4th Quarter 2022.
While it seems each year investors hope the word “unprecedented” will be left in the rearview mirror, 2022 was unfortunately not spared from its curse. With nowhere to hide as the Federal Reserve (Fed) took action and geopolitics swirled, the 60/40 investor experienced the steepest losses he or she had in a generation.
Reflecting on 2022
Following most periods of aggressive growth, central banks must rein in the economy to keep it from boiling over. WoodTrust clients will recall a late-2021 pivot in the firm’s narrative toward a story of economic phases… Phase 1: The Pandemic Actions Unprecedented Policy, Phase 2: Companies and Consumers React to the Stimulus, Phase 3: A Careful Unwinding Begins.
As WoodTrust began to tell this story, it was clear the global economy was entering Phase 3. Less clear was the break-neck pace at which the Fed would tighten monetary policy when it grew worried inflation was not, in fact, transitory. What started as a seemingly one-time price shock that would pass quickly became a stickier issue as tight labor markets gave workers the confidence to ask for more pay. Since the Fed has no control over the tight supply of labor, the only option was to do its best to destroy demand by raising rates, hopefully bringing the economy back into balance in the process.
In an attempt to stomp out the 40-year-high inflation rate, the Fed hiked rates more than it had in any calendar year since 1980. With bond yields near zero and stock valuations sky-high, both asset classes were heavily sensitive to rate increases. As the increases began, both bond and stock prices cratered – erasing years of gains in the process. After the market found some semblance of a bottom around the end of Q3, market participants were left wondering how these rate hikes would play into the fundamentals of the global economy in the coming months and years.
A Nebulous 2023
As is true with most rate hiking cycles, let alone the record-setting kind, the biggest associated fear is whether they will tip the economy into a recession. Unfortunately, while a recession can be a common byproduct of these cycles, a quick survey of Wall Street’s best and brightest forecasters shows there are several differing opinions about whether said recession will be big, small or even occur at all.
Some experts point to the strong labor market, explaining that while there are excessive job openings, excessive actual employment is more localized; therefore, it will be tough to have a full-blown recession as spending power may not fall apart. Other experts look to the energy markets, citing that energy prices are far too high to avoid a deeper, more painful recession.
Even more cloudy than the economic forecasts for 2023 are the expectations for the performance of different asset classes over the next twelve months. Some firms are defensive, unwilling to make large bets until they see the Fed take a meaningful pause and pivot. Others are getting aggressive, believing that the market has satisfactorily moved ahead of the economy and that all appropriate risks are priced in.
Given the significant spread in expectations, it is difficult to even surmise a reasonable “consensus view”. Thankfully, with an appropriate asset allocation and an understanding of their investment horizon, investors don’t have to.
A New Horizon
There are risks in the world and there are risks in capital markets; unfortunately, the former has a way of adding to the latter. It goes without saying that the world presently sits in a relatively delicate position as global super powers look to grow their influence and central banks all over the world work to keep their economies intact. While these themes should not be discounted and require constant scrutiny, it is important to understand what the painful reset of 2022 means for patient investors willing to look through the next 12-18 months in favor of what lies beyond.
While forecasters often struggle to appropriately time and project markets in the short- and medium-term, they tend to be more successful when framing expectations over multiple economic cycles.
Investors entered 2022 with a grim outlook for stock and bond market returns over the forthcoming 10-year period. However, one of the most significant drivers of return expectations is simply the starting point. With bond yields at their lows and stock valuations at their highs, it was difficult to imagine a world where much positive performance was attainable without taking a significant amount of risk. Jumping ahead to the beginning of 2023, bond yields are higher than they have been in 15 years and stock valuations are hovering near their 15-year average. These fresh starting points have led to a drastic improvement in long-term annualized return assumptions for stocks and bonds, raising them from 4.3% and 2.6% to 8.1% and 4.6%, respectively.1
This is the “New Horizon”. While price volatility may persist over the coming quarters, the risk investors must take to earn any unit of return in today’s market is substantially less than it was just over a year ago. Bonds are trading at yields where they can once again serve as the ballast of the portfolio. Stocks are available at prices where buying ownership in ingenuity, advancement and growth over the long-term no longer requires overextension. A patient investor with an appropriate asset allocation is entering an exciting phase of wealth building. As always, we thank you for your trust and look forward to our meetings with you in the near future.
1These returns are sourced from JPMorgan’s Long-Term Capital Market Assumptions, but the magnitude of increases in expectations is similar for most capital market forecasters.