Highlights
- The S&P 500 returned 7.6% in the fourth quarter, reducing its 2022 loss to 18.1%.
- Energy (+65.8%) and Utilities (+1.4%) were the only sectors with positive returns for the year.
- The broad Bloomberg Aggregate bond index returned 1.9% for the quarter and -13.0% in 2022.
- Value stocks outperformed growth stocks by 12.2% in the quarter and 24.1% for the full year.
- The rate of inflation slowed, but remained high, with year-over-year CPI up 6.5% in November.
- The Federal Reserve reduced its pace of interest rate increases to 50 basis points in December.
Equities
Well, at least it’s over. 2022 was a year most investors would like to forget. Even as economic growth weakened, the Federal Reserve decided in March that inflation wasn’t as “transitory” as it had thought and increased the short-term Fed Funds rate at that and every subsequent meeting. This action led rates to increase along the curve, producing double-digit losses in both stocks and bonds. Most recently, the fourth quarter produced another roller coaster ride for stocks. After reaching its low for the year in early October, the S&P 500 gained 14% through the end of November and then fell 6% in December. For the entire fourth quarter the S&P 500 gained 7.6%, resulting in a loss of 18.1% for the year (total returns).
Small cap stocks led large cap stocks in both the fourth quarter and the year. Reversing their relative performance in the third quarter, value stocks outperformed growth stocks by a substantial margin in the fourth quarter. Even given the substantial weight of the FAANG stocks in the growth index, it is still somewhat shocking to see that growth stocks’ return for the year was almost six times worse than that of value stocks.
Every sector, other than the Communication Services and Consumer Discretionary sectors, produced positive returns in the fourth quarter. Although oil prices were only fractionally higher, Energy was the best performing sector for the quarter, followed by the Industrials and Materials sectors. For the year, Energy returned an eye-popping 66% and was one of only two sectors, along with Utilities, to have a positive return. The Communication Services and Consumer Discretionary sectors were down almost 40% while Information Technology returned -28%.
While the rate of inflation has been coming down, there are increasing signs that corporate profits are under pressure as companies grapple with higher costs. Estimates for the S&P 500’s final 2022 earnings reflect an 8.7% decline from 2021. Current earnings estimates for 2023, while 13% higher than 2022, have come down 12.4% from a year ago. This decrease, along with the S&P 500’s gain in the fourth quarter, brought the year-end P/E ratio for the S&P 500 to 21.2, compared to 19.1 at the end of September. It was 22.7 at the end of 2021.
Fixed Income
December’s Consumer Price Index report showed that inflation continued to ease, with month over month prices up 0.1% and year over year prices up 7.1%, down from monthly and annual increases of 1.3% and 9.1% in June. Energy prices fell in November, while food and shelter prices rose, although, since shelter prices reflect costs for the last twelve months, they were higher than current market rents.
Having increased the targeted Fed Funds rate by 75 basis points at its last four meetings, the Federal Open Market Committee (FOMC) decided at its December meeting to increase the target range by only 50 basis points to 4.25% – 4.5%. Most members of the FOMC predicted at their December meeting that the Fed Funds rate would be somewhere between 5.0% and 5.5% at the end of 2023 before falling in 2024. In addition to increasing rates, the Fed has also been shrinking its balance sheet, from its peak of $8.9 trillion in March to $8.6 trillion in mid-December. Concern is already being expressed about the effect on the financial system of this withdrawal of liquidity, so it remains to be seen whether the Fed will get its balance sheet anywhere close to its $4.2 trillion pre-pandemic level.
Short and long-term Treasury yields continued to rise in the fourth quarter, with short term rates rising substantially faster than long-term rates. (The one-month Treasury yield increased 132 basis points while the 10-year yield rose by only 5 basis points.) As a result, the Treasury yield curve became more inverted (short-term rates higher than long rates), traditionally a leading indicator of recession. However, maturities between three and seven years saw yields fall slightly and this, along with a tightening of credit spreads, led the Bloomberg Aggregate Index, the broadest measure of the investment-grade fixed income market, to return 1.87% for the quarter. Demonstrating the value of higher starting yields, two-year Treasury yields rose 15 basis points but still managed a return of 0.51%. Year to date, the longest-term bonds, both Treasuries and corporates, have lost more than the S&P 500, a reflection of the extremely low starting yields and the risk of longer duration assets. By contrast 2-year Treasury Notes and intermediate corporate bonds lost only 4.1% and 9.4%, respectively.
