Happy New Year!
From everyone here at IMG, we hope you enjoyed your Holiday season and that 2023 is off to a great start. We began 2022 hopeful of moving past the worst of the COVID-19 pandemic. The shift to living with COVID versus in fear of it had ramifications as surging consumer demand was met with labor and supply shortages. Global and geopolitical issues further muddied the backdrop, all of which caused inflation to heat up and the Federal Reserve to repeatedly intervene with rate hikes. As we enter 2023, we are optimistic that the ongoing stabilization of supply chains coupled with more normalized consumer demand will help slow inflation. Moreover, while we cannot predict the future, we are hopeful that the Federal Reserve is nearing the end of its interest rate hike campaign.
2022 turned out to be the most challenging year for investors in over a decade as a number of economic and geopolitical headwinds impacted both the economy and the markets. The U.S. economy contracted in the first half of the year with Gross Domestic Product (GDP) declining in both quarters, sparking fears of an impending recession. The most recent U.S. GDP figures suggest that economic activity rebounded nicely in the second half of the year.
Sentiment had been relatively positive heading into the year. In 2021, a strong economic recovery from the pandemic shutdown led to a 28.71% return for the S&P 500 and investors became hopeful that we were entering the final phase of the COVID-19 pandemic. However, negative events began to unfold quickly in 2022, including the Russian invasion of Ukraine, tension between the U.S. and China, the disruption of supply chains, and heightened inflation.
This conflict had a number of widespread repercussions as the West attempted to weaken the Russian economy through restrictions, sanctions, and a collective effort to reduce oil and natural gas imports from the region. This worsened a global supply shortage of oil and agricultural products, further increasing prices for these goods and contributing to increased global inflation. Unlike European countries, the U.S. is not overly reliant on Russian or Ukrainian goods and services, and therefore has not been as negatively impacted by the ongoing war. Consequently, the dollar appreciated quickly as investors poured into American assets to hedge against the global uncertainty. A stronger dollar can be beneficial since it makes imports into the U.S. cheaper, however it also makes U.S. goods more expensive to foreign buyers.
As a result of the Russia/Ukraine conflict, concerns arose that the world’s second largest economy, China, might invade Taiwan. China continued its military intimidation towards Taiwan, while President Biden simultaneously stated that the U.S. would be willing to “militarily defend” Taiwan if China did invade. This came at a time when tensions with China were already heightened due to a dispute regarding American exports of semiconductor chips. The Biden administration placed severe restrictions on chips made using American tools from being exported to China in the interest of national security.
Until recently, China had also adopted a zero-tolerance policy in response to the pandemic. In 2022, Chinese lockdowns were so restrictive that global supply chains remained materially disrupted, obstructing the ports of trading partners across the globe. Labor shortages and resulting bottlenecks at ports and warehouses exacerbated shipping delays, and the inability to obtain products left companies with lower levels of inventory. Simultaneously, consumer spending surged past pre-pandemic levels as consumer balance sheets remained flush with cash. Higher fuel prices drove up transportation and freight costs that had already been on the rise due to labor shortages, particularly in the trucking industry. In addition, there was a reduced number of shipping containers available in the necessary places, less vessels in the ocean overall due to refurbishment and COVID-19 illnesses on board, and purchasing habits became far less predictable. These factors all caused many irregularities in global trade and helped push inflation even higher as companies passed costs onto their consumers to help offset their increased operating costs.
Inflation was the key driver for markets throughout the year. The pandemic-fueled economic downturn in 2020 resulted in central banks across the globe injecting money into economies via both monetary and fiscal stimulus in order to spark an economic recovery. In 2022, the demand for goods and services increased greater than forecasted, resulting in global demand significantly outpacing supply, causing prices to increase and inflation to rise. To curb inflation, central banks across the world began to embark on monetary tightening campaigns through strategic interest rate increases which should, in theory, help to pull excess liquidity out of the system. The Federal Reserve (Fed) started with smaller 0.25% increases in rates in the 1st quarter of the year, but due to rising year-over-year growth in inflation from March through June reaching near 40-year highs, the Fed believed it had to get more aggressive. In just 12 short months, the Fed’s target rate increased from 0.00-0.25% to 4.25-4.50%. This had a crippling effect on both stock and bond valuations in 2022, as future cash flows began to get discounted back at significantly higher rates.
The implications of aggressive monetary tightening across the globe may continue to filter through the economy in 2023. Whereas financial markets pulled back in conjunction with the rise in borrowing costs, it remains to be seen whether consumers and businesses will pare back their spending in 2023 and ultimately push the economy into a recession. Some positives as we look ahead are the fact that household finances still look healthy compared to past downturns, bank balance sheets remain in a position of significant strength, and the historically elevated level of job openings could provide some ballast in the unemployment rate if there is a spike in layoffs. Whatever the outcome may be in 2023, our performance in 2022 reflects our ability to weather down cycles effectively and we believe we are well positioned to participate when the next upcycle occurs.
| Asset Class | Benchmark | Q4 | 2022 |
|---|---|---|---|
| US Stocks | S&P 500 | 7.56% | (18.11%) |
| US Gov't Bonds | Bloomberg US Govt Intermediate | 1.01% | (7.73%) |
| Cash | Bloomberg US Treasury Bill 1-3 Mon | 0.89% | 1.52% |
2022 was a challenging year for stocks. The S&P 500 finished the year down over 18%, the worst calendar year since the 2008 Global Financial Crisis. Given the backdrop of persistent inflation, aggressive central banks, and geopolitical risk, there were some notable trends that persisted in equity markets in 2022.
