2022 proved to be a difficult year for investors. The combination of sticky inflation, Fed rate hikes, and international turmoil drove both equities and fixed income into negative returns. The S&P 500, a broad gauge of the U.S. stock market, dropped 18.11% for the year, while the Bloomberg Aggregate Index, representing U.S. fixed income, declined by 13.01%, per FactSet. The tech heavy NASDAQ fared even poorer, dropping 32.54% for the year, while the MSCI ACWI ex USA, a broad index of non-U.S. stocks, dropped 15.57%. These declines occurred against a backdrop of upheaval both at home and abroad, with events such as Russia’s invasion of Ukraine in February, skyrocketing gas prices over the summer, and the implosion in the value of crypto assets culminating in FTX’s bankruptcy and ongoing litigation towards the end of the year.
If 2021 was dubbed the “everything bubble”, then 2022 may as well be called the “everything bust”. The declines across traditional asset classes (fixed income and equities), crypto assets (with Bitcoin down 64.20% this year) and even geography (both U.S. and non-U.S. stocks) represent a truly historical drop in investments that in the past have been far less correlated. For our younger clients, this is their first bear market. For most of our clients, this is not. Regardless of your level of experience, it is perfectly understandable to be concerned about your portfolio. In this newsletter, we will review this challenging year and, using historical data and empirical facts, hopefully relieve part of your concerns by taking the long view on investing.
On the economic front, the main theme of 2022 was and continues to be the frustrating effects of inflation. At the start of the year, the threat of inflation was dismissed as “transitory.” However, with year-over-year inflation hovering around 6.50% as of December, it clearly continues to be a major issue. With the Federal Reserve’s control over short-term interest rates being the only viable (albeit blunt) option to tame inflation, we have seen benchmark interest rates increased to a targeted 4.25-4.5% band from a near zero level in a matter of months. Given the inverse relationship between interest rates and the price of bonds, this largely explains fixed income’s poor performance this year. This massive series of rate hikes has rippled beyond the markets into our daily lives as well, driving consumer interest rates to levels not seen in years. 30-year fixed mortgage rates, once below 3% at the start of 2022, have now jumped to 6.66% at the close of the year. Credit card interest rates on balances have shot up to an unprecedented 19.1% in the fourth quarter of 2022, beating out the previous record of 18.9% set in the first quarter of 1985, according to the January 9th, 2023, Consumer Credit Report from the Federal Reserve. Global central banks have also responded to inflation with hikes, though not as aggressively as the U.S. Federal Reserve. As seen in the chart from Vanguard below, benchmark rates around the world have increased to mid-2000’s levels at a fast clip.
Equities have also experienced a difficult 2022 due to the twin headwinds of rising interest rates and inflation. While the broad market index S&P 500 is down 18.11% for the year, there are notable divergences. Growth stocks have taken a particularly hard hit when compared to the broad market and their value stock counterparts. The Russell 1000 Growth Index is down 29.14% for the year, compared to the relatively tame decline of 7.54% of the Russell 1000 Value Index. Value’s outperformance relative to Growth can be attributed to investors’ preference for solid profits today, with heavily discounted potential future profits (as seen in Growth companies) less attractive in this economic environment.
While the decline in equities is certainly not pleasant to watch, there are some solid signs for at least cautious optimism. One side effect of reduced equities prices is that valuations have come down from the sky-high level of the pandemic to a level more in line with the historical average, as seen in this S&P 500 P/E graph over time from First Trust:
While domestic equities are approaching “normal” valuations, non-U.S. equities valuations are even more depressed. As seen in J.P. Morgan’s chart below, the MSCI AC World ex U.S. index currently trades at 12 times forward earnings, a 28% discount to the S&P 500 P/E. This represents a P/E multiple that is almost two standard deviations below where U.S. large cap stocks are trading. It remains to be seen whether this suggests that international equities are at bargain prices with a large upside surprise, or that the market is pricing in a rocky road ahead for these international stocks.
If anything, we can view this decline in stock valuations both domestically and internationally as an unfortunate but natural part of stocks moving closer to fair value. A potential source of good news, however, is the historical reaction of equties to interest rate hikes. First Trust took the average of the S&P 500’s returns preceding and following periods of interest rate hikes over the past 30 years. As demonstrated in their chart below, equities have on average seen positive (albeit initially subdued) returns during periods of rate hikes, with 2-year annualized returns in-line with the historical returns for the S&P 500. Summed up, the short-term negative reaction to increases in interest rates is eventually reversed as the market becomes acclimated to the new interest rate environment. Will the added stress of inflation make this time different? It is impossible to tell, but it is important to remember that equities have made positive returns in numerous instances after interst rate hikes, going well beyond the 30 year sample examined by First Trust.
While we certainly hope that markets and the economy rebound in this new year, it is important to point out an area of concern that we are watching. Top of our list is the recession question. By one measure (two quarters of negative GDP growth), the U.S. entered a recession in the summer of 2022. Technically, however, the National Bureau of Economic Research (NBER) has the official say on when a recession occurs in the United States, and they have not stated that this has happened yet. Regardless, public sentiment and equity valuations (a forward looking indicator) would certainly suggest that if we are not already in one, a recession may be around the corner. In their December 2022 whitepaper, Vanguard estimated that there is a 90% chance of a recession in the United States in 2023, observing that “the current monetary tightening cycle is historic and leaves the narrowest of paths for the economy to escape without a period of recession”. J.P. Morgan’s most recent Guide to the Markets, however, points out a more optimistic take on the slowing economy and depressed markets. They note that since equity markets are forward looking, we may have gotten through the worst of it, predicting that “calmer waters should lie ahead for investors. Inflation is falling, the Fed is nearing the end of its tightening cycle, and much of the expected weakness in economic growth is already reflected in market valuations.”
2022 was tough. Between the year’s slowing economic growth, market sell-offs, and persistant inflation, it can be easy for investors to become jaded. The uncertainty of what 2023 may bring can be further disheartening. While we do not want to discount the very real distress that comes from a bona-fide bear market across almost all asset classes, now is the critical time to take solace in the long view on investing. While no two market downturns are alike, in every instance across well over a century of financial history, the market does rebound after a major decline. The prudent investor recognizes that bear markets, in the words of BlackRock, “tend to be brief and painful.” We often focus more on the “pain” of bear markets rather than on their brevity. Reversing this focus may be beneficial in navigating such downturns. The chart below from Blackrock helps put this into perspective. As we reach out to each of our clients, we look forward to taking into account this long-term perspective as we work to ensure that your allocation and financial plan continue to meet your goals.
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