Everything, in retrospect, is obvious. 2022 was a bad year for investors. A 60/40 portfolio lost 17% – the worst performance in over 50 years. But what was to blame for the turbulent year? There are some good candidates, starting with the U.S. Federal Reserve, which caught everybody by surprise, including itself, we would argue.
Back in December 2021, the Fed expected its policy rate to rise to only 1.625% by the end of 2022, based on its economic projections. Things turned out different, of course. That major policy shock alone would have caused massive market turbulence, but the Fed was not alone as a source of market stress. COVID-19 and its aftermath were also a major factor.
Because the coronavirus caused a significant distortion of the business cycle, severe macroeconomic volatility ensued. For most of the year, inflation surprised to the upside while economic activity became quite volatile. Finally, let’s not forget that geopolitics — and its impact on world energy prices — was also an important consideration.
Looking back, it is easy to see why 2022 turned out to be a year for the record books in the disaster category. The market maxim “Don’t Fight the Fed” proved all too true. As the title of this missive states, in retrospect, it should have been obvious that the markets were not going to react well to a hyper-aggressive Fed. Much uncertainty remains around the future financial and economic impact of these rapid interest rate hikes. While the mood is far from apocalyptic in the early days of 2023, it is not exactly chipper either.
Summarizing the views of over 500 Wall Street strategists going into 2023, Bloomberg noted that “upbeat forecasts are hard to find, threatening fresh pain for investors who’ve just endured the great crash of 2022.” It is easy to understand why investors are worried: fears of recession are running high. According to a recent Bloomberg poll, economists assign a probability of 70% to a recession in 2023, most likely starting in the second quarter.
A recent Wall Street Journal survey revealed that more than two-thirds of economists at 23 major financial institutions foresee a recession this year. The financial community seems to agree. The latest Bank of America Global Fund Manager Survey, conducted in the first week of December, shows that 68% of fund managers expect a recession in 2023.
Usually, economists and investors don’t know the economy is in recession until it has already begun. If the economy really does fall into recession in 2023, it will be the most telegraphed recession in history. Keeping a historical perspective, last year marked the only time in the last 50 years the bond market (as measured by the Barclays Aggregate Bond Index) had two consecutive negative annual returns. The last time equity markets (as measured by the S&P 500) had back-to-back negative annual returns was after the dot com bubble burst in 2000 (the only other time that happened in the post-World War II era was 50 years ago in the early 1970’s).
Companies, consumers and the economy are in much better shape now than they were then, which should provide more confidence that 2023 will produce positive returns for both bonds and stocks. With that in mind, updates to portfolios in Q1 include:
- Continue to increase portfolio exposure to fixed income, moving to overweight in investment grade corporate bonds.
- Maintain neutral weighting to U.S. equity, balancing recession risks against more reasonable valuations after the 2022 correction.
- Move to neutral from underweight international equity, due to attractive valuations, higher dividends and anticipated U.S. dollar weakness.
We will continue to carefully monitor market developments and welcome the opportunity to speak with clients in more detail about portfolio strategies.