Together, we are long-term, goal-focused, plan-driven equity investors. We believe that lifetime investment success comes from acting continuously on our plan. Likewise, we believe substandard returns, and even lifetime investment failure, come from overreacting to current events.
The unforeseen and indeed unforeseeable economic, market, political, and geopolitical chaos of the past three years since the onset of the pandemic demonstrates conclusively that the economy can never be consistently forecast, nor the market perfectly timed.
Therefore, we believe that the most reliable way to capture the full return of equities is to ride out their frequent but historically temporary declines and sunbathe in the miracle of compounding equity.
These will continue to be the bedrock convictions that inform our investment policy, as we pursue your most important financial goals together.
Unrelieved chaos continued in 2022. The central drama of the year — and, it seems likely, of the coming year — was the Federal Reserve’s belated but very aggressive efforts to bring inflation under control.
After rising seven times in the nearly 13 years between the trough of the Global Financial Crisis (March 9, 2009) and this past January 3, the U.S. equity market sold off sharply; at its most recent trough in October, the S&P 500 was down 27%. (Bond prices also swooned in response to sharply higher interest rates.)
It seems more than a little ironic that, after the serial nightmares through which it’s suffered since the onset of the pandemic early in 2020, the mainstream equity market managed to close out 2022 somewhat higher than it was at the end of 2019 (3,839 versus 3,231, a gain of nearly 19%). Not great, but not at all bad for three years during which our entire economic, financial, political, and geopolitical world blew up.
If anything, this tends to validate our core investment strategy over these three years, which — simply stated — has been: stand fast, tune out the noise and continue to work your long-term plan. Needless to say, that continues to be our recommendation, and in the strongest terms possible.
The burning question of the hour seems to be whether and to what extent the Fed, in its inflation-fighting zeal, might tip the economy into recession at some point — if it hasn’t already done so. Over the coming year, the way this plays out may determine the near-term trend of equity prices. Our position continues to be that this outcome is simply unknowable, and that one cannot make rational investment policies with unknowable factors.
That said, we continue to believe strongly that whatever it takes to put out the inflationary fire will be well worth it. Inflation is a cancer that affects everyone in our society; if recession proves to be the painful chemotherapy required to destroy that cancer, then so be it.
Although this may be hard to remember every time the market gyrates (and financial journalism shrieks) over some meaningless monthly economic datum, we are not investing in the macroeconomy. Our portfolios largely consist of the ownership of enduringly successful companies — businesses that are even now refining their strategies opportunistically to meet the needs and wants of an eight-billion-person world. We like what we own.
As we always say — but can never say enough — thank you for being our clients. It is a genuine privilege to serve you.
Recapping A Challenging 2022
Markets faced several challenges in 2022, including high inflation, historic central bank policy, the war in Ukraine, and Covid lockdowns in China. Inflation was a major factor in the markets throughout the year, with the headline consumer price index reaching a 40-year high of 9.1% in June. High inflation prompted the Federal Reserve and its global central bank peers to aggressively raise interest rates, which caused stocks and bonds to trade lower. There were few places to hide as central banks rapidly tightened monetary policy. Figure 1 shows the S&P 500 returned -19.4% in 2022, the worst annual return since 2008, and Figure 5 (below) shows the Bloomberg U.S. Bond Aggregate produced its worst total return since 1976. This letter reviews the fourth quarter, recaps a difficult 2022, and discusses what the market will be focused on in 2023.
Putting 2022’s Interest Rate Hikes Into Perspective
The main story of 2022 was the reversal of monetary policy from extraordinarily accommodative levels during the Covid-19 pandemic. Figure 2 below shows the speed and size of interest rate increases as central banks worked to bring inflation under control. The chart tracks the cumulative percentage of interest rate increases and decreases by global central banks during rolling three-month periods since 1995. For example, the 68% at the end of November 2022 indicates that central banks across the globe raised interest rates by a total of 68% from September to November. In contrast, the total amount of interest rate cuts during that same period was only 4%. As the data shows, 2022 was the quickest, largest, and most imbalanced global tightening cycle since the late 1990s.
