As we prepare to ring in the New Year, some may be linking hands to join in a chorus of Auld Lang Syne with a particular enthusiasm for the lines: “Should auld acquaintance be forgot, And never brought to mind?” From an investor’s perspective, many will be pleased to have 2022 in the rearview mirror given how tough it proved to come out ahead. In short, it was a terrible year for both U.S. stocks and bonds and a sobering reminder that market cycles necessarily include downturns.
The most momentous event of the past twelve months has been the Russia-Ukraine war, which escalated steeply with President Putin’s decision to launch a military invasion on February 24th. In addition to the human and monetary costs and worldwide geopolitical fallout, the conflict has added to inflationary pressures, further spurring interest rate moves and negatively impacting most asset classes.
The S&P 500 peaked at an all-time closing high of 4,797 on January 3rd, the first trading day of 2022. The Dow Jones Industrial Average notched its closing high of 36,800 a day later, and neither indices came close to revisiting their high points. Both hit yearly lows around the beginning of the final quarter and have since rebounded into the end of the year, with the DJIA significantly outperforming the S&P 500 in the past three months as technology names remain under sustained pressure in the face of rising rates.
The S&P 500 closed on December 30th at 3,840 representing a return of 7.57% for the final quarter of 2022 and -18.10% for the year. The DJIA ended December at 33,147 for a return of 16.01% in the past three months and -6.84% for 2022.
While no investment style ended up in positive territory for the year, Large Capitalization Value fared significantly better than other styles, most notably down only around one-third as much as growth strategies. In terms of industry sectors, energy blew away every other category, up close to 60% in 2022 amid global and regional supply and demand dynamics spurred by war-induced price surges. WTI crude itself ended the year not far above where it started, at just below $80 / barrel, having surged above $120 / barrel in both March and June. The closest other sectors – utilities, consumer staples, and health care – managed to end the twelve months close to breakeven. Despite resilient investment in technology at corporate levels, investor sentiment cooling means the tech sector is set to underperform the S&P 500 on a yearly basis for the first time since 2013 and by the widest margin since 2002.
Emerging from the most acute phase of the COVID-19 pandemic, in 2021 real gross domestic product (GDP) grew faster, at 5.5 %, than it had in any year since 1984, and the U.S. led the way with its rebound among G7 nations. Some slowing was therefore expected in 2022, and the first two quarters of the year returned negative annual growth rates of -1.6% and -0.6% for Q1 and Q2 respectively. Factors weighing on growth included inflation, the Fed’s tightening policy, inventory buildup, and ongoing global trade issues. Despite the consecutive quarters of contraction, a recession has not been called, largely due to the strong labor market conditions and resilient consumer demand.
By the third quarter of 2022, domestic GDP growth was back to being positive, recording an annual rate of 3.2 %. The third quarter’s increase primarily reflected exports and consumer spending, partly offset by a decrease in housing investments. The unemployment rate remains low at 3.7% and around 4.3 million jobs have been added this year through mid-December.
Such strong labor figures, combined with the pace of wage increases, are acting in opposition to the Fed’s efforts to battle inflation. The central bank has raised rates seven times this year, the latest hike occurring on December 14th when Fed Chair, Jerome Powell, announced a boost in the benchmark rate of a half-point to a range of 4.25% – 4.50%, the highest level in 15 years and the largest rise in a year since the early 1980s. The policymakers also forecast that the key short-term rate will reach a range of 5.00% – 5.25% by the end of 2023, implying a further 0.75% hike over the course of the coming year. In tandem, the latest forecasts are for unemployment to rise to 4.6% in the next twelve months, and economic growth of just 0.5% for 2023, less than half the forecast the Fed had made in September.
Although Fed tightening is a somewhat blunt tool in the face of a web of complicated and intertwined factors that have pushed prices up, there is some evidence that the higher cost of capital is having an impact. Inflation in the U.S. slowed in November for a fifth straight month. The 7.1% year-over-year increase was well below the peak of 9.1% in June, though still high. Jerome Powell commented: “The inflation data in October and November show a welcome reduction. But it will take substantially more evidence to give confidence that inflation is on a sustained downward path.”
Equity investors were not alone in experiencing investment pain and uncertainty, as 2022 proved to be the worst year in decades for fixed income. Rising yields lead to negative price returns for existing bonds. The 10-year Treasury yield started the year at 1.5% and ended over 200 basis points higher at 3.8%, representing the largest annual increase since 1994, although down from an October peak of over 4.2%. Consequently, the Barclays Aggregate Bond Index is set to notch up its worst year since at least 1975.