Market Environment
2022 appears to have marked the end of the very low interest rate environment of the last 14 years, an environment that among other things gifted the world with blind-pool SPACs, meme stocks, and crypto currency. In response to accelerating inflation in late 2021 and early 2022, the Federal Reserve increased short-term interest rates to their highest level since 2008. The rise in rates led to lower stock prices and greater equity market volatility, with 1% moves occurring on 122 trading days in 2022 compared with only 55 trading days in 2021. As financial conditions have tightened and perception of risk has increased, investors have begun to worry more about the return of, rather than the return on, capital. The poster child for this shift in risk tolerance in this cycle is the collapse of the crypto currency exchange FTX, a financial debacle that appears to dwarf those of Enron and Bernie Madoff.
Despite the sound of bubbles popping, the Fed seems determined to keep increasing rates until it is convinced that inflation is on a sure path to its 2% target. Chairman Powell has even stated that he wants to see positive real rates (the nominal rate minus the rate of inflation) across the yield curve. In the coming year, as mentioned above, most FOMC members see rates rising north of 5% and staying there until 2024. Markets, however, still seem to believe that the Fed is not serious and that it will lower rates more quickly. At the end of 2022, futures markets were predicting that rates would peak in mid-2023 at just under 5% and fall to about 4.6% by year end.
Though you can’t blame the market for thinking that the Fed won’t hold the line (given its history of rushing in to bail out equity investors over the last 14 years), a central bank without market credibility is like a toothless guard-dog. The most recent FOMC meeting minutes show that the Fed is concerned about losing credibility with markets: “Participants noted that, because monetary policy worked importantly through financial markets, an unwarranted easing in financial conditions, especially if driven by a misperception by the public of the Committee’s reaction function, would complicate the Committee’s effort to restore price stability.” The complication is that when markets don’t believe the Fed is serious about tightening financial conditions, they behave in ways that contribute to inflation. Interest rates fall and stock prices rise, despite the Fed’s efforts to tighten monetary policy. Those gains facilitate increased demand, putting upward pressure on prices. This can force the Fed to tighten even further, thus increasing the risk of a “hard landing” for the economy.
While the economy has shown signs of weakening, it continues to grow, albeit slowly. Sectors most sensitive to interest rates have seen the greatest weakness, with sales of existing homes falling in November for the 10th straight month. Other parts of the economy have also cooled. Retail sales and manufacturing output both fell in November. All of this, along with lower energy prices since mid-year, have produced a lower rate of inflation in recent months. However, while wage growth slowed in December, the labor market, particularly in the service sector, remains tight. Wages are rising faster than they have over the last decade and household liquidity remains strong.
There is a great deal of uncertainty about the strength of inflationary forces. Although supply chain problems seem largely resolved, longer-term demographic forces are expected to increase the cost of labor and the emergence of de-globalization removes a source of cost reductions. In the face of these challenges, it remains to be seen whether the Federal Reserve will maintain its tighter policy stance until inflation is tamed, even at the risk of causing a recession, or whether it will back off and accept a higher rate of inflation and sluggish growth. Until some clarity emerges on that question, we can expect continued volatility in both the stock and bond markets.
Focusing on Long-Term Results
These remain challenging times for all investors. Navigating the risks in this market environment requires consistent focus on long-term goals and an appropriate allocation of assets. At Buckhead Capital, we work hard to help our clients clarify and achieve their financial goals. We try to understand the lessons that markets have provided and to use that knowledge in structuring portfolios to preserve and grow our clients’ capital. We continue to emphasize achieving an appropriate return for the risk taken. We do this not only through asset allocation (the mix of stocks, bonds, and cash) but also through individual security selection, sector weightings, and, in fixed income, target portfolio maturities/durations. This attention to risk management has historically produced better risk-adjusted returns over full market cycles. We continue to believe that this market cycle will be no exception.