The first trend was the outperformance of value vs. growth. Growth companies are generally expected to grow their sales and cash flows at a faster pace than the overall market. They can be young, unproven, volatile firms in innovative fields, many of which pay little to no dividend. Many of these firms operate in the Information Technology, Consumer Discretionary, and Healthcare sectors. Prior to 2022, growth companies dominated the market and performed particularly well during the pandemic. Their dominance was, in part, due to the fact that interest rates were essentially zero for much of the last decade. Lower rates offered cheaper borrowing costs and broadly supported a higher appetite for risk in the markets; the valuations of some of these companies skyrocketed to excess levels. However, the pace and magnitude of interest rate increases in 2022 caused higher valuation assets, including growth stocks, to falter. The Russell 1000 Growth index finished the year down 29.14% compared to the Russell 1000 Value index, which was down only 7.54%.
Another trend was the outperformance of historically defensive sectors in the market. Consumer Staples, Healthcare, and Utilities are considered to be “recession-proof” areas of the market that tend to hold up better during economic downturns. They are also seen as inflation hedges that have pricing power and exhibit inelastic demand even when prices increase. With the exception of Energy which was the best performing sector (+65.7%), these 3 sectors were the next best performers in the S&P 500 in 2022. The Energy sector can behave defensively during periods of geopolitical turmoil, so it is not surprising that the impact of the Russia/Ukraine conflict on oil and gas supply resulted in higher prices and thus the sector responded positively on the prospect of higher future earnings.
In a year in which U.S. Bonds delivered the worst returns seen in decades, lower than expected inflation reports in November and December provided a glimmer of hope. Throughout the year, the Federal Reserve (Fed) has engaged in aggressive monetary policy to combat the highest rising inflation since the early 1980s. The federal funds rate was increased six times throughout the year, which resulted in higher borrowing costs for both consumers and corporations.
Along with higher rates across the yield curve, we witnessed a dramatic inversion of the curve as the 2-year Treasury yielded more than the 10-year Treasury for the better part of the year. Indeed, the 2-year Treasury ended the year at 4.43% or 55 basis points (0.55%) higher than the 10-year note, which ended at 3.88%. Historically, an inverted yield curve has signaled a future recession. Despite this indicator, some investors are hopeful the recent deepening inversion of the curve reflects that inflation is finally subsiding and the Fed will be able to start cutting short term rates in late 2023.
Federal Reserve Chairman Jerome Powell acknowledged the recent inflation slowdown but echoed to date it has only been modest. There are still several areas of the economy which have not slowed, meaning additional rate hikes are possible. With no guarantee the Fed will pause or slow down their rate hikes, we look to the higher yields as an opportunity to earn additional income within our portfolios into the coming year.
Diversifying equity asset classes contributed significantly to relative investment performance in 2022. Asset classes with higher correlations to interest rates, inflation, and volatility have provided protection amidst market volatility. Managed Futures, MLPs, dividend stocks, value stocks, and gold are a few examples of the many asset classes that outperformed the S&P 500 in 2022.
Despite negative returns year to date across all interest rate-sensitive fixed income sectors, U.S. Corporations and State and Local Municipalities overall remain financially healthy with strong balance sheets heading into 2023. Short-Term Treasury Bills was the best performing sector in 2022 whereas riskier asset classes with higher correlations to credit and equity markets, such as High Yield bonds and Convertible bonds, underperformed. Foreign bonds also significantly underperformed due to the strength in the U.S. dollar.
| Asset Class | Benchmark | Q4 | 2022 |
|---|---|---|---|
|
Foreign Stocks |
MSCI EAFE NR |
17.34% |
(14.45%) |
|
Emerging Markets Stocks |
MSCI Emerging Markets NR |
9.70% |
(20.09%) |
|
US Mid Cap Stocks |
Russell Mid-Cap |
9.18% |
(17.32%) |
|
US Small Cap Stocks |
Russell 2000 |
6.23% |
(20.44%) |
|
REITs |
MSCI US REIT |
5.22% |
(24.51%) |
|
Commodities |
Bloomberg Commodity |
2.22% |
16.09% |
|
MLPs |
Alerian MLP |
10.11% |
30.92% |
|
Managed Futures |
Credit Suisse Mgd Futures Liquid |
(5.92%) |
22.13% |
|
Foreign Bonds |
FTSE WGBI Non-USD |
6.51% |
(22.07%) |
|
Emerging Market Bonds |
JPM EMBI Global |
7.44% |
(16.45%) |
|
US Inflation Protected Bonds |
Bloomberg US Treasury TIPS |
2.04% |
(11.85%) |
|
Floating Rate Loans |
Credit Suisse Leveraged Loan |
2.33% |
(1.06%) |
|
US High Yield Bonds |
Bloomberg US Corp High Yield |
4.17% |
(11.19%) |
|
Convertible Bonds |
ICE BofA US Convertible Bonds |
1.59% |
(18.71%) |
Sincerely,
David B. Smith, CFA
Managing Director and Chief Investment Officer
