Two Steps Forward, One Step Back - 2022 Review
The most challenging year for investors since the financial crisis came to an end last week. The large cap S&P 500 index finished down -18.1%. The tech-heavy NASDAQ plummeted 33% as more than 50% of the names in that index declined 50% or more. The Dow Jones Industrial Average dropped 8% as the value orient- ed names in that index of 30 stocks fared much better.
Value performed much better than growth with large value stocks performing the best at - 7.5%. Growth stocks were punished for their high valuations while investors sought low valuation sectors such as industrials, energy and financials as well as defensive sectors such as consumer staples and health care.
The biggest challenge for the average investor came from the one place that has traditionally been counted on to partially offset declines in stocks: the bond market.
The Bloomberg Aggregate U.S. Bond Index was down 13% in 2022; its worst year since its inception in 1976. Before 2022, the index's worst year came in 1994... when it dropped just 2.9%.
The dominant market story this year was the Federal Reserve's historic increase in interest rates. The central bank raised interest rates by a cumulative 4.25% in 2022 — from a range of 0%-0.25% in January to 4.25%-4.5% as of December — the most since 1980. Further in- creases are expected next year, although the Fed is almost at it’s terminus point with rate rises (expected to be 5.1%).
As a result, yields across the Treasury curve rose sharply, weighing on prices in both government and private bond
markets (bond prices fall when yields rise). At the outset of 2022, the yield on the U.S. 10-year Treasury stood at 1.5%; by late October, the 10-year yield was closer to 4.2%, and closed the year at 3.88%. The move in 2-year yields, which tend to be more sensitive to the path of Fed rate hikes, was even more dramatic, rising from around 0.75% at the beginning of the year to 4.4% at the end of the year.
With bonds suffering their worst year on record, it follows that the classic "60/40 portfolio" comprised of 60% stocks and 40% would also struggle.
Indeed, 2022 marks the second-worst year on record for the 60/40 portfolio since the inception of the Bloomberg Agg in 1976. A hypothetical 60/40 portfolio comprised of the S&P 500 and the Bloomberg Agg would be down 16.9% in 2022. The only time a 60/40 portfolio has fared worse was during the 2008 credit crisis, in which a 38% decline in the S&P 500 resulted in losses of 20.1% for the hypothetical 60/40 portfolio. Moreover, 2008's decline was more than entirely driven by the drop in stocks — in 2008, the Bloomberg Agg actually rose 5.2%. Bonds, in other words, did offer some support against a plunge in stocks. Unfortunately, in 2022 the story has been otherwise.
Nevertheless, we agree with Vanguard’s Chief Economist and Head of Portfolio Strategy, Roger Aliaga-Díaz, who writes "the goal of the 60/40 portfolio is to achieve long-term annualized returns of roughly 7%. This is meant to be achieved over time and on average, not each and every year." Roger’s point aligns with our investment process and some of our previous communications to you all: prudent wealth management demands a long-term perspective and it is important to adopt this perspective across asset classes, not just for the more volatile asset classes, e.g. stocks.
Turning to 2023, Wall Street’s consensus forecast is that 2023 will bring a recession. The strongest support for this scenario is the inverted yield curve. Ahead of each of the last 8 recessions in the U.S. the yield on the 2-year Treasury note has eclipsed the yield on the 10-year bond. Today, the 2-year yield is about 0.5% higher than the 10-year yield, signaling trouble for the economy in 2023.
But some economists cast doubt on the on the yield curve’s message. An inverted yield curve by itself isn’t sufficient to signal a recession. Indeed, there have been occasions where the yield curve inverted but no recession followed. Prior to a recession, along with a yield curve inversion, several other indicators usually occur but as of today are not happening:
In previous cycles when the yield curve inverted, credit growth slowed sharply or even contracted; this isn’t happening now.
The tight credit conditions that precede a recession also are absent.
U.S. corporations are under-leveraged according to the ratings agencies. Free cash flow to debt is at 11%, the lowest in the last decade.
Even with borrowing rates higher, company’s capital expenditures are high and not declining.
The jobless rate doesn’t currently signal an impending recession.
Consumers have excess savings and low debt costs. Rising mortgage rates have not affected the majority of people as most are holding mortgages below 4%, with some below 3%; this dynamic won’t change unless they move.
Despite 2022’s drop in stock, bond and home prices, consumers’ net worth is $145 trillion, up from a pre- pandemic $115 trillion (see graphs).
For all the predictions of a recession in 2023, monetary, credit, wealth, investment, and labor measures say otherwise.
However, some would argue that Fed’s rate hikes and quantitative tightening have yet to work themselves through the economy. There are certainly signs of the economy slowing down: corporate earnings growth is slowing and is predicted to stall this year, inflation remains pervasive (although prices are coming down and other indicators argue that will continue), and manufacturing is contracting.
If economic activity does need to weaken for the Fed to be sure inflation has moderated, we do not expect a lengthy, or deep, period of contraction. Given the decline already seen in the price of both stocks and bonds, we believe that while 2023 will be a difficult year for economies, the worst of the market volatility is behind us and both stocks and bonds look increasingly attractive.
No matter the direction of the markets going forward, we continue to choose logic over emotion and implement our process-driven approach to managing client assets. We welcome any questions or concerns you may have on your portfolio and financial plan, and as always, we appreciate your continued trust in our services.
