Market Commentary - Q4 2022 - More than $12 trillion in value was erased from the U.S. stock market this year
Key Takeaways:
- All three US equity indexes logged their worst year since 2008
- Bonds and stocks fall in tandem
- Tight labor market and sky high inflation force Fed’s hand
- The year big tech stocks fell from glory
- Defensive stocks act as one of few hideouts
- Home prices and unemployment rate
- Outlook and new investment playbook
All three US equity indexes logged their worst year since 2008
More than $12 trillion in value was erased from the U.S. stock market last year.
Nearly every asset class across global markets was sharply lower in 2022. Stocks crashed. Bonds had their worst selloff ever. Cryptocurrencies were demolished, leading to mass bankruptcies and the collapse of industry giants. Most importantly, the era of easy monetary policy came to a screeching halt.
The S&P 500 fell 19% for the year, the Dow was down 8.8%, and the tech heavy Nasdaq Composite declined 33%. All three indexes logged their largest declines since 2008, the year Lehman Brothers collapsed and the housing market imploded.
There were little places to hide as bonds had an even more bruising year. The yield on the 10-year U.S. Treasury, which influences everything from mortgage rates to student debt, climbed to 3.826% at year-end, from 1.496% at the end of 2021. Yields rise as bond prices fall.
Cash was eroded by record high inflation. Just about the only safe haven for investors was short-term government bonds (less than 1 year in maturity). For the first time in decades, savers could get close to 4% on cash or cash equivalents. However, real interest rates, the rate of interest an investor, saver, or lender receives after allowing for inflation; were still significantly negative as inflation nearly touched 10%.
The only shining lights in markets were the U.S. dollar, crude oil, and energy stocks. Foreign currencies fell to record lows against the dollar as inflation and interest rates ripped higher across the globe. Investors flock to the U.S. dollar as a safe haven during times of global economic uncertainty and instability.
Tighter monetary policy led investors to flee the most popular stocks across markets from previous years. Technology stocks such, the NYSE FANG+ Index, which tracks Meta Platforms (Facebook), Amazon.com, Apple, Netflix, and Alphabet (Google), among other stocks, was down 40% for the year.
Tesla shares suffered their worst year ever, falling more than 60% as its astronomical valuation finally came back down to earth. Elon Musk was also embroiled in more controversies at Twitter, for which he took ownership in October, weighing on Tesla’s stock.
Defensive sectors, such as consumer staples, health care, and utilities provided a higher floor. The S&P 500 utility stocks were down 0.5% for the year, consumer staples were down 2.7%, and healthcare stocks were down 3.2%.
When interest rates are low, it costs investors less to bet on shares of often-unprofitable, potentially overvalued companies promising to deliver big growth years down the line. Now, with short-term bonds, money-market funds, and other cash-like investments offering their highest yields in years, many money managers are reluctant to bet on risky investments with uncertain payoffs.
Bonds and stocks fall in tandem
According to Bank of America Global Research, investors with the classic “60/40” portfolio, who put 60% of their portfolio in stocks, and 40% into bonds, suffered their worst year in 100 years as bonds and stocks fell in tandem.
The appeal of the 60/40 portfolio is that when stocks have a bad year, bonds usually deliver some relief. This strategy failed in 2022 however, as soaring inflation, rising interest rates, war in Europe, and a squeeze in energy markets have seen valuations plunge across both asset classes.
Tight labor market and sky high inflation force Fed’s hand
In the past nine months, Jerome Powell has raised interest rates at the fastest pace of any Federal Reserve chair since the 1980s, triggering a market rout, bringing the housing market to a standstill and prompting fears of an imminent recession.
Many economists believe that the Fed was too late to start their rate hikes. We agree. When inflation was hitting 40 year highs, stock markets were up double digit percentage points, unemployment was at record lows, the Fed sat on the sidelines for months as supply constraints continued to push prices higher. Now, it seems they have been playing catch-up and frantically raising rates to try to slow down persistent inflation. The fear is that a soft landing will not be achievable and the Fed will tighten the economy into a recession, crushing demand and causing widespread economic damage.
The Fed is faced with two difficult questions: how high to raise rates from here, and how long to hold them at that level to conquer inflation.
While we have started to see signs of overall inflation coming down in November and December as energy prices cool, the concern is that core inflation has remained resilient and in some cases has increased while overall inflation has declined. This could mean that inflation will be higher for longer than many expect as core inflation tends to be stickier than overall inflation.
The main focus of the Fed is the extremely tight labor market. Wages have been rising while the employment rate has remained low. We are starting to see signs of layoffs across tech companies, however in order for the Fed to stop its rate hiking cycle, we believe the unemployment rate will need to reach 4.5-6%, which is significantly higher than November’s unemployment rate of 3.6%.
The Fed increased interest rates aggressively in 2022 in an effort to combat inflation by slowing the economy. Demand showed little signs of slowing as consumers continued to spend even as prices rose and supply constraints continued to be an issue as the war in Ukraine showed no signs of ending and multiple lockdowns in China stopped manufacturing.
