Fourth Quarter 2022 Market Update
February 2, 2023
“The monetary headwinds investors face are significant. Prolonged declining interest rates have been stimulative for financial assets. Investment and business strategies dependent on continued rapid money growth, cheap leverage, or buoyant capital markets may struggle for some time. But nature is healing, and the world is healthier than it was a year ago.” – Domestic Equity Manager
Fourth Quarter 2022 Market Update
While the fourth quarter offered investors slight relief, 2022 marked a tumultuous year for capital markets and one of the most challenging years for investment returns in decades. Inflation continued to be the overarching concern for investors, leading the U.S. Federal Reserve (the “Fed”) to take decisive action, and continue its historic monetary policy tightening agenda. The Fed delivered seven rate hikes over the course of the year, increasing the Federal Funds rate by a total of 4.25%, its most aggressive pace of rate hikes since the early 1980s. They continued to a send clear message that defeating inflation remained their key focus, even if their actions result in a recession for the economy. The pace and magnitude of these interest rate hikes took a significant toll on fixed income assets (as a reminder, fixed income prices are inversely related to interest rate movements), and the fear of a resulting economic slowdown hampered equity assets. The result was a bear market for both stocks and bonds in the same calendar year, a rare occurrence.
Domestic equity markets were positive for the fourth quarter, returning +7.6%, and offered a bit of respite for investors. Year-to-date (“YTD”) returns, however, remained decidedly negative at -18.1%, as measured by the S&P 500 Index. All sectors of the index were positive for the period, except for Consumer Discretionary (-10.2%) and Communication Services (-1.4%). The Energy sector continued its leadership, finishing up +22.8% and +65.7% for the quarter and year, respectively, marking its largest outperformance versus the market in the history of the GICS sector classifications. The only other sector with positive returns over the course of the year was Utilities, up +1.6%. The worst performing sectors were Communication Services (-39.9% YTD) and Consumer Discretionary (-37.0% YTD). Value stocks continued their outperformance over growth stocks, which saw significant valuation multiple compression and challenging returns given their sensitivity to rising interest rates. As measured by their respective Russell-based indices, large cap value stocks were down -7.5% YTD as compared to large cap growth stocks down -29.1% YTD, marking one of the largest years of relative outperformance for value stocks since the popping of the tech bubble in 2000. The Nasdaq Composite Index finished the year down -32.5%, trailing the broader market by more than 14%.
Developed international equities were up +17.3% for the quarter, with emerging market equities up +9.7%, as measured by the MSCI EAFE and MSCI Emerging Markets indices (in U.S. dollar terms). On a YTD basis, developed international equities finished down -14.5%, outperforming domestic equities, whereas emerging markets were down -20.1% YTD. Both international developed and emerging market equities faced significant headwinds to performance over the course of the year given the strength of the U.S. dollar, which waned over the quarter, but was up close to +8% over the year as measured by the U.S. Dollar Index. International returns in their local currencies (i.e., before being converted back to USD for domestic investors) were much higher and many markets outside the U.S. handily outperformed domestic equities before taking into effect currency translation.
The fourth quarter brought some relief to fixed income assets as the Fed slightly tapered the magnitude of its December rate hike (a 50 basis point increase as compared to the prior four consecutive increases of 75 basis points). As measured by the Bloomberg U.S. Aggregate Index, fixed income markets were positive +1.9% for the period, but finished the year down -13.0%, marking one of the worst years ever for the asset class. With inflation continuing to run dramatically higher than the Fed’s 2% target, the rapid and substantial interest rate increases drove rates higher across the yield curve and led to poor performance for most fixed income markets. Investment grade corporate bonds finished the year down -15.8%, high yield bonds were down -11.2%, and longer dated U.S. Treasuries finished the year deep in negative territory. On a YTD basis, 10-Year U.S. Treasuries were down -16.3%, with 30-Year U.S. Treasuries down -33.3%. Asset-backed securities were a relative bright spot in markets, finishing down -3.2%, and municipal bonds ended the year down -8.5%.
Long and Variable Lags
“Turning our attention to 2023, investors are facing a markedly different backdrop than 2022 and several big questions remain. To our eyes, we appear to be in between the cause and effect of this bear market. Inflation and rates were the cause of 2022’s market drawdown, and 2023 appears set to deliver the effect of weaker earnings and employment.” – Domestic Equity Manager
As investors close the books and look forward to 2023, the biggest question that remains uncertain today is what happens with the economy, and in turn, how the actions of the Fed will continue to impact markets. The pace and trajectory of interest rate hikes and other monetary policy decisions clearly rattled markets in 2022, however, they have not yet had as material of an impact on the overall economy. Economist Milton Friedman coined the phrase “long and variable lags” to describe how changes in monetary policy action work their way through a vast, complex, intertwined economy. While very difficult to accurately predict, history and a significant body of research suggest it can take 18 to 24 months for monetary policy actions to materially affect inflation, and thus, the overall economy.
