Key Points

• After one of the most difficult years for virtually all asset classes in 2022, investors welcomed a broad-based rally in the first month of 2023. Every major asset class saw solid returns in January ranging from +3% to +10%.
• The January rally added to the healthy returns from the final couple of months of 2022, resulting in double-digit gains for the trailing 3 months for four of the eight major asset classes. 
• In many regards, January 2023 was a repudiation of last year, a reversal of most of the trends that dominated trading in 2022. 
• Inflation risks are mostly behind us, but recession risks lie ahead. Despite the strong start to 2023, the economy and earnings have slowed. Playing some defense is prudent, there will be plenty of time to play offense.

Market Performance Summary

Asset Class Total Returns

Source: Bloomberg, as of January 31, 2023. Performance figures are index total returns: U.S. Bonds (Barclays U.S. Aggregate Bond TR), U.S. High Yield (Barclays U.S. HY 2% Issuer-Capped TR), International Bonds (Barclays Global Aggregate ex USD TR), Large Caps (S&P 500 TR), Small Caps (Russell 2000 TR), Developed Markets (MSCI EAFE NR USD), Emerging Markets (MSCI EM NR USD), Real Estate (FTSE NAREIT All Equity REITS TR).

Capital markets had a strong start to the new year. It was a welcome reminder to investors that stocks and bonds can deliver positive results, especially after a year in which stocks saw a bear market and bonds suffered a major correction. In many regards, January 2023 was a repudiation of last year, a reversal of many of the trends that dominated 2022. Whether looking at the broad market level, the sector level, or at a factor level, the winners in the first month of 2023 were last year’s biggest losers.

Among the broad equity asset classes listed in the chart above, Real Estate, U.S. Small Caps, and Emerging Markets had the worst returns in 2022, all losing more than -20% for the year. Real Estate (+10.1%) and Small Caps (+9.7%) were the number one and two performers in January, and Emerging Markets (+7.9%) was just behind third best Developed Markets International (+8.1%). On the fixed income side, International Bonds sank -18.7% in 2022, but rebounded +10.7% in January 2023.
Looking at U.S. sectors, Communication Services (-39.9%) and Consumer Discretionary (-37.0) were the two worst performers in 2022 but bounced back the most in January to return +14.5% and +15.0%, respectively. Information Technology was the third worst performer in 2022, losing -28.2%, but was the fourth best performer in January with a +9.3% rebound.

Likewise for styles and factors. The S&P 500 High Beta factor (the stocks that are the most volatile relative to the S&P 500 index overall) lost -20.3% in 2022 but rallied back +16.2% in January. Last month, we highlighted a chart showing how in 2022, Defensive sectors (+2.9%) greatly outperformed Cyclical sectors (-28.2%). But in January, Cyclicals rebounded +9.8% while Defensives slipped -0.9%. We also highlighted how growth as a style saw its largest calendar year underperformance relative to value in more than 20 years. The Russell 1000 Growth Index plunged -29.1% in 2022, making it the worst of the nine Russell U.S. style indices (Large/Mid/Small by Growth/Blend/Value). But it rebounded a solid +8.3 in January.

The same “worst-to-first” phenomenon carried on in fixed income too. With rates rising dramatically in 2022, long-duration Treasury bonds suffered the most, losing -29.3% for the year, but they were the top bond sector in January with a +6.4% total return.

Will the worst-to-first trend that played out in January continue? Or was it a typical counter-trend rally? Only time will tell. With deep losses for many of these assets in 2022, there was a heavy amount of tax loss selling towards the end of the year, and some of the trend reversal can be attributed to market participants simply re-establishing their positions after waiting out the wash-sale period following the tax loss selling. Many also attribute the reversals to technical factors that resulted in some of the most oversold conditions in those beaten-down groups, which were too much to pass up for bargain hunters. And many are pointing to the prospects for a more dovish Fed in 2023 as a primary factor driving the reversals. After all, the Fed’s 2022 rate hiking campaign was the most aggressive in decades and wreaked havoc on rate sensitive areas of the markets – essentially those that suffered the most in 2022.

