Easing inflation pressures and a resolution of the fiscal turmoil in the United Kingdom fueled a strong rally in stocks and bonds early in Q4, but hawkish Fed guidance, disappointing economic data, and rising global bond yields weighed on markets in December and the S&P 500 finished the quarter with only modest gains that capped the worst year for the index since 2008 and the fourth worst in its history.
The end of Q3 2022 had been volatile as global market interest rates spiked in response to the spending and tax cut package proposed by former UK Prime Minister Liz Truss and that volatility continued as Q4 began with the S&P 500 hitting a new low for the year on October 13th. However, that market turmoil ultimately resulted in political change as PM Truss resigned on October 20th after just 44 days in power after taking over from the disgraced Boris Johnson and was replaced by former finance minister Rishi Sunak, who immediately took steps to dismantle Truss’ plan and restore market confidence.
In part due to a very short-term oversold condition and following a no-worse-than-feared Q3 corporate earnings season, stocks and bonds staged large rallies in mid- and late- October and the S&P 500 finished the month with a substantial gain, up 8.1%.
The positive momentum for stocks and bonds continued into early November thanks to a growing number of price indicators that implied inflation pressures had finally peaked. The October CPI report showed the first solid decline in consumer price data for the year. Both stocks and bonds enjoyed solid gains in response to the data because while inflation still remained far too high on an absolute level, markets hoped these declines would result in the Federal Reserve not raising interest rates as high as previously feared.
Those hopes were boosted after the Thanksgiving holiday when Fed Chair Powell stated that interest rates would only need to rise “somewhat” higher than previous projections. Investors took that “somewhat” remark as a sign that previous estimates for rate hikes were too aggressive and that positive sentiment extended the rally into early December. The S&P 500 ended November at multi-month highs with another solid monthly gain of 5.6%.
However, investor optimism faded in December as global central banks signaled that they were still committed to aggressively hiking rates, economic data showed clear signs of slowing growth, and several negative earnings announcements raised concerns of a possible earnings calamity in 2023.
First, at the December meeting, the Fed revealed that they expected rate hikes to take the Fed Funds rate above 5% (from the 4.375% at the time), which was higher than market expectations. Then, economic data releases showed economic activity was slowing. Finally, both the European Central Bank and the Bank of Japan surprised markets with hawkish policy decisions, providing yet another reminder to investors that rates will continue to rise into the first part of 2023 despite clearly slowing global economic growth and the increasing threat of recession. Stocks dropped heavily from mid-December on and the S&P 500 ended the month with a loss of 5.90%.
Q4 and Full Year 2022 Performance Review
Unlike the first three quarters of 2022, when all four major indices saw quarterly declines, performance was mixed during the fourth quarter as the S&P 500 and Russell 2000 Small Cap Index were solidly higher. Like most of 2022, however, the NASDAQ lagged and fell in Q4.
Expectations for higher rates, slowing economic growth and underwhelming earnings weighed on the tech sector in the fourth quarter, which was the case for much of 2022. Conversely, less economically sensitive companies that trade at lower valuations than tech stocks outperformed again as investors continued to shift towards these more defensive sectors amid growing recession fears. The incineration of the crypto market did not help matters.
Market Capitalization
By market capitalization, Large Caps slightly outperformed Small Caps in Q4 and modestly outperformed throughout 2022. Concerns about future economic growth and higher interest rates (which can impact Small Caps disproportionately due to funding needs) were the main drivers of Large Cap outperformance in 2022. Small-cap stocks did show some resilience in the fourth quarter with the Russell 2000 index registering a solid gain as investors’ hopes for a peak in inflation and ultimately interest rates, led to some dip buying.
Value vs. Growth
From an investment style standpoint, Value massively outperformed Growth all year and that trend continued in Q4. Underwhelming earnings weighed on tech stocks particularly in the final three months of the year, while concerns about slowing economic growth combined with rising bond yields hit previously-highly-valued tech stocks all year.