The pace of interest rate increases is forecasted to slow during 2023. Central banks continue to hint that they are approaching the end of their interest rate hike cycle, citing concerns that further tightening could push the economy into recession, but we believe we are already there. In addition, data suggests price pressures are easing. While the year-over-year headline consumer price index rose by 7.1% in November 2022, which is still high compared to historical levels, it was down from the 9.1% rate seen in June 2022. As inflation and central bank policy try to return to normal, a new uncertainty is emerging – the unknown effects of 2022’s rate hikes.
Markets Wait for the Lagged Effect of Higher Interest Rates to Show Up in Economic Data
The Federal Reserve’s interest rate hikes occurred in 2022, but the full impact of its restrictive measures has not yet been fully felt in the real economy. While the U.S. economy contracted during the first half of 2022, it expanded at a robust +3.2% annualized pace during the third quarter. Consumer spending remained strong throughout most of 2022 despite high inflation, and the U.S. labor market added more than 4 million jobs through the end of November. The data indicates the U.S. economy has withstood tightening thus far, but the real test will come in 2023 as the cumulative impact of higher interest rates becomes clearer.
While a recession is not a foregone conclusion, it is possible the economy could be tested in 2023. An index of leading economic indicators shows the U.S. economy is already starting to slow as the impact of higher interest rates takes hold. Figure 3 diagrams the month-over-month change in The Conference Board’s Leading Economic Index, which tracks ten economic components that tend to precede changes in the overall economy. Included in the components are the average weekly hours worked by manufacturing workers, new home building permits, and the volume of new orders for capital goods, such as equipment, vehicles, and machinery. The chart reveals that the Leading Economic Index has decreased every month since March 2022, an indication the economy is slowing after a period of strong growth during the pandemic recovery.
Equity Valuations Are More Attractive, But Corporate Earnings Are An Open Question
Whereas inflation and central bank policy were the primary drivers of markets in 2022, economic data and corporate fundamentals are expected to play a larger role in determining the market’s direction in 2023. Figure 4 on the next page tracks two important S&P 500 metrics. The top chart tracks the next 12-month price-to-earnings ratio, which divides the S&P 500’s projected next 12-month earnings by its current price. It shows valuation multiples expanded during the pandemic as interest rates were cut to near 0% before reversing lower during 2022 as rising interest rates weighed on company valuations.
While current valuations are at a more attractive starting point today than at the beginning of 2022, corporate earnings are an open question entering 2023 with the potential for an earnings reset as the economy slows. The bottom chart in Figure 4 tracks the S&P 500’s trailing 12-month earnings growth, showing the jump in corporate earnings during the pandemic. Despite expectations for an economic slowdown, Wall Street analysts still forecast single-digit earnings growth for the S&P 500 in 2023. The positive earnings growth forecast is encouraging, but it creates a risk for the market. If actual earnings growth falls short of the forecast, stock prices could decline as markets price in lower actual earnings.
Equity Market Recap – Stocks Trade Higher in 4Q’22
Stocks traded lower during December but still ended the fourth quarter higher. The S&P 500 Index of large cap stocks returned +7.6% during the fourth quarter, outperforming the Russell 2000 Index’s +6.2% return. The Dow Jones Index, which includes large companies such as Visa, Caterpillar, Nike, and Boeing, was the top performer, returning +15.9%, while the Nasdaq 100 Index of technology and other growth-style stocks produced a -0.1% return during the fourth quarter.
Energy was the top performing S&P 500 sector during the fourth quarter, followed by the cyclical sector trio of Industrials, Materials, and Financials. We invested heavily into these sectors and expect to stay bullish for the next two to three years. Defensive sectors, including Health Care, Consumer Staples, and Utilities, were middle of the pack performers. Growth-style sectors, including Technology, Communication Services, and Consumer Discretionary, and interest-rate sensitive Real Estate underperformed as higher interest rates continued to weigh on valuation multiples.