The result of the excessive bearishness in 2022, combined with a month of excessive bullishness to start 2023, is a real jumble of headwinds and tailwinds for capital markets. Tailwinds include January being a seasonally strong period, and the January risk-on action mitigated a lot of the downtrends that developed in 2022. There’s also a good chance that peak inflation is behind us, and the Fed has now decreased the level of its rate hikes for the last two meetings (from four straight 75 basis point hikes to 50 basis points in December and 25 basis points at the start of February). And as the January employment report recently demonstrated, the labor market is still quite strong.

But one month doesn’t make a recovery and there are still formidable headwinds to challenge markets. Chief among them are the numerous recession indicators flashing (the labor market notwithstanding), there are “sticky” pockets of inflation that will keep the Fed on edge, there is developing weakness in the housing market, corporate earnings are steadily deteriorating, significant leverage remains in the financial system that needs to be alleviated, and geopolitical risks remain with Russia/Ukraine and China/Taiwan at the forefront, and now increasingly China/U.S. tensions.

The January reversal rally was certainly welcome but, as mentioned above, it was led by the more speculative, higher risk segments of the market. With the economy and earnings decelerating, it is becoming harder to justify the rising prices in those areas with fundamentals. We made some portfolio changes at the end of the year that further improved the quality of our portfolios, increased the dividend yield, and lowered the risk levels. The possibility of an economic and earnings recession warrants some defense, there will be plenty of time to play offense once the economy and earnings are no longer slowing. We continue to be advocates of diversification and will likely look to further diversify geographically in 2023 if overseas economies emerge from recession and the U.S. dollar retreats from its uptrend. We will also be watching for signs that long-term structural trends, like growth outperforming value, are shifting, as is the outperformance of large caps over small caps, and U.S. over non-U.S. These are long-term secular trends that have persisted for years but appear to be shifting, and we will adjust portfolios accordingly if the change of leadership continues to mean-revert to long-term historical levels.

Source: Bloomberg, as of January 31, 2023.
Price Returns for Equity, Total Returns for Bonds.
* The term basis points (bps) refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 0.01%. Bond prices and bond yields are inversely related. As the price of a bond goes up, the yield decreases.

Quick Takes

HAPPY NEW YEAR INDEED

Stocks and bonds had a strong start to 2023. How strong was it? Well, January 2023 ranked as one of the best Januarys in the last 40 years. The S&P 500 had its best January since 2019, up +6.3% with dividends, and before that, you must go back to 1997 (+6.3%) and 1989 (+7.3%) to find such strong starts to a calendar year for U.S. stocks. Though it’s not shown in the chart below, U.S. small-cap stocks and non-U.S. developed market stocks had historic starts to the year. The small-cap Russell 2000 Index had its fourth best January in the history of data going back 44 years with a total return of +9.7%. The MSCI EAFE Index was up +8.1% in January, which was also its fourth best January in 50 years and the best since gaining +8.3% to start 1994. For bonds, using the Bloomberg US Aggregate Bond Index as a proxy, January’s total return was +3.1%, which was the second best January in the last 40 years, only trailing the +3.5% in January 1988. In fact, the next closest January prior to 2023 was in 2015 when bonds were up +2.1% to start the year.

Stocks and Bonds have one of the best Januarys in History
January Total Returns by Year (1984 – 2023)

Source: Bloomberg.

TRADING PLACES

As mentioned in the opening, January 2023 was a reversal of many of the trends that dominated 2022. Many of the biggest losers for calendar year 2022 had the biggest gains in January 2023. In the chart below, some of the largest 2022 losses in market segments such as equity styles, sectors, factors, regions, as well as bonds are shown side-by-side with their subsequent rebounds in the first month of 2023.

Trading Places
2022 Returns vs January 2023 Returns

Source: Bloomberg.

