At year-end 2021, the S&P 500 closed at an all-time high, with many stocks hitting never-before-seen market caps. Companies exhibited record earnings, and housing prices soared in many parts of the country. Inflation fears were muted, and investors were accustomed to an easy money Federal Reserve (Fed). However, as the calendar flipped to 2022, little did many investors realize how the macro picture would change, largely due to persistently high inflation.
The year 2022 reminded us how markets can change on a dime, and in many ways, last year was the antithesis of 2021. But, while 2022 wasn’t pleasant for investors, it may have set the stage for better long-term returns. But before we get to that, let’s take a closer look at what moved markets last year.
The End of Easy Money Fed Policy
For too many years, investors had gotten used to a Fed that would save the day when market turmoil occurred, but as markets declined in the early part of 2022, the Fed did not step in to support financial markets. Instead, they reaffirmed their plan to start raising rates and to engage in quantitative tightening, which occurs when the Fed sells bonds in an effort to reduce the size of their balance sheet.
The Fed’s new stance resulted from persistently high inflation, and they made it clear that bringing inflation to heel was their number one priority. Indeed, Fed Chairman Jerome Powell affirmed that they would “stay the course until the job was done.”
The backdrop to all this was the highest inflation readings since 1981, as the consumer price index (CPI) soared to 9.1%. Given that one of the Fed’s primary jobs is to maintain price stability, they needed to tackle the swift decline in consumer purchasing power.
This led the Fed to hike rates seven times in 2022, with the target Fed Funds Rate increasing from 0.25% at the start of the year to 4.25%-4.50% at year-end. This was the largest annual increase since 1980 when Fed chair Paul Volcker tackled inflation with a series of unparalleled rate hikes.
By engaging in quantitative easing, the Fed also reduced their balance sheet by 2.4% in 2022, the first decline since 2018. They intend to keep reducing it in 2023.
While rising rates have been advantageous to savers, entities with large debts are starting to suffer. The U.S. government is perhaps the biggest loser, with the national debt exceeding $31 trillion (up from $23 trillion at the start of 2020). The interest expense on that debt rose to a record high of $766 billion in 2022. If it continues at that rate, it will be the largest expense item on the federal budget.
Recession or No Recession?
As the Fed tightened monetary policy to slow economic growth and rein in inflation, a healthy debate began about whether the U.S. economy is in a recession or not. Real GDP fell for consecutive quarters in 2022, but while that is considered a common proxy for a recession, it does not denote an “official” recession. Recessions are actually identified by the National Bureau of Economic Research (NBER), and as of this writing, they have not declared that the U.S. economy has entered a recession.
At present, the economic data is mixed enough that there are data points that can be used to support a number of different views around the direction of the economy. While Q1 and Q2 GDP declined in 2022, Q3 exhibited a positive change, and the year-over-year GDP growth was 1.9%. The job market also remains strong, though there are signs of layoffs in some industries, such as tech. The unemployment rate has moved down to 3.5%, one of the lowest rates ever.
Consumer sentiment, however, is uninspiring. The University of Michigan’s confidence index hit an all-time low in 2022 as the constant influx of negative news contributed to making consumers jittery. Inflation may have peaked but is still at a high level, eroding consumers’ purchasing power, an important consideration given that the American consumer contributes two-thirds of the GDP. People are having a harder time paying for basic goods and services, and housing costs have soared. Credit card balances are also increasing for the average consumer. Along with higher interest rates, this could be a problem for many families, making it harder than ever to pay down credit card debt.
The inversion of the yield curve in October 2022 is another indicator of a potential economic slowdown, as short-term rates, which are higher than long-term rates, have often preceded a recession.
Stocks and Bonds Moving Lower in Tandem
Against the backdrop of high inflation, tighter monetary policy, and recession worries, the stock and bond markets both declined in 2022.
The S&P 500 fell nearly 20% in 2022, its largest annual decline since 2008, while the Bloomberg U.S. Aggregate Bond Index also declined by double digits.
As always, some sectors and asset classes did disproportionately better or worse. Tech stocks took the brunt of the losses, as the Nasdaq 100 closed down by 32%. The Dow performed better, down only 7% on the year. Among sectors, the only ones to finish higher were Energy, which was up 64%, and Utilities, up 1%. Short-term bonds performed better than their longer maturity brethren, as rising interest rates drove down the values of long-term bonds. Value stocks outperformed growth stocks, and international markets performed slightly better than the U.S. but still ended the year in the red.
Looking Toward 2023
As we start 2023, some people feel we’re currently in a recession or on our way to one. Negative sentiment, persistent inflation, and the Fed’s abandonment of easy money policies seem to point that way. However, we should note that the U.S. economy is a resilient, diversified one, and jobs are currently plentiful.
Long-term investors should also realize they’re in a stronger position than last year. This is because the yields across every major asset class are higher. Treasury bills & bonds, corporate bonds, municipal bonds, REITs, and stocks have all seen increases in yield. This sets the table for higher long-term returns, though heightened volatility will probably persist in 2023, and surprises are inevitable.
According to the fable, back in the 1800s, J. Pierpont (JP) Morgan was asked by a brash young investor for a forecast about how the market would go. Morgan stroked his mustache and replied: “It will fluctuate, young man. It will fluctuate.”
While we don’t have a crystal ball to peer into the future, we do know that market fluctuations are the price you pay for better long-term returns. The best you can do as an investor is to stay the course, continue your investing path, and stay disciplined.