QUARTERLY MARKET UPDATE as of January 2023
2022 was a dismal year for the markets. With inflation rising sharply and seven consecutive interest rate increases by the Fed, there was nowhere to hide. Stocks, bonds, and international markets all had big declines. The bond market had its worst performance ever; and the stock market as measured by the S & P 500 declined 19%, while the tech heavy Nasdaq index dropped 33%!
A ray of hope entered in the fourth quarter with a good rebound in stocks, although another decline in December made this past year one to forget. While pending recession fears are an overhang, prospects for positive returns are much better this year.
In the fourth quarter the S & P 500 increased 7.5% with the Energy and Industrial sectors leading the way. Consumer Discretionary was the only sector down for the quarter. Interest rates continued to rise across the maturity spectrum, but we may have seen the peak in the intermediate and long end of the yield curve. The 10-year Treasury ended the year at 3.88%, down from 4.25% in October. International stocks had a very good quarter increasing over 17% as measured by the MSCI index, yet still down 14% for the year. The Russell 2000 small cap index was up 6.2% for the quarter.
Concerns over inflation drove the economic headlines last year, and for good reason. The annual rate of increase was far higher than expectations for most of the year peaking last June at 9.1%. Since then, prices have softened significantly. Last month prices dropped for used cars, gasoline, medical services, and utilities; while moderating in several areas including restaurant meals and new car prices. In November, the annual rate of inflation was down to 4.7% as measured by the core Personal Consumption Expenditures Index (PCE), and on a month-to-month basis the increase was only 0.2%.
Despite the slowing trend, the Fed has made it clear that fighting inflation is still a high priority. Absent an actual decline in inflation over the next few months, we expect the Fed to increase the short-term Federal Funds rate another ½ of a percent this quarter to 5%. Then we expect to see a pause in further increases. The Fed will need to assess the impact of their aggressive rate increases over the last year. Historically the actions from the Fed have failed to anticipate economic trends: raising rates too slowly when inflation first starts, and then continuing to increase rates beyond when it was necessary, forcing a deeper or longer recession. We are hopeful that lessons learned from the past of overtightening and raising rates more than needed will temper their decisions after the first quarter.
We do not expect to see a recession until we see job losses, and right now the labor market remains strong. This year the most anticipated economic reports will likely shift from inflation reports to payroll. We expect payroll reports will be the best predictor of further Fed action.
Yield curve inversion has been a good indicator of whether or not we’re going to have a recession, and currently the yield curve is inverted, with short term interest rates exceeding long term rates. The probability is high that at some point this year we will enter a recession, but there is optimism for not having a deep recession.
Higher mortgage rates have certainly frozen real estate sales, making affordability an issue. Prices have declined, but the continued shortage of housing will likely keep that part of the economy from crashing. Also, in the auto industry there hasn’t been an abundance of buying over the last few years with higher prices keeping buyers on the sidelines. A continued lack of housing supply and a meager auto spending cycle implies neither area will move from boom to bust.
Earnings growth rates will be compressed this year vs. the past few years and may weigh on the market. Big tech stocks fared poorly in 2022 and we expect that trend to continue this year. Small cap stocks historically outperform in an economic recovery. We are increasing our weight in small cap stocks in anticipation of growth improving by the second half of this year. Valuations are attractive in global equity markets vs. the U.S. and we will continue to increase our exposure to international when opportunities are available. Interest rates are now at high enough levels that allow an increased allocation to fixed income. We are now extending duration from ultra-short-term maturities to intermediate term for the first time in several years.