FROM TINA TO TARA

The Fed’s historic rate hiking in 2022 inflicted losses on fixed income assets, resulting in the worst calendar year ever for bonds. U.S. bonds, as measured by the Bloomberg U.S. Aggregate Bond Index, finished the year down -13.0%. Of course, bond yields move inversely to bond prices and the yield on the U.S. 10-year Treasury finished the year at 3.87%, a rapid climb from 1.51% at the end of 2021 and the all-time low of 0.55% in July 2020. The poor performance left fixed income out of favor with many investors. The paradox is that the frustrating performance in 2022, makes fixed income a more attractive piece of the asset allocation process moving forward. In recent years, “TINA” (There Is No Alternative to equities) was the prevailing sentiment because yields had dropped so low that they provided very little income, even falling behind the dividend yield on equities for a stretch of 2019 through 2021. But that is no longer the case. Fixed income yields have comeback as an attractive alternative to equities in the context of a multi-asset portfolio, especially for those needing income and/or reduced risk. The relative advantage of bond yields over equity dividend yields is now at levels not seen since April 2010. So welcome TARA (There Are Real Alternative to equities).

Fixed Income Represents an Attractive Alternative to Equities Again
Difference between US 10-year bond yield and S&P 500 dividend yield

Source: Bloomberg. Monthly data from February 1993 to January 2023. 10-year bond yields = US Generic Gov’t 10-Year. The S&P500 dividend yield = cash dividends paid out by S&P500 listed companies in relation to the overall market value of the S&P500 index.

HOME SALES SLOW

U.S. existing-home sales fell again in December, marking eleven straight months of negative sales and concluding the weakest year for sales activity since 2008. Sales of previously owned homes, which make up most of the housing market, slid -17.8% in 2022 from the prior year to 5.03 million. The Federal Reserve’s effort to cool the economy and curb inflation by raising interest rates flattened housing market activity in 2022 as borrowing rates more than doubled. More recently, mortgage rates have declined, from over 7.0% in November for a 30-year fixed rate, to 5.99% on February 2. The median selling price of a home is also well off its peak, which hit $413,800 in June 2022, and now sits at $366,900 at the end of 2022. That may offer some relief to homebuyers but many prospective sellers purchased their homes, or refinanced their mortgages, during the period when mortgage rates were below 4% and are unwilling to give up their current rate for a higher one on a new home, which has resulted in the supply of homes for sale being unusually tight.

U.S. Existing-Home Sales Slid Last Year as Rates Surged
U.S. existing-home sales, yearly change

Source: National Association of Realtors, The Wall Street Journal.

IS THE FED DONE?

Bank of America says the Federal Funds Rate will peak at 4.9% by June 2023 and the Fed will then begin to cut rates to under 3% by December. Research firm Fundstrat noted that Fed chairman Powell cited the word “disinflation” 13 times in his February 1 press conference following the FOMC +0.25% rate hike. In his December press conference, “disinflation” was not used once. Markets interpreted Powell’s comments as “less hawkish” and helped bid stocks higher from January’s big rally.

Market consensus says Fed hikes 25 bps in March, then cuts 200bps in 2H-2023
Current market pricing for Federal Funds Rate (%)

Source: BofA Global Investment Research Strategy, Bloomberg, Isabelnet.com. Pricing as of 02/02/2023.

TOO FOCUSED ON THE FED?

It’s understandable that market participants are extremely fixated on the Fed and what their next step in monetary policy will be. After all, the Fed played a central role in 2022’s decline in asset prices. The same can be said, for the opposite reason, for how well the market performed in January 2023 as expectations solidify that the Fed will be done hiking rates very soon, and even betting that they will be cutting rates in the back half of the year. Investors appear so optimistic that the Fed will no longer be an anchor on stock prices that they may be looking past other hurdles… such as the deteriorating profit outlook for U.S. companies. Wall Street analysts are paradoxically raising their price targets for stocks while simultaneously slashing the earnings estimates for them. The later action seems more sensible as the fourth quarter earnings season hits its halfway point as this is being written. Fourth-quarter earnings season has done little to support optimism about company fundamentals. Earnings have been coming in below pre-season estimates and companies are curbing their forward guidance at a higher rate than average based on expectations that growth will slow. In fact, a model by Bloomberg Intelligence shows that such earnings guidance for Q1-2023 has been cut by the most since at least 2010. As shown in the chart below the percentage of positive earnings surprises (green bars) has steadily declined for more than six quarters now, while the percentage of companies missing analysts’ expectations for earnings has expanded (shown in red). This will remain a challenge for markets as analysts appear too optimistic and continue to revise their estimates downward.