International stocks outperformed U.S. stocks during the fourth quarter. The MSCI EAFE Index of developed market stocks returned +17.7% during the fourth quarter, while the MSCI Emerging Market Index returned +10.3%. A weaker U.S. dollar boosted the returns of international stocks, with U.S. dollar weakness driven by a shrinking monetary policy gap as other central banks catch up with the Federal Reserve’s aggressive policy. Separately, China’s decision to relax its Covid-zero restrictions raised the prospect of stronger global growth as one of the world’s biggest economies reopens. We have been invested in China’s technology sector for over a year now and expect to remain in these positions as they reopen.
Bond Market Recap – The Great 2022 Yield Reset
The broad bond market experienced a significant resetting of interest rates during 2022, with yields steadily rising as the Federal Reserve pushed through large interest rate hikes. Despite posting positive returns during the fourth quarter, bonds produced significant losses during the first three quarters of 2022 as central banks raised interest rates at a rapid pace. The top chart in Figure 5 shows the Bloomberg U.S. Bond Aggregate produced a -13% total return during 2022, its biggest negative total return since tracking began in 1976. We own very few of these types of bonds and since 2015 have invested in private real estate and private credit, which cut the slide in bonds by almost half.
The bottom two charts in Figure 5 examine the current state of the credit market after 2022’s rate hikes. The middle chart shows the 10-year Treasury yield sits at its highest level since 2007. Yields are now higher across most credit classes, and investors can earn a yield of around 4% to 5% on a portfolio of high-quality bonds, such as U.S. Treasury bonds and investment grade corporate bonds, without locking up capital for long periods of time. In the corporate credit market, the bottom chart of Figure 5shows the high-yield corporate bond spread, which is the extra yield investors demand to loan to lower quality borrowers, is in line with its median since 1999.
The starting point for bonds, both in terms of yield and credit spreads, is now more compelling than it has been in a long time. However, there is still the potential for continued volatility in the bond market. There is still significant uncertainty regarding how high the Fed will need to raise interest rates and how long it will need to keep interest rates at restrictive levels to bring inflation down to normal. There is a risk that inflation could remain above the Fed’s 2% target, leading to an extended tightening cycle. At the same time, the economy is likely to start feeling the effects of 2022’s rate hikes in 2023, which could make bonds more attractive. The crosscurrents of uncertain central bank policy and a volatile global economy could keep interest rate volatility elevated and test bond investors’ nerves again during 2023. Which is why we’ve been investing in precious metals and plan to continue for the next few years.
2023 Outlook – Turning the Page on 2022’s Historic Tightening Cycle
2023 brings the next phase of the tightening cycle where the lagged effects of tighter monetary policy will be felt. It has the potential to be a year of two halves. In the first half, the focus is likely to shift from the number of future interest rate hikes to how much those interest rate hikes will slow the economy. Some data, such as the housing market, indicate that tighter monetary policy is being transmitted into the economy at a rapid pace. Home sales are slowing, and homebuilder confidence weakened month-over-month during 2022 and now sits at its lowest level since 2012. At the same time, consumers continue to spend and employers continue to add jobs. There is still a wide range of possible outcomes, and the unique nature of the pandemic followed by rapid interest rate cuts and hikes makes the path forward less certain. We believe we are in a bear market and our investments are positioned more defensively in nature. We are trying to take profit as often as we can during the quick bear market rallies we expect to continue for the next year or two.
The second half has the potential to be different depending on how severe the slowdown is in early 2023. Markets are based on forward-looking decisions, and investors will be watching closely for signs that the economy has bottomed and is recovering. Plus, Figure 1, which we reviewed on page 2, contains an encouraging historical trend: The chart shows there have only been two instances of consecutive negative S&P 500 return years since 1950, in 1973-1974 and 2000-2002. This does not necessarily mean the S&P 500 will produce a positive return in 2023 or trade higher in a straight line from here, because it may not. However, it does provide helpful historical context in a volatile environment.