The Fed’s determination to tame inflation has also contributed to a toxic cocktail for U.S. housing as we close out the year with a freezing in transaction volume and signs of price stagnation or declines, varying by region. Tightening monetary policy effectively doubled mortgage rates to above 6%, and there is a historically high spread between mortgage rates and 30-year Treasury rates, coupled with an increased supply of new U.S. housing exacerbated by buyer cancellations. While sales volume has collapsed somewhat, the inventory situation for existing homes is still very “tight”, but based on Case-Shiller data for October, home prices nationally are down an average of 2.4% with this figure set to rise for end-of-year data. The tight existing home availability coupled with falling prices is likely a reflection of an oversupply of new homes, which are often the price setters in a market.
The touted big “red wave” that was anticipated earlier in the year did not transpire in the U.S. midterm elections. A lackluster economy and unimpressive approval ratings for President Joe Biden proved not enough to galvanize significant voter change and, in the end, only six Democratic incumbents fell. Republicans were able to win back control of the House, while Democrats maintained the Senate. This exacerbates the likelihood of some entrenched standoffs over issues such as budget approvals but reduces the risks of major policy shifts, such as sweeping tax hikes. Current House Minority Leader Kevin McCarthy, a Republican representative from California, is in line to be the next speaker of the House, although faces some opposition from within his party ahead of the January vote.
Elected officials on both sides of the political aisle remain almost unanimously united in the commitment of the U.S. to provide financial aid to Ukraine in its ongoing operations to defeat Russian military forces and expel them from Ukrainian territory. The annual spending bill unveiled by Congress on December 20th contained an additional $44 billion in emergency aid for Ukraine. This would bring U.S. aid to Kyiv since Russia invaded in February to over $100 billion, allocated over four emergency spending packages. Making his first trip outside Ukraine since Russia invaded, in late December Ukrainian President Zelensky urged a joint session of Congress to continue to support his country’s defense.
In October, President Xi Jinping was reelected for a third 5-year term as head of the ruling Communist Party, cementing his position as China’s most powerful leader in decades and going against a precedent custom of the party leader recusing themselves after a decade in power. In late December, Russian President Vladimir Putin and Xi Jinping pledged to strengthen strategic ties between Moscow and Beijing, emphasizing their joint cooperation as their nations separate themselves and continue to make moves economically and militarily to further distance themselves from the U.S. and its allies. Domestically, China is also battling a public health crisis and the associated economic fallout from its recently abandoned “zero-Covid” strategy. While Chinese political decisions remain largely opaque from the outside, it appears the about-turn was triggered, at least in part, by citizen protests against draconian containment measures.
Over the pond, Rishi Sunak won the chaotic October race for leader of Britain’s Conservative Party making him the first person of color to become prime minister in British history, and the third to hold the position this year. Mr. Sunak replaced the short-tenured prime minister, Liz Truss, after Ms. Truss’s failed push for trickle-down economics with plans for both tax cuts and increased government spending, which was poorly received by financial markets. Mirroring the Fed’s move, the Bank of England raised their benchmark rate in December up to a 14-year high of 3.5%, pointing to persistent inflation risks, although several voting policymakers dissented regarding the hike. Financial markets were more spooked by the European Central Bank’s (ECB’s) decidedly hawkish tone that accompanied its 0.5% hike taking its key rate to 2.0%. Madame Lagarde is calling for significantly more rate increases and quantitative tightening in 2023.
The aggressive Fed action during the course of the year, coupled with war and geopolitical risk, proved to be strong headwinds that brought the equity bull market to a halt in 2022. There has been a clear linkage between a drop in equity values and rising interest rates, with growth stocks exhibiting the largest aggregate declines. However, we have yet to see a P/E (Price/Earnings) multiple contraction based on weaker earnings, but this could emerge as a theme going forward and could further exacerbate the relative shift toward value stocks as investors favor resiliency and earnings stability. An earnings recession, were it to transpire, tends to additionally favor sectors such as health care, consumer staples, and financials including insurance companies, on a relative basis.
The U.S. dollar index peaked for the year around the beginning of the quarter and has been steadily falling since the start of November, which may provide some respite for international equities as well as U.S.-based companies with significant presence overseas. For now, the relative strength of the U.S. economy, translating into higher profitability and earning capacity has meant U.S. equities have outperformed international equities for the fifth consecutive year.
Going into the New Year, it is reasonable to expect further volatility and a continued focus on the Fed as we gain clarity on whether a soft landing is achievable. At this juncture, a projected mild to moderate recession appears to be the majority consensus, but if conditions pivot to a more severe scenario it is hard to predict if the Fed will capitulate and pivot or stick to its policy of slowing the economy until inflation is tamed.
That said, here at Stolper Asset Management, we are neither macro soothsayers nor market timers. We continue to evaluate individual investment opportunities using a bottom-up analysis with a rigorous value-based approach. While not immune to broad economic conditions and market cycles, we believe this discipline is appropriate for those with a long-term investment perspective.
We therefore thank you for your patience during more trying market conditions and greatly appreciate your continued confidence in us as a trusted financial advisor. May 2023 bring much joy and fulfillment to you and your loved ones!
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