Q-4, 2022 MARKET REVIEW:
Year In Review
Twenty twenty-two has ended and the hope is that 2023 brings more certainty to the economic and investing landscape than has existed over the past 365 days.
It’s easy to forget that on January 3, 2022 the S&P 500 index closed at 4,796.56 and the 10-year Treasury yielded 1.63%. Contrast this to the reported S&P close price on January 1, 2023 of 3,847.44 and the 10-year Treasury yield at 3.75%. Intra year the S&P 500 index recorded a price as low as 3,623.29.
In the intervening period the Federal Reserve Bank implemented four 75, two 50 and one 25 basis point rate hikes aggregating to a 4.25%-4.5%. rate by the end of 2022. The starting point for those rate increases was around 0 in January 2022. The discount rate is the interest rate the Fed charges banks to borrow funds, usually overnight. This rapid change in interest rates implemented for the purpose of taming inflation produced uncustomary volatility in bond prices. When market and economic dynamics adversely impact stock prices investors shift away from more risky equity assets to the safe-haven that bonds customarily offer. In 2022, however, the sharp decline in bond prices, resulting from interest rate hikes, has also battered bond real returns .
We know that the market turmoil of the past year results from the increase in inflation world-wide. Though the United States is not immune to global economic changes, the cause of US inflation differs from the forces impacting Europe and Asia. The supply line dislocations that drove inflation globally in the last quarters of 2021 and the early months of 2022 are for the most part resolved. However, some overhang from that shock continues.
The interruption of traditionally sourced energy and food supplies from Russia and Ukraine, brought about as a result of the Ukraine war, now adversely impacts European, African and Asian economies to a far greater extent than it impacts the US economy. Until this winter several European countries have lacked storage facilities for energy resources as they have relied on oil and gas pipeline flow from Russia. The disruption of traditional supply lines at a time when available energy and food supply world-wide commands high prices fuels inflation in Europe. This tyranny of high energy and food cost also adversely impacts African and Asian economies.
The Fed seeks to return annual inflation to a 2% target rate and does this by implementing two primary policy tools to tighten money supply and reduce liquidity. The first is raising interest rates and the second the selling Fed owned mortgages and bonds to banks primarily in an effort to reduce liquidity in the banking system. The latter tool is referred to as quantitative tightening.
Marginal success in this battle to tame US inflation has occurred. From a high of 9.1% recorded in June 2022, the most recently released US Labor Department data report of November 2022 suggests that inflation now runs at about 7.1%.
Inflation can only be measured retrospectively. The Fed deploys its tools based on observed data. Because there is a time lag between the deployment of policy tools and when the impact of that deployment is observable in the economy, there is reason to be concerned that the rate of economic growth deceleration will accelerate to the point where the economy tips from positive to negative growth and results in an economic recession.
Employment levels as well as the number of unfilled job vacancies in the economy are some important indicators for understanding how the economy is performing. As of December 2022, Employment and job vacancies remain positive as are other indices of growth for the US economy. The Fed has repeatedly made clear that it will not pause in deploying its available policy tools until there is clear evidence that the economy is slowing and the rate of economic inflation is consistent with its 2% target. Continued policy tool deployment in an environment where there is only marginal evidence that the economy is slowing exacerbates the possibility that the lag associated with policy tool deployment may not be observed until interest rate hikes have tipped the economy into recession territory. The extent of economic contraction resulting from continued Fed monetary policy tightening, will only be known in the coming months. And, the extent of that contraction will impact market investment returns.
Increased interest rates and a contracting economy will adversely impact corporate profitability and share prices. This is the proverbial next shoe to fall. Market analyst will be scrubbing Q-4 corporate performance data to understand the impact of fed policy tool deployment on corporate profitability. Indications of decreased corporate profitability in the coming quarters of 2023 will impact the share prices of companies and the wider market indices, which track economic sector equity performance.
China’s subscription to a COVID Zero policy has slowed domestic consumption in that country, reducing that economy’s demand for raw material for manufacturing and adversely impacting export of Chinese manufactured products to a world that has looked to China for a broad swath of manufactured products. As such the impact of China’s COVID Zero policy has not only slowed China’s economic growth but has had the effect of rippling through the world’s economies.
In December 2022, China abruptly dismantled policies and practices designed to control COVID-19 in its population. The result is extensive infection spread, hospitalizations and undoubtedly mortality. This U-turn occurring in a population with neither built up immunity nor highly effective vaccines means that for some time period worker illness or fear of contracting the virus will continue to adversely impact manufacturing and exports. The International Monetary Fund projects that China’s economic growth, which for decades has surpassed that of the worldwide average, will in 2023 be more in line with that average.
The noticeable out-performer of the equity sector in 2022, most specifically Q-4, was value stocks. Defensive sectors which are most characterized by value stocks include healthcare, consumer stables, utilities and energy. Company performance in these sectors have propelled performance of the value index sector higher. Defensive sectors allow investors to avoid the steep decline in share prices associated with growth companies most impacted by higher interest rates while remaining invested in equity securities. Companies in these sectors traditionally compensate investor subscription by declaring annual dividends which help to offset some of the loss that will also occur to the company’s share price in volatile economic times.
The below illustrates the breadth of change in the domestic equity and debt markets over the past three months.
|US S&P 500**
|Growth (MSCI World Growth)**
|Value (MSCI World Value)**
|Small Cap (MSCI World Small Cap)**
|Barclays US Aggregate Bond Index (USD)
**Asset Class Data: JP Morgan, Quarterly Review of Markets
We continue to remain on the sidelines in the absence of clarity as to how markets will perform in this volatile economic environment.
Though Seslia client portfolios for the most part do not hold individual corporate or fixed income securities, our practice of investing in sector portfolios through the use of mutual, index or exchange traded fund means that market perception of sector profitability impacts the performance of our clients’ portfolios.
We have positioned client portfolios to provide exposure to defensive equities, as well as to enjoy monthly or quarterly returns from bond funds. We have not, however, abandoned technology and growth investments though we have trimmed some positions. Broad scale repositioning of portfolios when losses have already occurred simply makes real what is at the moment paper losses . Seeking to guess the direction and timing of future market moves does our clients no favor. The preferred investment strategy that we pursue is patience which will over time allows portfolios under management to enjoying the benefit of share price rebound once we are through this market dislocation.
Clients with investments pursuing dividend and or interest returns may continue to see losses in the market price of these holdings as prices adjust to changes in interest rates. Investors in these securities should, however, continue to receive the interest or dividend returns expected at the time the investments were made. The share price of these portfolios, similar to those of equity investments, will right themselves over time.