Happy New Year! I hope you all had a wonderful holiday season with your friends and families. 2022 was a great year on a personal and professional level for many of us, but I know I’m not alone in being ready to move forward from a market perspective.
While I’m eager to spend some time talking about where we think things might be headed in 2023, let’s first look back at 2022 to understand how we got here and what impact it might have on the year ahead.
What Happened in 2022?
It doesn’t matter whether you were a conservative or aggressive investor this year- if you owned some combination of stocks and bonds, chances are this was one of the worst performing years of your lifetime. The S&P 500 was down 18.32%, which was its 7th worst year since we started keeping track in the 1920’s.1 On the fixed income side of things, the US Aggregate Bond was down 12.03%, which was the worst year since the inception of the index in 1976.2 The traditional 60/40 portfolio of 60% stocks and 40% bonds was down 16.77%3, which was the worst year a 60/40 portfolio has had since 19374. I could go on, but you get the point… it was a bad year all around.
So, why was it so bad? Many of the problems stemmed from the highest inflation we’ve had in decades, which had a number of contributing causes-supply chain issues, loose fiscal and monetary policy, the war between Russia and Ukraine, etc. High inflation forced the Federal Reserve to take aggressive actions such as rapidly raising the Federal Funds rate. This in turn pushes other rates up and tightens financial conditions by causing us to borrow at higher rates of interest- whether it’s a mortgage, credit cards, auto loans, or many other vehicles that affect businesses and individuals both.
Higher interest rates often hurt both stocks and bonds in the short term. The issuance of new bonds at higher interest rates causes the bonds that everyone owned previously to trade at a discount to what they were bought for. On the flip side, stocks look desirable when bonds are only yielding 1-2%, but if yields go up to 4-5%, suddenly people start to see bonds as more attractive. And many aren’t as sure if they want the risk of stocks when bonds are providing such a good-looking alternative. Another issue is that higher interest rates hurt the companies themselves, both because the company must borrow at higher rates and also because profit margins drop as costs, such as wages, go up with inflation.
In the long run, stocks have proved to be one of the few asset classes that consistently beats inflation, and if you think about it, it makes sense. Think of the products and services that you love and would buy even if they cost 10% more. Those companies can afford to raise their prices and while it might hurt our monthly budgets, they are able to generate good returns, even in a higher inflation environment.
What we think we can expect going forward
I want to tackle this from both a historical perspective and one that takes a closer look at our current situation.
First, a historical perspective. From 1926-2021, S&P had six years where it returned -15% or worse5. The average return in the following year was only down 11.5%. The S&P has been down double digits in a year eleven times, and the average three-year returns following those eleven double-digit losses is +35%, while the average five-year returns are +80%, with every single five-year stretch being positive, even after the Great Depression6.
Now, some of you may be a little skeptical about historical numbers and I can sympathize. No two market cycles look exactly the same and our current economic environment does present some unique challenges.
We have already discussed some of why 2022 was a rough year in financial markets, and now we turn to how we see some of those issues resolving. First, the good news. The major focus of markets is on inflation, and in turn, how that will affect interest rates going forward. The Consumer Price Index (CPI) is one of the ways inflation is measured, and that number peaked at over 9% in June, and since then, has been steadily coming down to 6.5%, which was our latest annualized reading for the month of November7. The job is far from done, as the Federal Reserve’s inflation target is 2%, but the slowing path of inflation has caused the Federal Reserve to decrease how often they are raising rates. The other good news is that the unemployment rate has stayed near all-time lows, at 3.5%8. If you take these data points along with some other data, you can begin to envision a path where a recession could be delayed if not avoided all together.
Will there be a recession or not is the question that will likely dominate the media headlines over the coming year, but I want to paint a picture of something called a rolling recession, which is the framework I’m using to think about the economy, regardless of whether or not we officially have a recession.
A rolling recession (1960-1961 is a good example) is very different than a more typical boom-and-bust recession (think 2008 or 2001). In a boom-and-bust cycle, you see years of booming economic activity such as the mid-2000’s, followed by a downturn across the economy, such as what we saw in 2007-2009. In a rolling recession, you see downturns and recoveries that are specific to sectors of the economy, so one industry might be recovering while another is experiencing a contraction. The reason I believe this is the situation we’re in now is that 2020 was such an unusual recession, and it created an uneven recovery, which in turn, creates an uneven downturn two years later.
Let me give two examples of sectors that illustrate my point: technology and travel. The technology sector had a very short concerning period in 2020, followed by record profits for most of the major companies throughout the rest of the year. Even while the US was hitting double-digit unemployment, many of the largest technology companies were making all-time highs. Given that most technology companies did not experience much of a contraction in 2020, along with how higher interest rates disproportionately affect tech growth companies, it isn’t surprising that 2022 was a rougher year for the technology sector than nearly any other sector. On the flip side, the travel sector was decimated in 2020 as flights and cruises were cancelled left and right. This sharp downturn has now created a robust demand for travel, which you’ve probably noticed if you’ve been in an airport recently. We could examine a lot of other sectors and find similar stories, but the overarching point is that we believe the outlook for 2023 is extremely dependent on what sector we’re talking about.
In our view, we believe that if a recession does occur in 2023, it will not be as severe as some previous recessions, since at any given time, the sharp contraction in certain sectors may be partially offset by the rebound in other sectors. We also believe that this environment creates unique opportunities for investors that are focused on being opportunistic by sector, which is one of the areas in which we plan to be vigilant in 2023.
Lastly, remember that higher interest rates create higher potential returns in bonds, so while the ride to higher interest rates was painful, the result is bond portfolios with higher yields than we’ve seen in the last decade.
In conclusion
There are more pieces to the 2023 macroeconomic puzzle than I can touch on in one letter and we expect things to continue to evolve at a rapid pace, so if you have questions about anything I mentioned or would like to discuss anything I didn’t touch on, please reach out. Don’t forget that few things bring me more joy than talking markets.
Sincerely,
Christian Bryant
Sources:
1 https://dqydj.com/2022-sp-500-return/
2 https://www.spglobal.com/spdji/en/indices/fixed-income/sp-us-aggregate-bond-index/#overview
3 https://portfolioslab.com/portfolio/stocks-bonds-60-40
4 https://awealthofcommonsense.com/2022/06/the-worst-years-ever-for-a-60-40-portfolio/
5 https://t.co/KVqrZbJUSz
6 https://www.cdwealth.com/article/how-has-the-market-performed-after-its-worst-years/
7 https://www.bls.gov/news.release/pdf/cpi.pdf
8 https://www.bls.gov/news.release/pdf/empsit.pdf