S&P 500 Earnings Tracker
Share of members that beat, missed, or matched analyst EPS expectations

Source: Bloomberg Intelligence.

ECONOMIC GROWTH ALSO COOLING

U.S. economic growth slowed in the fourth quarter of 2022, concluding a year marked by supply chain issues, high inflation, and rising interest rates. The first estimate (of three) of Q4-2022 Gross Domestic Product (GDP), the broadest measure of economic output, slipped to a +2.9% quarter-over-quarter annualized rate for Q4-2022, down from +3.2% in Q3-2022, but beating Wall Street expectations for +2.6%. Consumer spending, the primary driver of economic growth, slowed in Q4 as well, with Personal Consumption coming in at +2.1%, a solid pace, but down from an unrevised +2.3% rise in Q3, and well below expectations for +2.9%. What made up for the slowing consumer spending? Inventory builds and government spending were large contributors to last quarter’s economic growth. In fact, government spending hit a record high in Q4 and the sharp rise in inventory made up half of the increase in GDP growth. Without government spending and inventory piling up, and trade, Private Domestic Demand was just +0.2% in Q4, the slowest pace in two and a half years.

Economic Growth Cooled in Q4
U.S. real Gross Domestic Product (GDP), change from the prior quarter

Source: MSCI, Bloomberg.

Asset Class Performance

The Importance of Diversification. Diversification mitigates the risk of relying on any single investment and offers a host of long-term benefits, such as lowering portfolio volatility, improving risk-adjusted returns, and helping investments to compound more effectively.

Source: Bloomberg.
Asset‐class performance is presented by using market returns from an exchange‐traded fund (ETF) proxy that best represents its respective broad asset class. Returns shown are net of fund fees and do not necessarily represent the performance of specific mutual funds and/or exchange-traded funds recommended by The Retirement Planning Group. The performance of those funds may be substantially different from the performance of the broad asset classes and to proxy, ETFs represented here. U.S. Bonds (iShares Core U.S. Aggregate Bond ETF); High‐Yield Bond (iShares iBoxx $ High Yield Corporate Bond ETF); Intl Bonds (SPDR® Bloomberg Barclays International Corporate Bond ETF); Large Growth (iShares Russell 1000 Growth ETF); Large Value (iShares Russell 1000 Value ETF); Mid Growth (iShares Russell Mid-Cap Growth ETF); Mid Value (iShares Russell Mid-Cap Value ETF); Small Growth (iShares Russell 2000 Growth ETF); Small Value (iShares Russell 2000 Value ETF); Intl Equity (iShares MSCI EAFE ETF); Emg Markets (iShares MSCI Emerging Markets ETF); and Real Estate (iShares U.S. Real Estate ETF). The return displayed as “Allocation” is a weighted average of the ETF proxies shown as represented by: 30% U.S. Bonds, 5% International Bonds, 5% High Yield Bonds, 10% Large Growth, 10% Large Value, 4% Mid Growth, 4% Mid Value, 2% Small Growth, 2% Small Value, 18% International Stock, 7% Emerging Markets, 3% Real Estate.
* The term basis points (bps) refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 0.01%. Bond prices and bond yields are inversely related. As the price of a bond goes up, the yield decreases.

Chris Bouffard is CIO of The Retirement Planning Group (TRPG), a Registered Investment Adviser. He has oversight of investments for the advisory services offered through TRPG.

Disclaimer: Information provided is for educational purposes only and does not constitute investment, legal or tax advice. All examples are hypothetical and for illustrative purposes only. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed. Please contact TRPG for more complete information based on your personal circumstances and to obtain personal individual investment advice.