Investors are undoubtedly glad to have 2022 behind them as it turned out to be the worst year for markets since the 2008 Financial Crisis – the biggest factor, inflation, reared its head for the first time in the last 40 years! Unlike most years of market turmoil, there was no place to hide in 2022 – whether in equities or fixed income, all major market indexes saw double digit percentage declines, which is a first.

The Fed vs. Inflation

It seems such a distant memory now, it is hard to believe that 2022 started out with the Fed calling the high inflation statistics “transitory.” As inflation persisted, it became clear that the Fed had fallen behind and risked letting inflation get out of control and dangerously imbedded in the economy. The Fed raised interest rates at the fastest rate in modern times climbing from a 0-0.25% range to a 4.25-4.5% range as the Fed found itself in a desperate fight to restore its credibility.

The pace of Fed rate hikes in this cycle is the fastest in modern times

Cumulative change in the federal funds target rate (%)

Line chart: cumulative change in the federal funds target rate across seven tightening cycles, by month since each cycle’s first increase. Nine months after its first increase, the current tightening cycle had raised the federal funds target by 3.75 percentage points. No other cycle since 1983 had moved even half that far in nine months, and the 1999 and 2015 cycles never reached 3.75 points at all. The 2004 cycle took 25 months to climb 4.25 points; the 2015 cycle took more than three years to reach 2.25. 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 0 3 6 9 12 15 18 21 24 27 30 33 36 Months relative to the first rate hike 1983 1987 1994 1999 2004 2015 This cycle
Source: Federal Reserve Board, retrieved from FRED, Federal Reserve Bank of St. Louis. Through 30 November 2022.

This more restrictive monetary policy is something we have not seen in a long time. Since the 2008 Financial Crisis, real interest rates have been zero or even negative in the US and much of the world. This “free” money led to numerous bubbles and excesses – stocks trading at sky-high multiples, bonds overpriced due to unnaturally low rates, real estate markets where bidding wars became the norm, and speculation in cryptocurrencies. Virtually free financing encourages poor allocation of capital, and now we are seeing those excesses unwind.

The Impact of Higher Rates on Stocks

Interest rate increases intended to curb inflation by purposely slowing the economy don’t typically bode well for corporate profits, so investors quickly began to fear the possibility of a recession. With mortgage rates doubling, the housing sector ground to a halt. High-flying tech and biotech stocks that were trading at lofty valuations in hopes of giant, but perhaps distant, future profits came crashing back to earth because in a higher interest rate environment, distant earnings are worth far less. With more competitive returns coming from interest rates, stocks in general need to provide higher expected returns, requiring lower purchase prices and valuations. Given stocks are valued based on a multiple of earnings coupled with those earnings slowing, purchase prices had to decline even further.

U.S. equity index returns
INDEX2022
S&P 500-18.1%
Dow Jones Industrial Average-6.9%
Nasdaq Composite-32.5%
Source: Morningstar Direct; See disclosures for important benchmark information

Overseas markets held up relatively well when measured in their local currencies, but the interest rate-driven appreciation of the US dollar magnified the losses for US investors.

International equity index returns
INDEX2022
MSCI EAFE (Developed Markets)-14.5%
MSCI Emerging Markets-20.1%
Source: Morningstar Direct; See disclosures for important benchmark information

Global equities markets also had to deal with the Ukraine/Russia conflict and its potential impact on other regions, not to mention on sky-rocketing energy prices. Supply chain interruptions disrupted global production and caused widespread inventory shortages. China virtually shut down their economy due to their zero-Covid policies. All these factors combined to create the most challenging global equities market environment since 2008.

Impact on Fixed Income

Since rising interest rates cause bond prices to fall, many investors were not surprised to see bonds decline, but many investors were shocked to see the degree to which they fell.

Fixed income index returns
INDEX2022
Bloomberg Global Aggregate Bond Index-16.3%
Bloomberg US Aggregate Bond Index-13.0%
Source: Morningstar Direct; See disclosures for important benchmark information

We not only had a historically rapid increase in interest rates, but our starting point for rates was historically low; regardless of maturity, bonds had very little interest income to buffer the blow from higher rates. The chart below illustrates the rarity for bond portfolios to realize negative returns. To put the effect of low interest income into context, 1994 saw a similar rise in interest rates from the Fed, but the damage was much smaller than 2022 because interest rates started at higher levels and the interest income buffered the price declines.

Negative returns have been uncommon in a diversified bond portfolio

Annual total return for a diversified portfolio of U.S. taxable bonds (1977–2022)

Bar chart: annual total return of a diversified U.S. taxable bond portfolio for each year from 1977 to 2022. Across the 46 calendar years from 1977 through 2022, a diversified portfolio of U.S. taxable bonds finished lower in only five of them: 1994, 1999, 2013, 2021 and 2022. Four of those five losses were smaller than three per cent. The exception is 2022, at negative 13.01 per cent, which is more than four times the deepest loss in the other forty-five years. Annual total return -20% -10% 0% 10% 20% 30% 40% 1977 1980 1985 1990 1995 2000 2005 2010 2015 2022
Source: Bloomberg US Aggregate Bond Index.

Outlook for 2023

While it is likely that market volatility continues in the coming year as most of the uncertainties that plagued investors in 2022 have followed into 2023, it is worth noting that in many ways, investors are in a much better position than they were a year ago.

  • Many excesses arising from the near zero interest rates of the past decade are being wrung out of the financial system, the Fed has made substantial progress in bringing rates in line with levels needed to control inflation, and the foundation is being set for the U.S. to resume robust and sustainable economic growth
  • U.S. equities have pulled back from peak market valuations, and even with more volatility in 2023 and a possible recession, working through these normal cycles for markets and economies removes excesses and positions the market for new leadership and growth, which we expect to present investors with new opportunities in 2023
  • Valuations in international equities markets have come down substantially, and with likely unwinding of the historically strong 2022 moves of the US dollar, we think they could prove much more beneficial to client returns in 2023 and beyond
  • Because bond yields are so much higher than a year ago, we expect bonds to resume their role as a diversifier for client portfolios, even if rates move somewhat higher as the Fed finishes their rate increases

2022 was a turning point for the markets in many ways, and we think 2023 will present exciting opportunities to reposition existing allocations and introduce some new allocations to client portfolios to take advantage of opportunities arising from this evolving market environment. While we are seeing exciting opportunities, we also recognize that more turmoil may lie ahead. As we ride out further volatility and position for the next bull market, we currently favor diversified exposures relative to individual names. As always, we are excited to share our research, diligence, and ideas with you as we navigate the market environment in 2023.

Outlook: While it is likely that market volatility continues in the coming year as most of the uncertainties that plagued investors in 2022 have followed into 2023, in many ways, investors are in a much better position than they were a year ago.