|Thayer 4Q22 Commentary/Key Questions
What happened in the fourth quarter and year 2022?
The fourth quarter of 2022 brought modest relief to financial markets, trimming losses after an unusually difficult nine months. The S&P 500 index gained 7.5%, while ending the year with an 18.2% decline, the largest since 2008’s 38.5% drop. The globally inclusive ACWI index rose 9.9%, reducing its 2022 loss to 18.4%. Bonds (measured by the AGG index) ground out a 1.6% gain in the quarter, but still lost 13.0% on the year, by far the worst on record and toughest return since shedding 2.9% in 1994, almost 30 years ago. Longer maturities, more sensitive to rate upshifts, bore the brunt. Long term U.S. Treasuries lost as much as 30% on a mark-to-market basis in 2022.
U.S equity weakness in the year was driven by growth stocks, notably the largest ones. Of roughly $12 trillion in total U.S. market value lost, about $3 trillion – 25% — came from the five “FAANG” names (Meta/Facebook, Apple, Amazon, Netflix, and Alphabet/Google). Technology and communication sectors were the S&P’s weakest (off 28-40%), while the only sector to gain appreciably was energy, surging 66%. After many years lagging behind the U.S., overseas stocks outperformed, losing less for the year (the EAFE index shedding 14.0% versus the S&P’s 18.2%) after gaining more in the fourth quarter (up 17.4% versus up 7.5%). Returns were aided by a weaker dollar in the quarter, and possible attraction to significant valuation discounts outside of the U.S.
Thayer client portfolios gained commensurately in the quarter, ameliorating the prior nine months. The quarter was aided by an early-October policy add to both non-U.S. and U.S. stocks.
What made 2022 uniquely challenging?
Financial markets over the year were unusually focused on a single date point: inflation. Markets thus became hyper-sensitized and prone to major moves with successive price index reports, each carrying implications about Federal Reserve policy interest rates. By extension, employment and other economic reports suggesting various levels of inflationary pressure moved bonds and stocks as well. The year’s first nine months were dominated by negative inflation surprises and the need to absorb an aggressive, unprecedented interest rate policy response by Jerome Powell and the Federal Reserve: rate hikes adding up to 4.25%, over seven meetings from March through December. This scale and speed have no match in Fed history. Once the inflation data showed improvement later in the year, markets started to recover.
The Fed’s 2022 impact was indeed profound. Bonds’ off-the-charts losses were jarring for any asset allocator, accustomed to some protection from the fixed income space. Higher interest rates and borrowing costs cooled rate-sensitive elements of the economy and raised recession fears. The pricey tech sector, with valuations based on promises of strong earnings well in the future, suddenly looked less attractive as higher interest rates from other investments became increasingly available.
Is the Fed seeing success on the inflation front?
While Jay Powell and other Fed officials maintain a stern tone regarding the need to tame inflation, we have begun to see actual improvement on the ground. Based on monthly readings of both the CPI (Consumer Price Index) and Fed-favored PCE (Personal Consumption Expenditures) index, we’ve begun to see increasingly established signs of an inflection point having been crossed by the middle of last year, aided by a drop in energy costs. As laid out by Alan Blinder in the The Wall Street Journal, the CPI’s 12-month 7.1% reading ending with November data, inclusive of food and energy, comprises a 10.6% rate in the first seven months and 2.5% in the last five. (And in the just-released December numbers, the monthly CPI was down 0.1%.) Meanwhile, the PCE’s 5.5% 12-month inflation rate comprises 7.8% in the first seven months and 2.4% in the last five, the latter not too far off the Fed’s 2.0% preferred level. It’s still early, and energy prices are volatile, but the trend looks favorable.
We’ve also seen better news regarding the supply chain, in which severe bottlenecks and supply constraints early in the COVID recovery had a dramatic upward impact on pricing of goods. The bellwether Los Angeles/Long Beach port, the U.S.’s largest, is now experiencing turnaround times of less than three days, faster than any time stretching back to the beginning of COVID. More generally, the supply chain logistics community, highly educated and armed with sophisticated software, now has had time to find workarounds and re-establish efficiencies.
What does the 118th Congress portend for financial markets?
The 2022 mid-terms produced a shift in governmental power, though only a modest one, with Republicans taking the House with a narrow ten seat majority, with the Democrats keeping the Senate, adding a seat for a 51/49 majority. Generally, the financial markets like divided government as opposed to unified power, as we had over the last two years. Moreover, with a national debt approaching $32 trillion, markets might favor a pause in the major legislation that we’ve seen under President Biden’s administration thus far, including a $1.7 trillion omnibus spending bill passed just before power changed hands.
With a smaller shift than had been expected, the power dynamics may point to a greater need, as well as possibility, to work across the aisle. But big question marks come with the spectacle of a 15 round vote to elect House Speaker Kevin McCarthy and associated concessions to the Freedom Caucus, a potentially disruptive small element within his party. These include a greater number of Caucus members on the powerful House Rules Committee, and allowing a single member to force a vote to replace the Speaker, weakening protections that had been in place under Nancy Pelosi. With the House holding the purse strings of fiscal policy, these dynamics could complicate basic spending functions, including the next need to raise the debt ceiling sometime before June. This also could cloud other key spending areas, including defense and support for Ukraine and its war effort. On the other hand, if a small group is tagged with a single-handed threat to our credit rating, the economy and financial markets, their power likely would be short-lived, something that hopefully would be factored in in advance.
What is the outlook for economic and financial conditions in 2023?
Economic output is likely to decelerate in 2023 as higher interest rates and tighter monetary policy work their way through the system, both here and overseas. Much of Wall Street, along with both the International Monetary Fund and the World Bank, are unified in this view. The World Bank’s 1.7% global 2023 projection, revised down from 3.0% in June, includes a modest 0.5% expansion in the U.S., and essentially no growth in Europe. The forecast also includes a 4.3% rebound in China, up from 2.7% in 2022, aided by reopening from the latest COVID lockdown, and emerging markets overall holding steady at 3.4%.
U.S. prospects are indeed murky, with signs of deceleration in both services and manufacturing, including particularly rate-sensitive elements such as housing and autos. Moreover, much of the export economy is hindered by slowing growth overseas, along with a stronger dollar last year up until the currency’s reversal in the fourth quarter.
But importantly, the employment picture continues to look very robust. A healthy December labor report closed the books on a year in which 4.5 million jobs were added, second highest in history only to 2021’s 6.7 million, latter which was more a function of reclaiming 2020’s deep COVID-driven losses. The consumer base that powers two-thirds of our GDP indeed looks solid enough to keep any recession at bay, or at worst relatively mild.
Having added equity exposure to model and client portfolios three months ago, we will hold that position, as always subject to alteration based on ongoing developments and/or changes in pricing. We also would upwardly rebalance bond exposure based on a view that the inflation and Fed policy shock generally has had the bulk of its impact on bond valuations.
|Sincerely, David Beckwith Chief Investment Officer Thayer Partners, LLC
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