As we welcome a new calendar year, we pause to reflect upon the one which has concluded and consider what 2023 might offer investors. 2022 was a tumultuous year in the financial markets, with double-digit losses for both stocks and bonds. A rapid rise in inflation and interest rates served as the catalyst for the decline in both stocks and bonds. Volatility in the financial markets was also stoked by recession fears and the geopolitical uncertainty and economic strains caused by Russia’s war in Ukraine.
The Federal Reserve increased interest rates quickly and substantially in response to inflation that reached 40-year highs, raising the federal funds rate by 4.25% in 2022. The faster-than-expected rate increases resulted in the worst-ever annual bond market return. If there is any silver lining to the bond market pain, it is that now bond yields are once again attractive sources of income (bond yields rise as prices fall). On the equity side, the Fed’s aggressiveness pricked the stock market valuation bubble. After years of above-average gains in the stock market, valuations have returned to more reasonable levels.
Economic growth was mixed in 2022. After an economic contraction in the first half of the year, the domestic economy recovered in the second half of 2022 with 3.2% GDP growth in the third quarter and early estimates also predicting growth in the fourth quarter. The fast increase in interest rates also pricked the real estate bubble as mortgage rates more than doubled from the start of 2022, putting downward pressure on home building, home sales, and typical spending for new households like renovations, furniture, and appliances. A historically strong U.S. labor market was a bright spot in the economy. In 2022, the pace of job growth was more than twice the pre-Covid levels of 2019. At 3.7%, the November unemployment rate was just slightly above its 50-year low in 2019.
With the Fed so intent on slowing the economy to rein in inflation, recession fears will continue in 2023. In the U.S., inflation is still outpacing wage growth, reducing consumer confidence. Additionally, despite a very tight labor market, there are early signs of cooling that we are watching carefully. Large layoffs are already being announced in the tech industry reflecting the realities of adjusting to slower growth ahead. Looking abroad, European economies are particularly vulnerable to geopolitical uncertainty and inflation resulting from the war in Ukraine. Beijing’s recent decision to end its zero-Covid policy could bolster the global economy as China reopens. Should we experience an economic downturn, while recessions are painful, they are also natural and necessary occurrences that lead to a reallocation of resources, which in turn sows the seeds for long-term growth.
Despite the likelihood of recession, there are promising signs of calmer waters ahead for investors. Leading indicators point to inflation moderating domestically, which will provide empirical support for the Fed to end its tightening cycle. In 2023, we expect inflation, interest rates, and corporate earnings growth to slow. Combined, these should result in a positive bond market return. In bond portfolios, we continue to focus on quality and liquidity, while looking for opportunities to extend maturities to lock in higher yields.
Much of the expected weakness in economic growth is already reflected in market valuations. As we stated earlier, while stock valuations are more reasonable, a risk from lower corporate earnings and profits remains. Therefore, it is important under these challenging conditions to favor investment in companies whose economic earnings are better protected and to make purchases with a greater margin of safety. Additionally, for some clients, we are encouraging diversification toward multinational companies as we believe this long period of U.S. dollar strength may be drawing to a close.
As investors, we expect surprises. In 2022, the war in Ukraine came as a shock and transitory inflation was recognized by the Fed as persistent, which in turn prompted our central bank to reverse course and aggressively hike rates, bringing the typically uncorrelated stock and bond markets tumbling. The surprises of 2023 will become known as the year unfolds. It’s in uncertain times that investors most need the fortitude to stick to their long-term plans and not make rash decisions based on transitory factors. A sound investment plan accounts for the unexpected. Indeed, amidst jaw-clenching news reports on the financial markets in 2022, many of our clients found that their statements reflected resiliency.
The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.