Value stocks, meanwhile, were viewed as more attractive in the market environment of 2022 due to much lower valuations and exposure to business sectors considered to be more resilient than high-growth parts of the market.
Sectors
On a sector level, ten of the eleven S&P 500 sectors finished Q4 with a positive return, although only two ended 2022 with gains. Energy outperformed other sectors not just in Q4 but for all of 2022. Energy stocks were helped in the fourth quarter by progress on the post-COVID economic reopening in China which increased energy demand expectations, while a falling US dollar was an added plus for commodities including oil and gas.
Other strong sector performers in the quarter were Industrials and Materials, which also benefitted from an improving Chinese demand outlook and a weaker dollar. For the full year, energy was by far the best-performing sector in the market as an early-year surge in oil and natural gas prices in response to increased geopolitical risks and reduced Russian supply helped push energy stocks sharply higher.
Defensive sectors, specifically Utilities and Consumer Defensive, were the next best-performing sectors finishing the year with small gains and losses respectively as investors rotated towards less economically sensitive corners of the market amid rising recession risks.
The tech sector and those sectors with overweight exposure to high-growth companies badly lagged both in Q4 and over the course of 2022. For the quarter, Communication Services were only fractionally positive while the Consumer Cyclical sector posted a negative return on severe weakness in some high-growth internet and consumer stocks. For the full year, those same two sectors posted the worst returns in the S&P 500, as investors shunned growth-oriented companies which they perceived to be excessively-valued, particularly those in the low/no profit tech space, some of whose stock prices are down as much as 80%-90% from their highs near the end of 2021.
Foreign Markets
Internationally, foreign markets handily outperformed the S&P 500 in the fourth quarter thanks to a large bounce in Chinese stocks as Beijing ended its “Zero-COVID” policy and commenced an economic reopening, while a finally falling dollar boosted global economic sentiment. Foreign developed markets outperformed emerging markets in Q4 thanks in part to a large bounce in UK shares following the resignation of PM Truss and the abandonment of her fiscal spending and tax cut plan. For the full-year 2022, foreign developed markets registered solidly negative returns, but thanks to the fourth-quarter rally, relatively outperformed the S&P 500.
Commodities
Commodities saw gains in Q4 as both oil and gold logged positive returns. A falling dollar paired with an improving outlook for Chinese demand as the government moved towards reopening their economy pushed oil higher throughout the quarter. Gold, meanwhile, saw steady gains in the final three months of the year thanks primarily to the decline in the US dollar. For 2022, commodities posted a large, positive return due to the significant gains in oil futures and other energy commodities that came in response to geopolitically-driven supply concerns following Russia’s invasion of Ukraine. Gold, however, saw only a slightly positive return for 2022 as sharp rises in the US. dollar and market interest rates mid-year weighed heavily on the yellow metal.
Bonds and Fixed Income
Switching to fixed income markets, the leading benchmark for bonds (Bloomberg Barclays US Aggregate Bond Index) realized a positive return for the fourth quarter but declined sharply for the full year of 2022, as more-aggressive-than-expected Fed rate hikes combined with decades-high inflation pressured most bond classes.
Looking deeper into the fixed income markets, longer-duration bonds outperformed those with shorter durations in the fourth quarter, as bond investors reacted to more-resilient-than-expected economic data. For the full year, shorter-term bonds handily outperformed longer-duration bonds as they were inherently less impacted by Fed rate hikes and spiking inflation.
Turning to the corporate bond market, both higher-yielding, lower-quality corporate bonds and investment grade bonds posted similarly positive returns for the fourth quarter, as investors reacted to the possible peak in inflation. Lower-yielding and safer investment-grade corporate debt underperformed for the full year, however, as investors shunned those bonds for shorter-duration debt and corporate debt with higher yields.
