Market Performance Summary

After posting solid returns in October and November, capital markets couldn’t maintain their momentum in December, as the traditional fourth quarter seasonal rally stalled. The quarter still finished in positive territory for all major asset classes, but for the year there were few places to hide aside from cash and energy stocks.

Asset Class Total Returns

Source: Bloomberg, as of December 31, 2022. 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).

In that setting equities, bonds, and real estate struggled. Real Estate was the best performing major asset in 2021 but fell to the bottom in 2022, down -24.9%, as the pain of tighter monetary policy, rising home prices, and surging mortgage rates cooled demand for real estate. By the end of the year, the pace of existing single-family home sales had fallen the fastest it ever has in any previous Fed tightening cycle. Homebuilder confidence ended the year near the lows in April 2020 in the depths of the Covid lockdowns.

Equities didn’t fare much better in 2022, with decades of high inflation and rising interest rates pressuring valuations and threatening the outlook for corporate earnings. U.S large caps (S&P 500 Index) finished the year down -18.1% and small caps (Russell 2000 Index) fell -20.4%. Non-U.S. developed markets (MSCI EAFE Index) outperformed U.S. stocks for the first time in five years but were still down -14.5% as the U.K. officially entered a recession and the Ukraine conflict weighed heavily on European markets. Heightened tensions over a China/Taiwan conflict and concerns over China’s housing market and Covid lockdowns sent emerging markets down -20.1%.

Normally that amount of turmoil in equity markets would send investors seeking safety in bonds, but not in 2022 with the high inflation and aggressive Fed policy. Like equities, the bond markets felt the impact of higher interest rates. U.S. bonds (Bloomberg U.S. Aggregate Bond Index) finished the year down -13.0%, its single worst calendar year ever. 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. Bond yields move inversely to prices. Non-U.S. bonds (Bloomberg U.S. Aggregate Bond ex U.S. Index) were hit even harder in 2022, falling -18.7% for the year – also their worst year ever.

Perhaps the silver lining for investors is that 2022 likely marked a peak in inflation and 2023 should see a steady reduction in inflation pressures – and a corresponding slowdown in the pace of rate hikes by the Fed. In fact, future markets are pricing in a reversal of Fed policy to rate cuts by the end of 2023. History is also on investors’ side, as past years with an anomalous drop in both stocks and bonds, like 2022, were typically followed by above-average positive years (see the “Historic Year” and “Volatility Hostility” sections further on for more details). Markets aren’t out of the woods yet as the economy and earnings still face stiff headwinds in the first half of the new year. The likelihood of a modest recession is rising, but a deep and extended economic downturn isn’t a base case scenario. And if the Fed does ease its rate-hiking campaign in the first half of 2023, both stock and bond markets may begin to recover in the back half of 2023 in anticipation of a better economic environment.

Source: Bloomberg, as of December 31, 2022.
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

FED vs. INFLATION

Perhaps the biggest macroeconomic story in 2022 was the shift from a very accommodative Federal Reserve to what has become the most aggressive interest rate hiking cycles in history. In its attempt to stamp out decades-high inflation, the Fed raised the federal-funds rate target at its fastest pace in history, resulting in a surge in bond yields from near historical lows to their highest levels in years. The Fed eased into the new restrictive monetary policy in March with a 25 basis point (bps, or 0.25 percentage points) increase, then bumped it up to a 50bps increase in May, but then got very aggressive with four straight 75bps hikes in June, July, September, and November. Before June, the Fed hadn’t raised the Federal Funds policy rate by three-fourths of a point in any single meeting since 1994. At the latest Federal Open Market Committee meeting in December, the Fed tacked on another, slightly less aggressive, rate hike of 50bps. The rapid increase comes after two years of rock-bottom interest rates following the pandemic recovery. Of course, the Fed’s action sent Treasury yields soaring. The 2-year U.S. Treasury yield began the year at 0.73% but climbed +387 percentage points during the year to finish at 4.43%. And the benchmark 10-year Treasury started 2022 at 1.51% and climbed +236 percentage points to 3.87%. The Fed next meets in February, and the futures markets are currently pricing in the probability that Fed will slow the rate-hike pace to 25bps in February and then another 25bps in March.

The Fed Attempts to Stamp Out Inflation
Treasury Yields and Federal-Funds Rate

Source: Federal Reserve Economic Database, Morningstar. Data as of December 31, 2022.

HISTORIC YEAR

The Fed’s unprecedented rate hiking in 2022 wreaked havoc on capital markets, resulting in an incredibly frustrating year for investors… even well-diversified investors. How challenging, and out-of-the-norm, was 2022? Stocks (using the S&P 500 Index as a proxy) have been positive in 73% of calendar years since 1928 but were down -18.1% in 2022 – the seventh worst calendar year total return in that 95-year period. And bonds (using the 10-year U.S. Treasury Bond as a proxy) were also down in 2022, despite being positive in 80% of the calendar years since 1928. But bonds weren’t just down, they had their worst year in history, with the 10-year Treasury suffering a -16.5% loss. Combined, stocks and bonds haven’t had negative returns in the same year since 1969 – a truly anomalous event. In fact, 2022 was only the fourth year in the last 95 that both stocks and bonds were negative and only 1931 saw a worse combined total return for stocks and bonds. 2021 and 2022 were also the first back-to-back calendar year losses for bonds in history. So, on many fronts, 2022 was truly an outlier. The good news for long-term diversified investors is that in almost every year following a materially negative year for stocks and bonds, the subsequent year saw strong rebounds. Fortunately, we repositioned our bond exposures early in 2022 to be well-underweight duration (i.e. interest rate sensitivity) and mitigated bond losses to single digits.

