus our long-term expectations for equity returns are higher than previously forecast. But in the short term, stocks will remain susceptible to recession risks.
We will stay focused on cheaper stock sectors which have already priced in a lot of bad news and are offering dependable dividends. We also prefer quality stocks to mega-tech equities which are still highly priced and increasingly subject to US regulatory scrutiny. We will also be watching for opportunities in small cap stocks, which tend to outperform large caps when bear markets end.
We expect markets to bottom and recover later in 2023 when economic recovery is beginning, but in any scenario, we expect that this year is likely to remain volatile, with equities ending somewhat higher than when this year began.
Non-US markets outperformed the US equity market in 2022, dropping (-16.0%) (MSCI ACWI xUS) while the S&P 500 dropped (-18.1%) mostly driven by the US dollar softening in the fourth quarter.
Although we remain underweight to non-U.S. equities, there is the potential to increase exposure to beaten down areas of the market in the new year, especially if the U.S. dollar’s strength softens. This could occur as the U.S. economy slows and interest rate differentials begin to converge as the Fed nears the end of its tightening cycle.
Summary
Throughout 2022, we were diversified in fixed income and equities, with some modest commodities exposure. Our positioning towards defensive, value-oriented and dividend paying stocks both in the US and ex-US helped on a relative basis. Our exposure to interest rate risk was less than the benchmark, and the allocation to inflation-protected bonds helped our performance last year.
We believe that a modest underweight to core equities, defensive and value-oriented stocks is still warranted at this time in the economic cycle.
Thus, a modest overweight to short-duration bonds and cash still seems prudent. The timing of when to change this positioning will be dependent to a large degree upon what the Fed does this year. If and when the Fed stops raising rates, we expect to increase our allocations to defensive equity and value-oriented stocks with small stocks appearing to be relatively attractive. If and when the Fed begins to lower the Fed funds rate, we will consider taking more exposure to growth-oriented sectors such as tech.
As always, markets will price in a 2024 recovery well before the recovery takes hold, as they did when pricing in a recession in 2023 a year before the event. This time will be no different, so we will probably begin our repositioning at some point this year, but for now we will continue waiting to see more data.
The essence of our investment thesis, that diversification matters, that markets are macro-inefficient, and that careful rebalancing can help performance has, in large part, been proven again last year. We will continue to maintain our diversification and invest relative to our overall assessment of financial risk in the year and years ahead.
Data Sources: Bloomberg, Conference Board, Trading Economics, S&P Global, iShares, MSCI, YCharts, FRED.