Q1 and 2023 Market Outlook
Markets ended 2022 on a decidedly negative note and the December losses helped to ensure that 2022 was the worst year for stocks since 2008 and the worst year for bonds in multiple decades, as both asset classes posted annual declines. That hasn’t happened since the 1960s.
The losses in stocks and bonds were driven by decades-high inflation, a historic Fed rate hike campaign and geopolitical unrest. But while those factors were clear negatives for asset prices in 2022, it’s important to note that as we enter 2023, the market is approaching a potentially important transition period that could possibly see each of these headwinds ease in the months ahead.
First, inflation has shown definitive signs of peaking and declining. The Consumer Price Index (CPI) has fallen from a year-on-year high of 9.1% in June to 7.1% in November, while other metrics of inflation have registered similar declines. To be clear, inflation remains much too high in an absolute sense, but if price pressures ease faster than expected, that will present a positive surprise for markets in the first several months of 2023.
Second, after a historically aggressive rate hiking campaign in 2022, the current Fed hiking cycle is likely nearly complete. In December, the Federal Reserve signaled that it expected the peak interest rate to be just 75 basis points higher than the current rate. That level could easily be reached within the first few months of 2023 and the Fed ending its rate hike campaign will remove a significant headwind from risk assets.
Finally, while both economic growth and corporate earnings are expected to decline in 2023, those negative expectations have been at least partially priced into stocks and bonds at current levels. As such, if the economy or corporate America proves to be more resilient than forecasts, it could provide a positive spark for asset markets in early 2023.
As we start the new year, we should expect financial media commentary to be focused on the 2022 losses and current market risks, including earnings concerns and recession fears. But the market is a forward-looking instrument, and while there are undoubtedly economic and corporate challenges ahead in 2023, some of those best-known risks are at least partially baked into markets already and the truth is that there are some potentially positive catalysts lurking as we start a new year.
Summary
As I have said many times in my weekly report: market history is clear. Declines of the magnitude we saw in 2022 are followed at some point by strong recoveries. The S&P 500 hasn’t registered two consecutive negative years since 2002, while bonds, represented by the Bloomberg US Aggregate Bond Index, have never experienced two negative consecutive years in history.
That reality underscores an important point, that market declines such as we witnessed in 2022 have ultimately yielded substantial long-term opportunities for investors in both stocks and bonds.
The stagflation of the 1970s and sky-high interest rates of the early 1980s eventually gave way to the strong economic growth and market rally of the 1980s. The dot-com bubble burst of the early 2000s was followed by substantial market gains into the mid-2000s. The financial crisis, which remains the most dire economic situation we’ve experienced in modern history, was followed by strong rallies in the years that followed, and not even the worst global pandemic in over 100 years could result in sustainably lower asset prices.
As such, while we should be prepared for continued volatility and are focused on managing both risks and return potential, we understand that a well-planned, long-term-focused, and diversified financial plan can withstand virtually any market surprise and related bout of volatility, including multi-decade highs in inflation, historic Fed rate hikes, geopolitical unrest and rising recession risks.
Anglia Advisors understands the risks facing both the markets and the economy, and we are committed to helping you effectively navigate this challenging investment environment. Please make use of my Weekly Market Report to stay up to date on my thoughts.
It’s a cheesy quote, but it’s true. Successful investing really is a marathon, not a sprint. Even intense volatility like we experienced last year is unlikely to derail a sensible, well-planned diversified approach set up to meet your personalized long-term investment goals.
Therefore, it’s critical for Anglia Advisors clients to stay invested, remain patient while continuing to buy into the market on as regular a basis as you can and stick to the plan that we worked on together - a unique, personal allocation target based on your financial position, risk tolerance, and investment timeline.
I remain vigilant on your behalf towards risks to both portfolios and the economy and want to thank you for your ongoing confidence and trust.
If you are already a client, please do not hesitate to contact me with any questions, comments or to schedule a portfolio review. If you are a prospect, I’d be delighted to discuss bringing you into the Anglia Advisors family.
Simon Brady, CFP®
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