Distribution of Historical Stock and Bond Returns
(1928 – 2022)

Source: Aswath Damodaran/Stern School of Business NYU, Bloomberg.

VOLATILITY HOSTILITY

We were communicating our expectations for a very volatile year in the markets early last year, anticipating a bumpy ride with the Fed ready to raise interest rates, fiscal stimulus from the Covid relief bills waning off, and uncertainty from midterm elections. Of course, there was also an unexpected geopolitical shock with Russia’s unexpected invasion of Ukraine. And without fail, the volatility indeed followed. Nearly half (48%) of the trading days in 2022 saw a 1% swing intra-day in the S&P 500 Index and 92% of trading days saw stocks hitting new lows exceed stocks setting new highs. Analysis by All Star Charts of data going back 50 years shows that the combination of stock volatility and weakness is unprecedented. As shown in the chart, only 2008 and 1974 rival 2022. The good news is that historically, such outlier years tend to be one-and-done incidents. Though it’s only two observations, the subsequent year’s market performance for both those 2022-like outlier years were outliers themselves. The S&P 500 rebounded from 1974’s loss of -26.5% (total return), with a +37.2% total return in 1975. And after 2008’s -36.9% plunge, the market rallied back with a +26.5% gain in 2009.

Stock Market Weakness and Volatility Were Extremely Elevated in 2022
Combination of Volatility and Weakness Set Record

Source: All Star Charts.

INFLATION ALLEVIATION

For the third month in a row, the feature of this space is another indication that inflation pressures continue to ease. November’s deceleration in the Fed’s preferred inflation gauge, the Personal Consumption Expenditure (PCE) Core Price Index (also known as the PCE Core Deflator), adds to evidence of moderating price inflation. The measure most likely will end in 2023 lower than what the median Federal Open Market Committee (FOMC) participant anticipated in the latest Summary of Economic Projections. Fed Chairman Jerome Powell has stressed the PCE Core Deflator is a more accurate measure of where inflation is heading. The Fed will still want to see some signs that wage levels and rents are also cooling, in addition to goods and services prices, but this report is moving in the right direction and should be contributing evidence that the Fed’s aggressive rate hikes in 2022 are having their intended impact.

Fed’s Preferred Inflation Indicator Is Cooling
Personal Consumption Expenditure (PCE) Core Deflator moderates over last three months

Source: Bureau of Economic Analysis, Bloomberg.

SPENDING STAGNATES.

In the same report of the PCE Deflator, Personal Spending, adjusted for changes in prices, stalled in November, marking its weakest level since July – and coming in below economists’ expectations. An increase in services spending, led by restaurants and accommodation, offset a decrease in merchandise spending. New vehicles were the leading contributor to that decrease. Like the softer Consumer Price Index figures released earlier in December, and the PCE Deflator, the spending data signals welcome relief in inflation pressures and suggest the US has passed peak inflation.

Consumer Spending Stalls in November
US Personal Consumption Expenditure Core Price Index

Source: Bureau of Economic Analysis, Bloomberg.

VALUE GETS A VICTORY

With inflation and volatility prevailing themes throughout 2022, growth-oriented stocks faced serious headwinds. Indeed, growth as a style saw its largest underperformance relative to value in more than two decades. 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). On the contrary, the Russell 1000 Value Index was the best performing Russell U.S. style index in 2022, albeit with a still negative -7.5% total return. The difference between the two, -21.6 percentage points, is the largest outperformance of Large Value over Large Growth since the dot com bubble bust in 2001. Growth had outperformed value for five straight years, and 10 of the last 14 years since the Great Financial Crisis. Both valuations and macroeconomic dynamics likely favor value for the foreseeable future. According to Ned Davis Research, the Price-to-Earnings (P/E) of stocks in their Growth universe is +113% above its long-term average, while the median Value stock is -12% below the long-term average. From a macroeconomic standpoint, higher inflation, higher interest rates, and higher volatility – all headwinds to risk-taking and growth stocks – are likely to persist for at least another few quarters.

Regime Change: Growth versus Value
Russell 1000 Growth Total Return minus Russell 1000 Value Total Return (1979-2022)

Source: Bloomberg.

DEFENSIVES DOMINATE

Very similar to the Growth versus Value dynamic, certain market sectors are more defensive than others because they generally have relatively stable earnings that tend to be more resilient to cyclical downturns in the economy. The consumer staples, health care, and utilities sectors are typically considered lower-risk, defensive sectors. They also tend to be more resistant in the face of inflation because consumers generally will continue to purchase staples, health care, and utilities, even as prices increase. With heightened market volatility, economic deceleration, and rising inflation prevalent throughout 2022, it’s not surprising to see how well defensive stocks held up relative to cyclical stocks. As seen in the top half of the chart below, the MSCI Defensive Index was positive in 2022, rising +2.9%, handily outperforming the S&P 500 Index which fell -19.4%. The MSCI Cyclical Index, however, materially underperformed, falling -28.2%. Defensives outperformed Cyclicals in 10 of the 12 months in 2022 (see the bottom half of the chart below). Inflation has been easing but the economy faces headwinds for the next few quarters which may help Defensives maintain their momentum.

Cyclical Stocks Outperform Defensive Counterparts
MSCI U.S. Defensive and MSCI U.S. Cyclical Indices

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.