The encouraging December inflation figure of 6.5% follows several signs that U.S. economic activity cooled in late 2022. U.S. imports and exports fell in November from October, while retail sales, manufacturing output and home sales all declined. Job and wage growth slowed in December. All encouraging signs that higher rates are beginning to slow demand.
JPMorgan Chase CEO Jamie Dimon said the Fed could need to lift its benchmark federal-funds rate to 6% to tame inflation. That would be higher than the peak level between 5% and 5.5% in 2023 that most Fed officials projected after their December meeting.
“Inflation won’t quite go down the way people expected,” Mr. Dimon said. “But it will definitely be coming down a bit.”
The year big tech stocks fell from glory
For the better part of the previous decade, investors crowded into shares of fast-growing technology companies whose strong gains year after year reinforced bets that they had nowhere to go but up. Surging prices for FAANG stocks propelled major indexes to 70 all time highs in 2021. In 2022, the S&P 500 closed at one record high and the Nasdaq had zero as tech stocks fell from glory.
The music stopped last year when the Fed’s aggressive monetary policy shifted the momentum. Investors were forced to reassess the pros and cons of holding the shares of firms whose appeal centered on their potential for generating windfall profits many years in the future.
“When money is basically free…you’re willing to place a high value on future earnings, particularly of growth stocks,” said Erik Knutzen, chief investment officer of multi-asset strategies at Neuberger Berman. “That all changes when rates rise.”
Defensive stocks act as one of few hideouts
In a year of stock market turmoil, investors have flocked to trusted safety plays. Shares of utility, consumer-staples, and healthcare companies have weathered the storm better than most of the market this year.
These sectors are often referred to as defensive areas of the market, which means their earnings are somewhat shielded from a slowing economy. The idea is that consumers still pay electricity bills, buy groceries, and pick up prescriptions even when times get tough. They typically have less earnings volatility, consistent cash flows, and quality balance sheets compared to other parts of the market like technology or consumer discretionary sectors.
To be clear, those sectors haven’t posted huge share-price returns, or even any gains at all in 2022. However, their modest losses compared with 2022 declines of 30%+ in other sectors, provided one of few hideouts for investors. The only sector to beat defensive stocks in 2022 was energy as oil prices surged amidst geopolitical conflict and war in Ukraine.
The S&P 500 utility stocks finished the year down 0.5%, consumer staples were down 2.7%, and healthcare stocks were down 3.2%. The S&P 500, meanwhile, fell 19% for the year.
Home prices and unemployment rate
U.S. existing home sales slid in November for a 10th straight month, extending a record streak of declines as high mortgage rates, low inventory, and elevated home prices pushed many buyers out of the market.
Sales of previously owned homes declined 7.7% in November from the prior month to a seasonally adjusted annual rate of 4.09 million. November sales fell 35.4% from a year earlier. The streak of declines is the longest on record in data going back to 1999, the National Association of Realtors said.
The Pending Home Sales Index, a leading indicator of home sales based on contract signings, declined 4% to 73.9 in November. This is close to the level seen in April 2020, when the index fell to 70.0. Pending home sales fell 37.8% compared with the same month a year earlier.
We believe home prices of single family residences will continue to decline in 2023, especially in the markets that saw huge price increases during COVID, as higher mortgage rates combined with rising unemployment take a toll on household balances sheets and spending. This could raise opportunities for real estate investors over the course of 2023. However, limited inventory and record home owner equity should prevent large house price declines or a housing market crash like we saw in 2008.
Outlook and new investment playbook
Business Cycle
As a continuation to our research piece and investing thesis of “Seeking opportunities in business cycles”, we believe that the US economy is now in the late stage to recession stage of the business cycle.
It has been our view for the majority of 2022 that US equity markets will need to wipe out their COVID gains that were largely attributed to an influx of money supply created by the Federal Reserve. We believe that the S&P 500 will retest its 2022 low of 3,491 as the economy falls into a mild recession in 2023.
A mild recession is our base case, however low growth and inflation is here to stay
When recessions destroy demand, central banks often come to the rescue with lower interest rates and easy monetary policy. This potential recession or market downcycle will likely be the opposite of past recessions as cutting interest rates could cause any declines in inflation to reverse like we saw in the 1970s. Loose policy is not on the way to help support risk assets, in our view.
We believe what worked in the past decade will not work in the next decade as the era of quantitative easing is over. We are calling this our new investment playbook.
The Great Moderation, the four-decade period of largely stable activity and inflation, is behind us. The 40 year bull market in bonds, prices rise as yields fall and vice-a-versa, has broken down. Interest rates are once again meaningful.
Theme 1: Pricing in enough damage, “buy the dip” is dead. Disconnect between the market expectations and Fed.
