The year 2022 is one for the history books as inflation not seen since the 1980s drove the Federal Reserve to hike interest rates at a record pace.[i] We also saw Russia begin its invasion of Ukraine, the persistence of the COVID-19 virus, and China’s appointment of Xi Jinping to an unprecedented third term as president.[ii]
It was a volatile year, and stocks and bonds both sold off. Global stocks ended the year down 18.4%[iii], the worst performance since 2008. Investment-grade bonds ended the year losing an unprecedented 12.9%, which is multiples worse than the previous worst year of -2.9% in 1994[iv]. Yield curve inversion (measured by the 2Y/10Y bond yield spread) hit an extreme not seen in decades[v], portending slowing growth and recession. In total, the stock and bond markets lost over $30 trillion in 2022.[vi]After a blistering two-year stretch for risk-on assets, 2022 was a sobering repricing period for capital markets.
We see this repricing as healthy because the record pace of rampant speculation that occurred in the second half of 2020 and most of 2021 was not sustainable. Unprofitable tech companies, driven heavily by narratives, saw their valuations extend far beyond what was reasonable. Some of the biggest darlings of the Zero Interest Rate Policy (ZIRP)[vii] rally were SPACs, innovation funds, cryptocurrencies, speculative tech companies, collectibles and meme stocks. Each of these ZIRP beneficiaries has seen drawdowns as violent as their rallies in a rational repricing based on elevated interest rates.
We enter 2023 with cautious optimism and the belief that what we experienced in 2022 is positive for the economy long term. Bond yields are now at their highest level since the 2008 crisis, creating greater expected returns for fixed income. Equity multiples have reset back to historical averages from the elevated valuations of 2021. Additionally, inflation has cooled considerably from its peak, and the possibility of a Fed pivot remains on the table depending on the trajectory of future data.
Our investment principles are built around fundamental valuation, which sometimes means having contrarian takes. We do not chase momentum rallies unless the economic and fundamental rationales are there. To do otherwise would be akin to gambling and speculation, which might feel good on a hot streak but rarely ends well. As fiduciaries, we view portfolio and risk management through the lens of prioritizing capital preservation for sustained long-term growth.
The Fed’s interest rate policy and shape of the yield curve has a profound effect on asset valuations. Using a traditional valuation model, a rise in interest rates directly lowers the present value of all future cash flows because of the denominator effect. This is illustrated in the graphic below, where “r” is the discount rate for future cash flows. This framework applies to both stocks and bonds and provides a striking visual that can help explain the significant headwind that monetary policy creates.
However, after hiking interest rates by over 4% in 2022[ix], the Federal Reserve is likely close to the end of its recent tightening cycle, especially if inflation continues cooling. Financial markets are already pricing in interest rate cuts going into 2024, a more dovish view than what has so far been indicated by the Fed[x]. Thus, our outlook for bonds is more positive than it has been in many years despite a historically challenging 2022.
We see the looming recession as another key theme for 2023. On the positive side, employment remains strong, and real GDP has mostly recovered back to trend growth[xi]. However, many market participants are expecting recession, and the yield curve has inverted to its worst level in four decades, a harbinger of slowing growth and rising recession risks. What’s interesting about recessions is that equity markets tend to be the first to price them in, and by the time recession hits, stocks may already be nearing bottom. Over the past century, the average annualized market returns two years out from a recession is a reasonable 7.8%[xii]. Thus, we believe in staying the course with your equity asset allocation and practicing balance, patience and discipline.
As always, we appreciate your continued trust and partnership as we navigate the market cycle together.
SFG Asset Management Team
[i] Source: Bloomberg
[iii] The MSCI ACWI returned -18.36%. https://www.msci.com/documents/10199/a71b65b5-d0ea-4b5c-a709-24b1213bc3c5.
[iv] Source: Bloomberg based on data going back to 1980.
[vii] ZIRP is “Zero-Interest-Rate Policy”
[ix] Source: Bloomberg
[x] Source: J.P. Morgan Asset Management.
[xi] Trendline GDP growth of the past 21 years is at ~2%. Source: J.P. Morgan Asset Management.
[xii]Data goes back to 1926 and takes into account 15 recessionary periods. Source: Dimensional Funds.