In the beginning of December, I was able to visit Universal Studios and Islands of Adventure in Orlando, FL with a few friends for a VIP Experience tour. The tour includes breakfast, lunch, and a guided walk throughout the parks guaranteeing you to ride at least ten rides, skipping the lines and going straight to the front. As an annual passholder, it was not my first time at these parks and I eagerly put together a list of rides that were essential for us to ride. The list included multiple rollercoasters, several simulators that were in 3D, and other rides that spin you and move you around in a quick fashion. As the day ended, I realized what started with excitement ended with a sore neck, nausea, and a group discussion on if thirteen rides were really a good idea after all. While that day is one of my favorite memories of 2022, the feeling getting off the last rollercoaster resonated with me as to what many investors probably felt in 2022: a period of excitement to begin the year, followed by the discomfort of what turned out to be a year full of ups and downs and unexpected nausea and fatigue.
2022 turned out to be an uncharacteristically bad year for the markets. The S&P 500, DJIA, and NASDAQ all closed lower with the DJIA fairing best declining only about 7%, S&P 500 was down about 18%, and the NASDAQ was down close to 33%. Investors have always accepted that down years will come in the equity markets, but it was the performance in the bond market that really rocked investors emotions. The US Aggregate Bond Index declined about 13%, corporate bonds were off almost 16%, and high yield bonds were down about 11%. Add that performance to the inflation we all felt in 2022 and the average investor really felt like there was nowhere to hide.
The reasons for the poor performance in many different markets centered around two issues: inflation and interest rates. Inflation began heating up in 2021. The responses from Covid-19, both from Congress and the Federal Reserve, left too many dollars chasing too few goods. Multiple rounds of stimulus checks gave American consumers the cash to go out and buy new clothes, new electronics, new furniture, and new vehicles. This led to a splurge in spending at a time when supply chains were not functioning correctly and could not handle excess demand. As demand for scarce goods increased, so too did the price. This is where the Federal Reserve made their mistake. They saw the inflation in goods and expected it to be “transitory.” They thought that eventually supply would get figured out and prices would settle. Unfortunately, this settling process took too long, and the inflation spread to other parts of the economy. Shipping prices rose. Building material costs rose. Cost of labor across industries rose. The price of oil, which had gone negative almost two years prior, was shooting towards $100/barrell in the beginning of 2022. Finally, the cost of food and services began to take off. By the Spring of 2022, the Federal Reserve had no choice but to raise interest rates rapidly to slow down demand. This increase in rates is what drove the markets lower.
The bond performance makes sense in this context. When bond yields go up, bond prices go down. The Federal Reserve increased interest rates at a rapid pace this year in response to inflation. Rates went from 0%-0.25% to a range of 4.25%-4.5%. Correspondingly, prices went down rapidly. The equity markets struggled for a variety of reasons in response to higher interest rates. First, interest rates are used in a variety of ways to value stocks. Most commonly, interest rates are found in the denominator of a formula to value a stock. If your denominator is increasing, then the value, or price, will decrease. This year, as rates went up, stock values came down. Additionally, companies struggled with their input costs. Labor, materials, financing- all of these costs rose for many companies and if sales did not increase at the same rate, then profit fell, and companies were less valuable. Companies also faced a variety of other factors such as currency and accounting headwinds.
The natural question following such a rough year in the markets is to ask, “What will happen in 2023?” While nothing is certain yet, there is reason to be confident for the year ahead, but there is also still much to be concerned about. Let’s take a quick look at both sides.
When looking forward to 2023 the main thing for concern is if the economy is or will be tipping into recession. In 2022, Q1 and Q2 had negative real growth. For many of us, we are used to hearing this as the definition for a recession. While negative real growth generally coincides with a recession, many economists resisted calling a recession in 2022. The main reason for this was an extremely tight labor market. Unemployment remained solidly below 4%, spending most of the year around 3.6%. The economy added jobs in 2022 and is expected to show real growth in 2022, despite two negative quarters. Regardless of if the US did have or avoided a small recession in 2022, the outlook for 2023 is essentially around no growth. Some economists are expecting a slight decline around -1.0% in GDP, while others think a slight gain of about 1.0% in GDP is possible. This is really where market returns hinge in 2023. GDP is essentially composed of consumer spending, government spending, private investment (business and real estate), and net exports. Exports should be slightly better in 2023 as the dollar declines vs other currencies. Real estate should be a drag, while businesses seem to be holding up decently well. A divided congress likely means little additional spending will get done. The real question will be how well consumer’s hold up in 2023. US Consumers were resilient in 2022 and a tight labor market suggests they will continue to do well, but inflation needs to come down.
Despite the concerns for 2023, there is hope for investors. In the face of higher interest rates and inflation, consumers and businesses have held up generally well. Years of near zero interest rates have allowed homeowners to lock in 30-year mortgages at historically low rates. This provided them with more room in their budgets to absorb higher prices. A tight labor market has also given many workers wage increases to help offset inflation. Businesses have been successful at raising prices to help offset their increased labor costs so far and have signaled less increases to come. Additionally, we can see the inflation story may have peaked in 2022 at nearly 9.0% and is continuing its trend lower. December expectations are currently around 6.5%, with the trend continuing in 2023 settling below 4% in December of 2023. Some estimates have it reaching 2.5%. Finally, if inflation is peaking, the need for substantially higher interest rates seems unlikely and rates will be reaching a terminal point.
What does all this information mean for investors in 2023? Let’s start with bonds. For the first time in almost twenty years, bonds look attractive! With short term rates approaching 5%, it’s possible to expect decent returns with less risk and volatility than equities. Portfolios in the years past that have been reaching for equity income can utilize more fixed income instead. The story for equities in 2023 is murkier. If corporate earnings remain resilient, stocks could do well. If the economy feels more stress from lower spending and higher costs, stocks could fall from here. We remain committed to large-cap, US companies that have a history of dividend increases and quality earnings as the cornerstone of our equity portfolios. If you are concerned with how your portfolio is allocated or just want to be refreshed on where it stands, check in with your CandorPath advisor for a quick review meeting.