Markets ended the holiday-shortened week little changed, closing out the S&P 500’s worst year since 2008. For the year, the Dow Jones Industrial Average, S&P 500, and NASDAQ fell 9%, 19%, and 33%, respectively. U.S. bond market performance was equally poor, with the Bloomberg U.S. Aggregate Bond index losing 13%, its 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 U.S. bond market since at least 1926. 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 U.S. 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.
Higher rates impacted equity and bond markets alike, nullifying the historical relationship between the two. Whereas investors typically seek the relative safety of bonds during bouts of equity market volatility, in 2022, the sharp rise in rates, precipitated by higher inflation and the Fed, resulted in significant bond market losses. For investors, that meant there were few places to “hide.”
As we look ahead to 2023, we expect market volatility to remain elevated in the near term until such time that slowing inflation, economic growth, or both obviate the need for further Fed rate hikes. While many prognosticators assume that a recession is inevitable, 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 economic activity that is slowing, not plunging. As the Fed slows and ultimately ceases further rate hikes, and inflation continues to slow, that should provide a constructive backdrop for equity and fixed-income markets alike.
