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December 2022 Market Commentary

January 11, 2023

Investors hoping for a Santa Claus rally in December were no doubt disappointed with the metaphorical lump of coal that markets delivered instead. Bucking the historical trend of ending the year on a positive note, the S&P 500, Dow Jones Industrial Average, and NASDAQ fell 5.9%, 4.2%, and 8.7%, respectively, bringing full year returns to -19%, -9%, and -33%, their worst performance since 2008. With little doubt, 2022 will long be remembered as a year to forget.

Inflation, and all its attendant ramifications, was the biggest story of 2022. After spending the majority of the past decade fretting about disinflation, the US Federal Reserve was caught flat-footed as inflation surged in the latter part of 2021 and into 2022. Contributing to the Fed’s slow response was its desire to continue supporting the nascent post-pandemic recovery. Russia’s invasion of Ukraine in late February further exacerbated global inflationary pressures. Forced to play catch up, the Fed enacted seven rate hikes between March and December, raising the Fed Funds rate by a cumulative 4.25%. The result was a steady decline in inflation over the second half of the year, as well as the highest mortgage rates since 2002, the worst housing market downturn since 2008, surging financial market volatility, and growing fears of a recession.

In many respects, the narrative for the year was also the narrative for December. Since peaking at 9.1% in June, headline consumer price inflation has now slowed to 7.1%. Measures of core inflation, which exclude more volatile food and energy prices, are also showing signs of improvement. That said, “sticky inflation”, those prices which are relatively slow to change (think rents and many service-based categories like medical services) remains stubbornly high. That in turn has forced the Fed to remain aggressive in its efforts to combat inflation. At its December meeting, the Fed lowered it pace of rate hikes from 0.75% to 0.50% but revised upwards its forecast for the ultimate level to which rates may rise. In other words, the Fed is now comfortable shifting to smaller rate hikes, but may ultimately raise rates higher, and keep them at those levels longer, than markets had previously been expecting, or at least hoping.

The Fed’s upwardly revised forecasts further inflamed concerns that its inflation-fighting efforts will ultimately trigger a recession. Somewhat counter intuitively, those concerns were also exacerbated by better-than-expected economic data. Throughout an economic cycle, economic data is viewed through various lenses. At times, economic data, such as rising wages, stronger employment, higher consumer spending, etc., is viewed as “good”, in that it points to a strengthening economy. At other times, the same economic data can be viewed as “bad”, for fear that it could spur the Fed to raise rates to prevent the economy from overheating. Such is the case right now, where the concern is that “good” economic data will force the Fed to maintain, or perhaps increase, its inflation-fighting efforts, thereby triggering a recession. An example of this was revised GDP data released in mid-December showing the economy grew at a 3.2% pace in 3Q22, up from the prior 2.9% estimate. One would be forgiven for thinking that the markets may have embraced the news, viewing it as a sign the economy might avoid recession. Instead, the S&P 500 fell 1.4% on the day, concerned that the data would embolden the Fed to remain aggressive in its policy actions. Moving into 2023, we expect markets to remain conflicted over how to interpret economic data until such time that slowing inflation, economic growth, or both, obviate the need for further Fed rate hikes.

Every investor knows that equity markets can be volatile. As result, many hold bonds in their portfolios to help counteract the volatility. And typically, it works. For example, in 2008, when the S&P 500 lost 38%, the US bond market, as measured by the Bloomberg US Aggregate Bond index, gained 5%. In 2002, when the S&P 500 lost 23%, bonds did even better, returning 10%. The tendency for bonds to rise when equities fall is referred to as negative correlation. In 2022, however, that historical correlation broke down. Instead of moving inversely with one another, both asset classes behaved quite similarly. As a result, investors were left with few places to “hide”.

The primary reason for the break down in correlations was rising rates. Mathematically, rising rates result in bonds losing value. For example, in a rising rate environment an investor would rather buy a currently issued bond yielding, say 4%, rather than a bond issued several years ago when yields were closer to 2%. In order for the owner of the 2% bond to attract a buyer, they must lower the bond’s price so that the resulting yield equals the 4% offered by current bonds. For equities, rising rates don’t necessarily equate to falling prices, but in 2022 they did, as investors fretted that the Fed’s aggressive rate hikes would impact economic activity as well as corporate profits. Equities with extended valuations, i.e., high price-to-earnings ratios, were impacted particularly hard.

Rising rates in December resulted in the Bloomberg US Aggregate Bond index losing 0.5%, bringing full-year losses to -13%. That marked the index’s worst year on record back to 1976, easily surpassing its previous worst year of -2.9%, recorded in 1994. By some estimates, 2022 was the worst year for the US bond market since at least 1926.

Within the month, fixed income markets experienced a tale of two halves. During the first half of the month, prior to the Fed’s December meeting, rates fell on signs of slowing inflation and hopes that the Fed would reduce the size of its rate hikes. Those hopes came to fruition when the Fed raised rates by just 0.50%, ending four consecutive 0.75% increases. Speaking after the meeting, Fed Chair Jay Powell had some encouraging words regarding inflation, but also stressed that the Fed would have to maintain its restrictive stance for “some time.”

Upon further reflection of Powell’s comments about the Fed’s need to remain vigilant in its fight against inflation and following comments from some other Fed members that the market’s post-meeting reactions weren’t reflecting Fed guidance, yields reversed course and steadily climbed over the final two weeks of the month. In addition to the Fed’s actions, the Bank of Japan, and European Central Banks both announced aggressive changes to their monetary policies helping reinforce the broad-based nature of the fight against inflation.

Municipal yields followed a similar pattern to Treasury yields, falling through the first half of the month, before rebounding during the second half of the month. For the month munis lost 0.1%.

Looking ahead, many prognosticators assume that a recession in 2023 is inevitable. While that may ultimately prove to be the case, we continue to believe that any downturn is likely to be relatively mild given the continued strength of the labor market and other economic indicators showing activity that is slowing, not plunging. For investors, as the Fed slows and ultimately ceases its rate hikes, and inflation continues to slow, that should provide a constructive backdrop for equity and fixed income markets alike.

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Information and research contained herein do not represent a recommendation of investment advice to buy or sell stocks or any financial instrument nor is it intended as an endorsement of any security or investment, and it does not constitute an offer or solicitation to buy or sell any securities. It is not possible to invest directly in an index. There is no assurance that investment products based on the index will accurately track index performance or provide positive investment returns. Past performance is not a guarantee of future results. These materials have been prepared solely for informational purposes based upon information generally available to the public from sources believed to be reliable. The views and opinions expressed in this publication are subject to change, at any time, without advance notice or warning.

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