Musings on investments Q4 2022
Happy New Year! We think most of you would agree that we are thankful to see 2022 in the rearview mirror. It was a challenging year on a whole host of levels with inflation spiking up to levels not seen in many decades, a new war in Europe that shows no sign of abating anytime soon and the actions of the Fed in pushing up interest rates. All this has unsettled markets and provided ample grist for speculation about the timing of the next recession.
Digging a bit deeper however we find pockets of good news to hearten those with a slightly longer outlook. Just as every bull market eventually sows the seeds of its eventual demise so too each bear market prepares the path for future recovery. The high inflation of the past year will eventually moderate allowing consumers to maintain their footing. The supply chain and international turmoil of the last couple of years have paved the way for significant “onshoring” of manufacturing, helping workers who will fill those new opportunities here at home. Lastly discounted equity prices and higher yields in bonds provide an attractive outlook going forward.
Let us give you a blow-by-blow of the major asset classes in our portfolios; what they have done, what we anticipate going forward, and how we have approached each. We hope you will find this helpful.
The past year has been a difficult one for fixed income investors. In fact, for the broad market benchmark, Bloomberg U.S. Aggregate Bond, the decline of over -10% represented the weakest calendar year in the index’s history back to 1976. Many observers dug into the record books to locate a year of similar negativity, which has not occurred in the last 100 years if measured by the standard of intermediate-term U.S. treasury bonds.
Interest rates were driven by expected and actual monetary policy by the Federal Reserve, with the 10-year treasury note yield beginning the year at 1.5%, rising to roughly 4.2%, before ending at around 3.9% as recession worries began to mount.
Corporate bonds followed suit, with yields increasing and prices pushed down by those higher yields.
The strength of the U.S. dollar has been a headwind to foreign bond returns during much of 2022, although that pressure has faded a bit in recent months.
The yield curve remains significantly inverted, with short term interest rates higher than those of longer maturity bonds. This sort of inversion occurs when investors anticipate a period of recession. While a yield curve doesn’t guarantee a recession is imminent it does indicate that the prospects for recession are good.
It is important to note that the silver lining of price declines in bonds comes from the higher yields produced by the lower prices. For many years bond yields have been very low but now those higher yields will be available for reinvestment and/or cash flow, providing a significant benefit for years to come.
Bond returns in our portfolios have been helped by the inclusion of floating rate securities which tend to be not as affected in a rising rate environment. In addition, for much of the year we kept maturities shorter than normal, and those short maturities helped dampen the negative affect of rising rates as well.
Stocks suffered a -20% to -25% bear market early in 2022, with fears of a recession coupled with expected negative economic results from rising interest rates. The varying probability of future recession has caused vacillation in stock markets over the year and may continue to in 2023.
Other than the more obvious concerns of inflation and Fed policy, a key concern moving into 2023 involves the potential decline in corporate earnings during a slowdown and/or recession. Currently, a sharp decline does not appear to be priced in, but expectations revised downward remain a risk into the new year, as these could take equity prices down as well.
In the domestic part of the portfolio a partial shift to value stocks helped returns as investors sold growth issues and tech stocks and purchased energy, financials and other value sectors.
International stocks have continued to be hurt by the repercussions of the war in Ukraine along with other country specific problems and the strong dollar. Valuations in international issues as a whole look quite attractive at this juncture with higher recession probabilities priced in. International issues outperformed domestic stocks over the last part of 2022. This came mostly from the dollar losing some ground vis a vis other major currencies.
Real estate markets, although usually slow-moving due to the limitations of their physical infrastructure, have been forced to evolve into a new post-pandemic reality. Specifically, retail and office properties have seen generational-level shifts in a short period of time. Physical retail has been challenged by online commerce, a trend already in place prior to the pandemic, but accelerated during it.
Similarly, office properties have been disrupted by an ongoing trend toward remote work. Higher interest rates have also have broadly challenged the real estate landscape as they have through history. These all could continue to be a head wind for the environment into next year.
On the positive side, ‘modern’ real estate, such as data centers, distribution centers, cell towers, as well as classic industrials, have continued to show growth.
Commodities were one of the better-performing assets of the year, in contrast to trends in all other traditional asset classes. As both a recipient and source of inflation, commodity prices have proven themselves to be a reliable hedge during such inflationary periods. Towards year-end, weaker demand due to recessionary fears tempered sentiment somewhat, while tighter long-term supply constraints could be a source of strength looking ahead.
Commodities, without cash flows to measure, are priced purely by supply and demand. On one side, expectations for a global recession lower potential demand (for everything from crude oil to copper) into the new year, although a re-opening China counters some of these fears.
On the other hand, though, a lack of capital expenditure for production in these same critical sectors has created potential for long-term undersupply—which could keep prices elevated if severe enough. In portfolios, the benefits of the asset class remain the same as they have historically, as a classic hedge against risks such as unfavorable inflation, geopolitics, and weather.
It’s important to remember that longer term, the outlook favors continued growth in the economy and greater prosperity for businesses and individuals. In the short to intermediate term, however, the outlook is a bit more nuanced.
As the year closed, markets were very concerned with the inflation picture and, perhaps more importantly, about the prospects for recession. The Fed has been very clear about their willingness to continue to adjust rates to fight inflation and the fear is that they will overshoot and tip the economy into recession. This is by no means certain, and the possibility still exists for a soft landing for the economy and a gradual easing of rates as inflation cools. Recession or not, it is clear that the worries about this and attendant market volatility will continue over the next little while.
It seems probable that inflation will indeed continue to cool over time as 2023 progresses and as the rolling 12-month comparisons become more favorable with the higher prices of 2022 becoming incorporated into the numbers. That could allow the Fed to ease back on their tightening and allow the market to begin to price in recovery. A mild to moderate recessionary period would provide even more certainty to rates.
As investors we certainly need to pay attention to the economic trends but must also bear in mind that everyone else is as well. Markets are always forward looking and often, just as a recession begins (which we only know in hindsight), markets are already pricing in a return to growth.
As such, even though it feels wrong, times like these are the times when portfolios have their best expectations of robust intermediate (several year) returns. The events of the last year have bonds in a better position (with their higher yields) than they have been in many years. Stocks, too, look reasonably attractive although, stocks being stocks, we could certainly see more downside before the eventual recovery.
We wish the very best for you and your family in 2023.
This market commentary is provided for information purposes only and is not a complete description or analysis of the securities, markets or developments referred to in this material. There is no guarantee that these statements, opinions or forecasts provided will prove to be correct. All expressions of opinion are subject to change. Information has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Past performance does not guarantee future results.
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Cultivant team &