The possible end to the war in Ukraine, the full reopening of China’s economy, the relaxing of inflation in the United States, and the slowing of interest rates all have the potential to drive this market higher.
In addition, we remain bullish with commodities – the building blocks of everything infrastructure, electric vehicles, and the push for global clean energy. We like the energy and natural gas market. We like precious metals as interest rates begin to level off and possibly retract. We like deep value companies who pay nice dividends for us to wait out this storm. We also like, in small percentages, cannabis and biotechnology – large possible gains in the years to come.
And finally, we have faith in the future of America. We have proven resilient after so many bear markets since the end of WWII. We have no doubt that resolve will continue to accelerate.
We wish you and your family happiness and health in the New Year! We look forward to serving you for many years to come.
As always, if you’d like to meet with us one-on-one, please don’t hesitate to reach out to our office.
Past performance does not guarantee future results. The performance information shown herein is based on total returns with dividends reinvested and does not reflect the deduction of advisory and/or other fees normally incurred in the management of a portfolio.
Stock performance and fundamental data is based on the following instruments: SPDR S&P 500 ETF (SPY), SPDR Dow Jones ETF (DIA), iShares Russell 2000 ETF (IWM), iShares Russell 1000 Growth ETF (IWF), iShares Russell 1000 Value ETF (IWD), iShares MSCI EAFE ETF (EFA), iShares MSCI Emerging Markets ETF (EEM), Invesco QQQ Trust (QQQ).
Fixed Income performance is based on the following instruments: iShares Core U.S. Aggregate Bond ETF (AGG), iShares Investment Grade Corporate ETF (LQD), iShares National Muni Bond ETF (MUB), iShares High Yield Corporate ETF (HYG).
Fixed Income yields and key rates are based on the following instruments: Bloomberg US Aggregate, ICE BofA US Corporate, ICE BofA US Municipal Securities, ICE BofA US High Yield, 2 Year US Benchmark Bond, 10 Year US Benchmark Bond, 30 Year US Benchmark Bond, 30 Year US Fixed Mortgage Rate, US Prime Rate.
Commodity prices are based on the following instruments: Crude Oil WTI (NYM $/bbl), Gasoline Regular U.S. Gulf Coast ($/gal), Natural Gas (NYM $/mmbtu), Propane (NYM $/gal), Ethanol (CRB $/gallon), Gold (NYM $/ozt), Silver (NYM $/ozt), Copper NYMEX ($/lb), U.S. Midwest Domestic Hot-Rolled Coil Steel (NYM $/st), Corn (CBT $/bu), Soybeans (Chicago $/bu).
U.S. Style performance is based on the following instruments: iShares Russell 1000 Value ETF (IWD), SPDR S&P 500 ETF Trust (SPY), iShares Russell 1000 Growth ETF (IWF), iShares Russell Mid-Cap Value ETF (IWS), iShares Russell Midcap ETF (IWR), iShares Russell Mid-Cap Growth ETF (IWP), iShares Russell 2000 Value ETF (IWN), iShares Russell 2000 ETF (IWM), iShares Russell 2000 Growth ETF (IWO).
U.S. Sector performance is based on the following instruments: Consumer Discretionary Sector SPDR ETF (XLY), Consumer Staples Sector SPDR ETF (XLP), Energy Sector SPDR ETF (XLE), Financial Sector SPDR ETF (XLF), Health Care Sector SPDR ETF (XLV), Industrial Sector SPDR ETF (XLI), Materials Sector SPDR ETF (XLB), Technology Sector SPDR ETF (XLK), Communication Services Sector SPDR ETF (XLC), Utilities Sector SPDR ETF (XLU), Real Estate Sector SPDR ETF (XLRE).
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