Although the Fed’s policy actions have been aggressive from a historical perspective, we are only very recently starting to see some trends change, particularly in interest rate sensitive areas like housing, which have started to show stress. Other economic indicators continue to flash warnings signs, including commodity prices rolling over, the deepest yield curve inversion since the early 1980s, and others; signaling additional pressure ahead. Importantly, the Fed’s tightening cycle (and its first interest rate hike) began in mid-March 2022, less than 12 months ago. If you believe in the “long and variable lags” principle, monetary policy action could still take months to fully play out and be understood by investors and other market participants.
Corporate Earnings and Recession Risks
“The effects of higher rates and tighter financial conditions will continue to be felt into 2023, with a recession the most likely outcome. However, unlike the last two recessions, this one won’t be caused by a crisis (subprime meltdown or pandemic) but rather by the Fed, which suggests this version may look different than what we have seen in the recent past.” – Global Fixed Income Manager
As it stands today, the consensus view of economists seems to be that the lagged effects of the Fed’s monetary tightening (including 425 basis points of interest rate hikes and counting) will be a drag on economic growth and may drive the economy into a recession. Although there are varying views about whether a “soft landing” is achievable, an economic recession of some sort now appears to be the base case scenario for more and more economists. Interestingly, and somewhat puzzlingly (in our view), is that consensus earnings estimates still call for growth and margin expansion across the S&P 500 Index in 2023, a view that we find to be somewhat at odds with a recession, even if mild or shallow. We should acknowledge that corporate earnings and profit margins have remained resilient over the past few quarters, even in light of a challenging backdrop. However, the achievability of continued earnings growth seems to be exceedingly optimistic, and with risks skewed to the downside, at least in the near-to-intermediate term. Market participants will continue to closely monitor the earnings picture as it comes into focus over the next few quarters.
“The last few years have been like watching a high-speed car chase with the world swinging from guardrail to guardrail at breathtaking speed.” – Domestic Equity Manager
Market participants had no shortage of macroeconomic, geopolitical, and monetary pressures to assess and react to over the course of the year. The economy was rocked by multiple shocks including persistently high inflation, the war in Ukraine and its effect on commodity prices, signs of slowing global growth, lasting COVID-related disruptions, and arguably most significant – the most aggressive Fed interest rate hiking cycle in decades. The confluence of these and other factors led to persistent volatility across capital markets throughout the year. In fact, over the course of the year, there were more than 200 intraday swings in the S&P 500 Index of more than 1% (+/-), the most since 2009. The CBOE Volatility Index (or “VIX”), often used as a measure of volatility or “fear” in markets, averaged a level of approximately 26 over the course of 2022, up from an average of approximately 19.5 in the prior year. At certain points this year, volatility spiked to levels historically only seen during periods of meaningful market stress (e.g., the depths of the COVID-19 pandemic, the Global Financial Crisis, etc.).
While volatility in equity markets is never pleasant to experience, it is somewhat normal and expected on a recurring basis. On the flip side, fixed income stress and volatility like investors experienced in 2022 is unprecedented. The combination of the two made for a particularly painful year as both equity and fixed income markets experienced sharp losses, with traditional 60/40 benchmark portfolios (i.e., an asset allocation of 60% equity and 40% fixed income) suffering one of the worst years in the last century. Given the continued uncertainty in markets, coupled with a weakening macro environment and some additional structural liquidity considerations, our expectation is that volatility remains elevated above its historical long-term average in the near-to-intermediate term.
As the calendar year ends and we turn the page to 2023, we acknowledge that the past twelve months have been historically difficult, and that economic uncertainty, market volatility, and inflationary environments can create stress for investors. In such periods, we fall back on our core beliefs and principles that a long-term focus, a thoughtful and diversified investment plan, and an emphasis on risk management are paramount for investing success. Inevitably, the uncertain environment that we find ourselves in today will become clearer over time and markets will adjust. In the meantime, we continue to believe that there are opportunities for disciplined investors to allocate capital in today’s markets that will yield attractive risk-adjusted returns over time.
As one of our long-term investment managers recently shared, “when most are moving and reacting faster, slowing down can be a superpower.” We found that quote to be noteworthy in a period like we found ourselves in today. And while we are continually looking to take advantage of tactical investment opportunities, we also strongly believe that a long-term focus is key and will reward investors over full market cycles.
As always, we welcome the opportunity to discuss your portfolio in detail and appreciate the trust and confidence that you have placed in Prairie Capital.
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