MARKET RETURNS:  Stock and bond markets rallied in the fourth quarter, paring some of their losses from earlier in the year.  Yet both asset classes posted double-digit declines for 2022.  Inflation and central bank policy response were the main drivers of those negative returns, pressuring bond prices and compressing stock market valuations.  Indications that inflation fighting efforts have been effective drove the Q4 rebound.  International developed markets were the best performing region within global equities as challenges regarding U.S. dollar strength and geopolitical concerns related to U.K. politics and reliance on Russian gas proved less severe than feared.  Sector returns were particularly dispersed, with a differential of over 100% between the best (energy) and worst (communication services) performers.  That variability showed up in investment style returns as value stocks outperformed their growth counterparts by a wide margin, marking a reversal from the past several years’ trend.  Alternative investments tended to be more resilient while higher short-term interest rates translated to a moderately positive return for cash.

LOOKING FORWARD:

Policy Effects: Aggressive central bank tightening appears to be having the desired effects, providing room for a shift to more moderate policy.  Inflation gauges are showing signs of deceleration (see below left) as the intended demand reduction has coincided with easing of supply chains.  An economic downturn is widely anticipated, with economists seeing a 63% probability of a recession occurring within the next 12 months in an October Wall Street Journal poll (see below right).  Sentiment polls of consumers, small businesses, and investors reflect a similar pessimism.  Appetite for speculative assets has diminished, whether we consider crypto, special purpose acquisition companies (SPACs), “meme stocks”, or even the housing market.  This is what the Fed wants: to prevent the economy from overheating and get inflation under control.

 A remarkably robust labor market may be the exception to this trend.  Two main factors help to explain this dynamic.  First, the supply of workers remains low with the U.S. civilian labor force below pre-Covid levels.  Drivers include less immigration due to mobility restrictions as well as early retirements prompted by the onset of the pandemic.  Second, shifts in the economy have occurred so rapidly that many businesses haven’t been able to execute responses.  Manufacturing and logistics businesses had been hiring rapidly due to an accelerated shift to e-commerce but have begun reducing headcount.  Many service businesses still aren’t fully staffed as consumption patterns have shifted from goods to experiences, providing capacity to absorb laid-off workers from other sectors.

Implications for Markets: It may seem counterintuitive to add risk to portfolios at a time when the economic outlook appears gloomy.  However, the market is not the economy.  Investors attempt to incorporate information about likely future outcomes into asset prices, albeit without the benefit of perfect foresight.  Prices (and future returns) can therefore be most attractive when the outlook appears dire.  Stocks typically find bottom midway through recessions as investors begin to anticipate an impending recovery.

Investors should not be cavalier about risk but instead acknowledge that a dose of contrarianism can be beneficial.  Human nature leads us to be risk-averse after a market selloff, though it’s important to also remain mindful of return potential.  Bonds now provide interest rates close to the highest levels seen in a decade, with short-term yields particularly compelling (see below).  Stock market valuations have fallen to levels consistent with long-term averages, implying more favorable expected returns over a multi-year horizon.  Maintaining a long-term perspective can be a significant advantage in times like these for investors with a corresponding time horizon.

Conclusion:  We see a healthier dynamic for markets going forward after a period of painful adjustment in 2022.  Significant policy support since the pandemic boosted asset prices but left them untethered from underlying fundamentals.  Rapid tightening of financial conditions has restored capital discipline, re-established the role of high-quality bonds as income generators and stock diversifiers, and curbed speculative excesses.  The associated valuation reset within public markets has provided an opportunity for real fundamental value to drive asset prices once again.  Central bank actions seem to have been effective so far in reducing inflation, providing room for policy moderation.  Yet risk is an ever-present aspect of investing, with persistent inflation, a more severe or prolonged recession, or geopolitical conflict the most likely manifestations.  We believe a disciplined approach to diversified portfolio construction should serve clients well in the long-run and help them endure shorter-term sentiment shifts.

Index Descriptions:

S&P 500 Index TR is a market capitalization weighted index which represents the broad market for large company U.S. stocks.  Returns reflect the reinvestment of dividends.

The MSCI EAFE Index NR USD is a market capitalization weighted index which represents the broad market for large and mid-sized developed market stocks excluding those from the U.S. and Canada.  Returns reflect the reinvestment of dividends and foreign withholding taxes and are translated into U.S. Dollars.

The MSCI EM Index NR USD is a market capitalization weighted index which represents the broad market for large and mid-sized developing market stocks.  Returns reflect the reinvestment of dividends and foreign withholding taxes and are translated into U.S. Dollars.

The Bloomberg Barclays U.S. Agg Bond Index is a market capitalization weighted index which represents the broad market for taxable investment grade U.S. dollar-denominated bonds. Returns reflect the reinvestment of interest.

The US Treasury Bill Auction Avg 1-month is an index comprised of short-term U.S. government-issued investments with yields collected weekly and can be considered a proxy for cash. 

Portfolio performance, characteristics, and volatility may differ from the benchmarks shown. Opes portfolios are managed according to their respective strategies which may differ significantly in terms of security holdings, industry weightings, and asset allocation from those of the benchmarks. Benchmarks are unmanaged and provided to represent the investment environment in existence during the time periods shown. An index is not available for direct investment, and does not reflect advisory fees, any of the costs associated with buying and selling individual securities, or any other fees, expenses, or charges. Past performance may not be indicative of future results.

The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. All opinions expressed herein constitute the judgment of the author(s) as of the date of the report and are subject to change without notice. The material has been gathered from sources believed to be reliable, however Opes cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. This information may contain certain statements that may be deemed forward looking. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those discussed.  Opes does not provide tax or legal advice, and nothing contained in these materials should be taken as such. As always please remember investing involves risk and possible loss of principal capital. Advisory services are only offered to clients or prospective clients where Opes and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Opes unless a client service agreement is in place.