The last year was full of many issues and varying levels of uncertainty – and the markets do hate uncertainty. Ukraine, Russia, China, inflation, crypto, and the U.S. midterm elections all became headline material, with their impacts on the equity and bond markets in the U.S. and abroad also featured in the news, in their turn. While the equity markets did finish above the absolute lows of 2022, both stocks and bonds declined for the year, which has only happened six times in the last 100 years. As we look back at various issues, we will also discuss our thoughts for the future.
By Daniel Yu, CFA, CFP®, AIF® – Co-Chief Investment Officer and Senior Investment Manager
& Robert Papelian, CFA, CMT, CFP® – Co-Chief Investment Officer and Senior Wealth Advisor
Inflation: the Watchword for 2022?
In 2022, inflation quickly accelerated to over four times the 2% target of the Federal Reserve, and the Fed responded to the persistent inflation by rapidly raising rates. The rapid increases resulted not only in a strong decline in bond prices, but also a rapid repricing of equity assets as bonds became competitive to stocks. Looking ahead, we expect the Fed to be diligent in fighting inflation and to hold rates higher for a longer time than usual. We do anticipate a recession in 2023, but one that is less severe than prior recessions.
With the Fed rate hike campaign, not only did capital markets return to focus on corporate fundamentals, but the foreign exchange markets were also impacted as the U.S. dollar index strengthened against a number of currencies. The strong U.S. dollar created an environment that made international investments more appealing, all else being equal, to U.S.-based investors. As the U.S. dollar declined in the last quarter of the year, we saw international markets finish the year on a relatively strong note compared with U.S. equities. Looking ahead, international equities remain undervalued relative to U.S. markets, and U.S. investors may benefit from revisiting their international equity exposures as we consider positioning for the longer term.
Looking Ahead to 2023
Looking ahead, we expect some of last year’s themes to carry through at least the first half of this year. Namely, we expect dividends and distributions to shareholders to be important contributors toward total returns (with the other component being capital appreciation), as well as the continued out-performance of value overgrowth equities.
There will likely be some volatility across markets and across these trends, with the picture becoming clearer as economic data unfolds to show us whether and when we find a recession, or if the Fed is able to engineer a “soft landing” for the economy. In turbulent market times, we often find that opportunities present themselves in different areas at different times. We do not expect 2023 to be a story of “a rising tide lifts all boats,” and so we are preparing to implement different strategies depending on what the changing economic environment does from here.
Perhaps one silver lining that came out of 2022 and the Fed rate hike campaign is simply that rates are higher. The low-rate environment in recent years has made income-oriented investing difficult for many investors who rely on their portfolios for cash flows. Indeed, rising rates coupled with high levels of inflation were major drags on bond investors last year, with the aggregate U.S. bond market delivering a negative total return for just the fifth time in as many decades (and the biggest decline in terms of magnitude over that same period).
However, with higher rates and cooling inflation, investment-grade bonds should once again serve as ballast to a diversified portfolio and help generate income for cash-flow-oriented investors, and the dynamic landscape may bring additional opportunities in different classes of fixed income.
Cryptocurrencies had a hard year, with rapid declines as the Fed increased rates. The industry also experienced several hacking events and thefts of crypto currencies. However, the biggest headline centered on the collapse of FTX and the fraud case being made against its founder. Looking ahead, we do expect greater scrutiny and regulation of crypto. Most likely, blockchain technology will find wider application in our economy and prove more useful than crypto supplanting established currencies.
Events on the World Stage and at Home
Early in 2022 the Ukraine/Russia conflict took center stage, quickly impacting the price of both energy and food. By all reports, Russia expected the conflict to be over in a short amount of time, but the war has bogged down amid questions about the strength of the Russian military. Looking ahead we would expect the biggest change to be to the sourcing of energy for Western Europe. A move away from dependence on Russian-sourced natural gas means Europe will need to invest in its energy infrastructure on many levels.
China had two big pieces of news in 2022. Chairman Xi secured a third term as the Chinese President, something that has not happened since Mao. China also abruptly ended its zero-COVID policies. We expect the Chinese reopening to be a bit chaotic as COVID works its way through the population. In the longer term, the policies of the Xi government will continue to consolidate power to the CCP.
In the realm of U.S. politics, the biggest headline was that the Republican Party did not have as strong a showing in national elections as the Party had projected. However, we do now have divided government, and therefore anticipate that we will not see any tax increases. Moreover, we expect the use of omnibus spending bills to go down and for debates about the debt ceiling to be even more contentious.
All in all, 2022 was a very eventful year, and one thing we know with certainty is that each year brings its own highlights and challenges with the capital markets. As some of these headlines and topics come to an eventual close, we know that 2023 will result in the beginnings of new stories: as the saying goes, uncertainty is the only certainty. While the environment remains challenging, we are optimistic about our ability to help you navigate these dynamic times, as disruption in the markets usually opens new areas of opportunity. We greatly value your trust and continued business and look forward to our continued partnership with you in the new year.
© 2023 REDW Wealth LLC. This publication is intended for general informational purposes only and should not be construed as investment, financial, tax, or legal advice. Advisory, Assurance, and Tax is offered through REDW LLC. Wealth Management is offered through REDW Wealth LLC.