A recession is just about a given; central banks are on course to overtighten policy as they seek to tame inflation causing a hard landing and destruction of demand. This keeps us tactically overweight in cash. We expect to turn more positive on risk assets, specifically equities, at some point in 2023, however we are not there yet. When we do eventually get there, we don’t see the sustained and powerful bull markets of the past. Interest rates will remain elevated and investors that have had zero allocation to bonds over the past decade will likely have allocations over the next decade. We favor an 80/20 portfolio over the classic 60/40.
In other words, it’s not quite time to buy. Concentrated, overvalued markets have not been friendly to investors, and stagflation risks still loom large. The absence of substantial equity outflows is historically unusual and keeps our tactical asset allocation in cash cautious.
Active U.S. household investors, the $40tn whale in equity markets, never sold aggressively enough in 2022 to reverse the $4.2tn equity inflows since COVID. We believe we won’t see a bottom in equities until large outflows occur.
That’s why the old playbook of simply “buying the dip” doesn’t apply in this regime of sharper trade-offs and greater macroeconomic volatility. The new playbook calls for a continuous reassessment of how much of the economic damage being generated by central banks is priced into markets. You can see below that there is a disconnect between the fed-funds forecast and the market.
2022 was a year with almost no new record highs for stock indexes. Few analysts or investors expected 2022 to bring a repeat of the mammoth gains seen in 2021, when the S&P 500 notched 70 record-high closes, the most in more than two decades. But the scarcity of milestones in 2022 was almost as stunning, traders say.
The S&P 500 wrapped up 2022 with only one record close, the lowest total since 2012, according. The Dow closed the year with two. The Nasdaq ended the year with no record closes, the first time that has happened since 2014. You can see from the below chart that after the 2000 dot com bubble and 2008 financial crisis, it took multiple years for the market to regain its all time high. We believe this downturn will play out similarly.
Economic damage is building. In the U.S., it’s most evident in rate-sensitive sectors. Surging mortgage rates have cratered sales of new homes. We also see other warning signs, such as deteriorating CEO confidence, delayed capital spending plans and consumers depleting savings. In Europe, the hit to incomes from the energy shock is amplified by tightening financial conditions.
We expect the Fed to stop hiking and supply/demand activity to stabilize in 2023. We find that earnings expectations don’t yet price in even a mild recession. For that reason, we stay overweight cash for tactical purposes.
We believe at some point in 2023 valuations will get closer to reflecting the economic damage, as opposed to risk assets just responding to unrealistic hopes of a soft landing. On the contrary, it’s also very possible that markets look through the damage as the upcoming recession and market risk sentiment improves as the recession we face is likely to be a mild one. That is why it is important for investors to stick to their long-term allocations and disciplined financial plans. Having tactical allocations for near-term moves is acceptable as long as the long-term core of the portfolio remains invested according to your goals.
Theme 2: Bonds finally have a place in portfolios, especially for aging population
Bonds finally offer meaningful income after yields surged globally. This has boosted the allure of bonds after investors were starved for yield for years. We favor highly rated investment-grade credit and short-term treasury bonds under two years in maturity.
The labor force participation rate fell dramatically in the pandemic as the economy shut down. Many people who left the workforce haven’t come back – and won’t ever return as the boomer generation enters retirement. As strong equity returns are harder to come by, yield will become even more important for investors.
Theme 3: Learning to live with inflation
It has been 40 years since we have had to live with any meaningful inflation. This will take some getting used to and we will need to learn to live with higher than normal inflation for the foreseeable future.
High inflation has sparked a worldwide cost-of-living crisis. We do see inflation cooling as spending patterns normalize, but we see it persisting above policy targets in coming years. Energy prices should ease somewhat, however the war in Ukraine will keep them above normal levels for the foreseeable future.
We also believe the market is overly optimistic about when inflation will cool and at what level the Fed will stop raising rates. We believe inflation linked bonds will continue to perform well along with real assets that can provide an income, like multifamily housing.
Theme 4: Value over growth
The “free money” era in Silicon Valley is over. We have seen many startups fail and asset classes like crypto currency and NFTs implode as venture capital money was being thrown at anything with a buzz, regardless of whether or not they were profitable or had any chance of becoming profitable in the future.
2022 was the year that value finally dethroned growth’s decade long outperformance. We believe value stocks will continue to outperform growth stocks as investors must get used to a higher interest rate and inflationary environment over the next decade.
We believe that defensive sectors will also continue to outperform technology and small cap value will outperform large cap value.
Conclusion
Investors shouldn’t react emotionally or aggressively when rebalancing portfolios to reduce risk exposure. Aggressive market-timing attempts, such as shifting an entire portfolio into cash, can backfire. Some of the strongest returns can occur during the late stages of an economic cycle or immediately after a market bottom. It’s often better to stay invested to avoid missing out on the upswing.
With so many assets trading at steep discounts to their earlier prices, this could seem like a time to buy. But a murky view into the path ahead is keeping many investors from jumping in with both feet.
