Market & Economic Commentary: Q4 2022

A “terrible, horrible, no good, very bad” year

The fourth quarter began with data pointing to cooling inflationary pressures that relieved fears of continued aggressive action by the Federal Reserve. As a result, markets rallied. The S&P 500 Index was up 8.10% in October and 5.59% in November. However, December’s economic data rekindled concerns that a strong labor market and a robust economy would force the Federal Reserve to raise interest rates further, risking economic recession. This resulted in the S&P 500 closing down -5.76% for the month.  While the strength of the returns early in the quarter helped to power the S&P 500 to a positive return of 7.56%, it provided little solace in a year in which it ultimately lost -18.11%.  International Developed and Emerging Markets experienced similar results: the MSCI World Ex-USA NR finished up 16.18% for the quarter and down -14.29% for the year, and the MSCI EM NR up 9.70% for the quarter while finishing down -20.09% for the year. [1]

In years past, investors have looked to fixed income to provide a hedge when equity markets stumble.  Unfortunately, bonds were caught up in the same macroeconomic dynamics that dragged down equities and posted historically poor performance as yields climbed in response to interest rate policies of central banks around the globe.  The Bloomberg Barclays U.S. Aggregate Bond Index finished up 1.87% in the fourth quarter, though down -13.01% for the year.  Indeed, the 10-year Treasury note in 2022 saw its worst performance in 234 years.[2]  The Bloomberg Barclays Global Aggregate Index, representing bonds from developed and emerging markets, ended up 4.55% for the quarter but down -16.25% for the year.[3]

Inflation, Rising Rates, and Recession Worries

In 2020, to combat the economic impact of the pandemic, the Federal Reserve cut its policy rate from 2.25% to 0% while massively expanding its balance sheet to stabilize markets.  This, in conjunction with the fiscal stimulus provided by Washington, created a liquidity surplus.  Those extra dollars found their way into our pockets, and from there, we collectively used them to buy all manner of items for our homes and ourselves.  All of this consumption bumped into constrained supply exacerbated by Covid-related shutdowns and labor shortages.  As a result, spending on goods sharply rose above historical consumption trends, pushing prices up at a 7% annual clip since 2020.  In February 2022, the war in Ukraine added further strains to the global supply of commodities.  The ultimate result was a Consumer Price Index (CPI), which soared to a four-decade high of 9.1% in 2022.  This elevated and prolonged inflation caused the Federal Reserve to reevaluate its stance that inflation was transitory and to take a far more aggressive posture.  A series of unprecedented rate increases in a short period followed, bringing the benchmark rate up to a target range of 4.25% to 4.5% by year-end. 

By early December, the pace of inflation, as measured by the CPI, had slowed significantly (though it remains elevated).  However, the market still contended with cautious comments from Federal Reserve Chairman Jerome Powell and the other Federal Reserve governors who remain determined to remove rapid price growth from the broad economy (including the wealth-creating equity markets).  

Will Inflation Be Contained?

As we move into the new year, investors now worry that adequately taming inflation may push the Federal Reserve to elevate rates to a level that will increase unemployment and trigger a recession.  The Wall Street Journal reports that “90% of investors expect the U.S. to enter a recession before the end of 2023.”  In such an environment, we now have, for the time being, a backward dynamic where any further “good” news on the strength of GDP growth or the labor market could be perceived as “bad” news by the financial markets as it could trigger further interest rate increases and be a source of continued volatility in the markets in the coming year.  Still, with signs of moderating inflation and the full brunt of recent increases still to work through the economy, the cycle of rate increases appears to be close to the end.  Even a plateau at somewhat higher rates should not drastically impair the economy, given that in the historical context, rates of 5% have not impeded economic growth.  As shown below, rates at current levels remain moderate by historical standards.

If we do have a recession in the new year, its severity is likely to be lessened by the fact that it comes during a time of historically low unemployment and improving wages while banks and average company balance sheets remain strong.

Final Thoughts

Markets are forward-looking by nature, and current market prices tend to reflect market participants’ collective expectations for the future.  When expectations for a recession are prevalent among investors, as they are now, it’s likely already reflected in prices.  This is one of the reasons it is not uncommon for global markets to reward investors even when economic activity has slowed.  For instance, over the past century, investors in the U.S. have endured 15 recessions.  In 11 of the 15 (or 73% of the time), returns on stocks were positive two years after a recession began, with an annualized average market return of 7.8%.[4]   

Furthermore, a down year for markets can cause anxiety, but they happen more commonly than most investors realize.  In fact, since 1928, the S&P 500 has finished the year with negative results 26 times, or roughly once every four years.  Down years are an essential aspect of investing that investors should prepare themselves to endure, for it is the “down” markets that set the stage for further appreciation.  No one can predict either the depth or duration of the market corrections, but they eventually end, and history has shown that investors are rewarded for their patience and resilience when they do.

It has been a challenging year for investors, and there is likely more turbulence ahead.  However, time and again, we see that the best option for the long-term investor is to maintain the course with their portfolio.  The returns available for long-term investors are the reward for their steadfast patience through short-term market movements or macroeconomic events.

Index Disclosure and Definitions

Investors cannot invest directly in an index. Indexes have no fees. Historical performance results for investment indexes do not
reflect the deduction of transaction and/or custodial charges or the deduction of an investment management fee, the occurrence of which would have the effect of decreasing historical performance results. Actual performance for client accounts will differ from index performance.

S&P 500 Index represents the 500 leading U.S. companies, approximately 80% of the total U.S. market capitalization.

Dow Jones Industrial Average (DJIA) Is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the NASDAQ.

The Nasdaq Composite Index (NASDAQ) measures all Nasdaq domestic and international based common type stocks listed on The Nasdaq Stock Market and includes over 2,500 companies.
MSCI World Ex USA GR USD Index captures large and mid-cap representation across 22 of 23 developed markets countries, excluding the US. The index covers approximately 85% of the free float-adjusted market capitalization in each country.
MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets (as defined by MSCI).  The index consists of the 25 emerging market country indexes.
Bloomberg Barclays US Aggregate Bond Index measures the performance of the U.S. investment grade bond market. The index invests in a wide spectrum of public, investment-grade, taxable, fixed income securities in the United States – including government, corporate, and international dollar-denominated bonds, as well as mortgage-backed and asset-backed securities, all with maturities of more than 1 year.

Bloomberg Barclays Global Aggregate (USD Hedged) Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging market issuers. Index is USD hedged.

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[1] Morningstar Direct, as of Oct 1st, 2022

[2] Kollmeyer, B. (2022, October 28). What's next for bonds after 10-year Treasury note's worst performance since 1788? MarketWatch. https://www.marketwatch.com/livecoverage/stock-market-today-10-28/card/what-s-next-for-bonds-after-10-year-treasury-note-s-worst-performance-since-1788--eH3SxR2FBNRnycUF4e2r

[3] Morningstar Direct, as of Jan 4, 2021

[4] Source: Dimensional.  Growth of a hypothetical investment of $10,000 in the securities in the Fama/French US Total Market Research Index over the 24 months starting the month after the relevant Recession Start Date. Sample includes 15 recessions as identified by the National Bureau of Economic Research (NBER) from October 1926 to December 2007. NBER defines recessions as starting at the peak of a business cycle.

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