While stocks broadly advanced in 2021, the coming year does not have as favorable of a backdrop. The Fed will be less accommodative and will tighten monetary policy. Inflation remains a risk for the market as it can force the Fed’s hand to raise rates at a disruptive pace.
- CRA Financial: January 2022
That excerpt was from our own 2021 end of year market commentary. What we had wrong was the amount of Fed interest rate hikes and the accelerated pace of these rate hikes that we saw in 2022. The market had expected around three 25 basis point rate hikes through the end of 2022. What actually occurred was a whopping SEVENTEEN 25 basis point hikes increasing the key Federal Funds rate all the way up to a target of 4.25% - 4.5%.
In the spirit of transparency and fairness, when we penned last year’s letter, there was a new Omicron variant threat of Covid arising, and the government was still administering Covid relief programs. Additionally, China’s zero Covid policy was expected to end sooner than it did; leading to supply chain disruptions. Additionally, there was not a war on the ground in Europe. In hindsight, it is very humbling to try to predict the path of the markets. So much has transpired in just a year, which now seems like ages ago. Things that make perfect sense now, were not so obvious then. We take note, reassess, and move on.
As a result of these events, U.S. inflation accelerated in the first half of the year, with the Consumer Price Index peaking at 9.1% year-over-year in June, but ebbing to 7.1% by November. Core inflation peaked at 6.6% in September and eased then to 6%. The CPI and PCE numbers should be carefully monitored in 2023 for an indication of where the Fed is heading. The Fed has stated that they want to see inflation return to 2%. We expect that rates will remain higher to restrict the economy and continue to bring inflation down in 2023. With that being said, it is very possible that we see the Fed pause their rate hikes in the coming months and even possibly cut interest rates towards the end of 2023 or in 2024.
Source: J.P. Morgan *
To give you an idea of how challenging the markets were in 2022, the S&P reached its closing high for the year on January 3, 2022, the first trading day of the year. The U.S. equity markets continued to slide during the final month of the year giving back gains from the months of October and November 2022. Big tech and consumer discretionary companies in particular struggled as growth stocks continued their stretch of underperformance relative to value. The Dow Jones Industrial Average declined by (-4.17%) during December, ending the year with a loss of (-8.78%). The S&P 500 Index declined by (-19.48%) for the year after nearly a (-6%) decline in December. The tech-heavy NASDAQ Composite Index had one of the worst years ever, declining by (33.1%) during 2022, of which (-8.73%) loss was attributable to December alone.
The new threat spooking the markets was not so much inflation, which seems to be cooling, but rather a self-induced recession caused by continued Federal Reserve monetary tightening. Despite the December sell-off, all major U.S. stock indexes had positive returns in the fourth quarter with the only exception being the NASDAQ at (-.79%). The Russell 2000 Index advanced by 6.23% during Q4 but was (-20.44%) on the full calendar year. Developed International stocks actually outpaced U.S. markets during the 4th quarter and on a full year basis with returns of 17.34% and (-14.45%), respectively. That is hard to believe, given higher trending international inflation, continued energy shortages, and an ongoing war in Europe. The dollar weakening throughout the quarter helped to give these stocks a boost. It just further demonstrates the unpredictability of the markets.
Fixed Income Markets and The Fed
The Federal Reserve stayed on its course of monetary tightening during the 4th quarter of 2022, lifting their key Federal Funds rate by 75 basis points on November 2nd. They raised rates again in December with a well telegraphed and lower 50 basis point raise in early December. Most of the heavy lifting occurred during the summer with three successive 75 basis point rate hike increases after falling behind on inflation, which also peaked during the summer. The Federal funds rate sits at a range of 4.25% and 4.5% at year-end after starting the year near 0%.
Consequently, during 2022 the U.S. Aggregate Bond Index declined by (12.5%), its worst year ever. The 10-year treasury yield increased during December but remained well off the peak yield of 4.24% seen in October of 2022. The 10-year note closed the year yielding 3.88%. A year ago, this note yielded just 1.51%. It is also worth noting that the Bank of Japan’s recent move off the 0% line is a major change to global economic policy which may have been a contributing factor to higher yields in the past month.
Energy Stocks and Oil Prices
Energy was the leading and only positive sector for the domestic stock market in 2022, returning roughly 42.60%. Most of those gains occurred during the first five months of 2022. WTI Crude oil prices ended the year at $80.26, after peaking in June at over $120 per barrel. The closing price at year-end was $75.21 per barrel.
Russia’s invasion of Ukraine caused the price of crude oil to jump to the highest level in more than a decade, presaging higher gasoline prices while agricultural and other commodity costs soared. Many of these increased costs such as lumber have once again returned to pre-Covid levels.
Cryptocurrencies and the FTX Implosion
The apparent fraud that occurred undoubtedly had an adverse impact, besides the obvious declines of the cryptocurrencies themselves, on the financial markets in 2022. People sell whatever they can when margin calls are issued. This whole industry should mature over time, as larger institutions, including Fidelity, become players in this space. This should provide stability to an industry in need of some financial oversight and regulation. Regardless, the events that have occurred over the past few months are highly deflationary.
2023 Market Outlook
There is no shortage of market strategists calling for a retesting of the 2022 lows prior to ultimately advancing higher in the second half of 2023. A contrarian view could take the position with most expecting further equity market weakness that it actually may not occur. Regardless, Inflation has now trended lower since a mid-summer peak and the pace of rate hike increases has subsequently diminished. We are now closer to the end of the tightening cycle than the beginning.
China reopening remains a wildcard in that supply chain and resulting inflation could continue to ease, or that increased China internal demand could keep commodity, including oil prices, elevated.
One thing that has become apparent is that globalization is disrupted now that world economies are continuing to be negatively impacted by the policies of two Autocratic nations, namely China and Russia. As an example, Apple is reducing manufacturing reliance on China and shifting to Southeast Asia including India. This could dampen profits in the near-term, as critical investments must be made now to benefit the company in future years.
On a positive note, fixed income now offers attractive rates and, even in certain cases, on a risk-free basis. A 1-year treasury yield sits around 4.7% at year-end. That being said, a 60%/40% equity-fixed income portfolio has a very good chance of returning above 7% in 2023, if the S&P advances to 4200, or just 9 % higher than year-end.
We are looking forward to a better investing environment in 2023. Larger than normal tax-loss selling undoubtedly served as increased pressure on both fixed income and equity markets. That is now over as portfolios have largely repositioned for 2023. By the end of 2022, most commodity prices had broadly returned to February levels, with oil and gasoline futures reaching year-to-date lows during December. That is positive for the inflation outlook especially when coupled with functioning railroads and unclogged ports.
Thank you for choosing to be with our firm. We are grateful to work with so many good people. We wish you better financial fortune and continued good personal health in 2023. 2022 was a very challenging, at times frustrating, and in the end, a very humbling year. We remain eager to assist, monitor, investigate, sometimes even coach when warranted, and pledge to always be available as a go-to resource for all your financial needs.
As always, let us know if you have any questions.
CRA Investment Committee
Matt Reynolds CPA, CFP®
Tom Reynolds, CPA
Robert T. Martin, CFA, CFP®
Gordon Shearer Jr., CFP®
Jeff Hilliard, CFP®, CRPC®
Joe McCaffrey, CFP®
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