- Markets react to decelerating inflation data, despite the Fed’s concerns.
- All broad asset classes had positive performance in Q4; inflation-sensitive themes did best, in our view.
- Our strategy is to tactically add fixed income if yields rise and inflation-sensitive themes if earnings accelerate.
Quarterly Recap: Markets Key in on Slowing Inflation; Fed Continues to Warn of More/Longer Tightening
Financial markets and the Federal Reserve seemed to be at odds in the fourth quarter. The Fed and other central banks continued to raise interest rates aggressively and tried to convince investors that they will keep interest rates higher for longer due to the high level of inflation. Despite this, stock and bond markets delivered positive returns as investors focused on the deceleration in the inflation data, rather than the level. Investors seem to believe that, despite what they are saying, central banks will be able to pause, and perhaps begin lowering rates in 2023.
We tend to agree that inflation is cresting, particularly as energy prices decline and large companies begin to shed jobs. In our view, these are all encouraging signs that the Fed and its peers are making headway in their attempts to fight inflation. However, we also believe the Fed’s insistence that the fight against inflation will take longer and be fiercer than most investors are expecting.
Against this backdrop, we see two ways that markets could continue to rise from here. The most likely upside scenario we see is that earnings and the economy remain resilient even as the Fed continues its current path. The second is that Q1 inflation data strongly decelerates, allowing Fed Policy to be less contractionary, a scenario we view as less likely. On the other hand, either a large breakdown in earnings or a re-acceleration of inflation, which would force the Fed to accelerate rate hikes, would lead to worse market outcomes, in our view. While we believe these negative scenarios are less likely, future earnings announcements and inflation data are critical inputs moving forward.
Returns Recap: Markets Bounce in Q4; Inflation-Sensitive Equities Lead
The dichotomy of elevated but cooling inflation also drove return differences in the equity market, in our view. This dichotomy led to cyclical-oriented stocks, whose business models benefit from inflation-driven revenue growth, to outperform growth-oriented stocks, whose share prices tend to react negatively to rising interest rates. As such, markets with less growth-oriented stocks – such as international equities, small cap US equities, and emerging markets – all outperformed the US in the fourth quarter (see chart, left). Apart from emerging markets and global equities, all of these value-oriented markets also ended up outperforming US Large Cap for the entire year.
International markets outperformed the US for macro and micro reasons. From a macro perspective, international markets benefitted from their currencies rebounding versus the dollar. A combination of aggressive central bank moves overseas and lower risk from the war in Ukraine benefitted non-dollar currencies in the fourth quarter. As you can see from the table below, European markets benefitted from a 9% rise in their currencies, which when combined with strong 10.4% equity returns, led to a combined 19.3% gain. From a micro perspective, investors began to price moderate levels of inflation into value stocks. As earnings are reported, we will be looking for earnings growth to justify the rising stock prices. If these companies are able to deliver, we think it might set up international equities for long-term investment rather than short-term tactical trades.
Finally, fixed income returns were still volatile for the quarter, but ended up being positive and better than cash for the first time this year. More volatile bonds that ‘look like stocks’, such as high yield, were the highest performers amongst fixed income, with default data still well below historical averages and yields starting the quarter elevated. Our belief continues to be that interest rates will ultimately rise from here, but that higher starting yields means that 2023 will not be a repeat of the challenging returns of 2022.
US Sectors: Inflation-Sensitive Stocks and Cyclical Stocks Beat Tech and Growth
Looking under the hood at US sectors (see chart, right), we see a similar theme where value-oriented sectors continued to outperform growth-oriented sectors, with more defensive sectors like Health Care and Consumer Staples returning positive results somewhere between value and growth. Our outlook here is the same as international – we will look carefully at Q1 earnings and guidance, which could provide evidence of a structural shift from a growth-stock led market to a value-led one.
Defensive stocks held up remarkably well in 2022, as recession fears have entered the market, and earnings have been surprisingly resilient for these companies in the face of inflation. However, we are cautious on defensives looking into 2023, and we will be watching for evidence of increasing input cost pressures impacting profit margins.
Technology and Communication Services continued to lag the defensive and cyclical sectors, despite the respite in rate increases. We believe this is due to concerns about the profitability of these sectors. Real Estate also struggled, which we believe is due to the slowing of inflation, coupled with a slower recovery in office traffic and associated consumer spending, which also caused weakness in the discretionary companies.
Moving forward, we believe selection within sectors will be important. In 2023, we believe it will be key to identify cyclical stocks whose earnings merit the increase in multiples and equally important to identify growth-oriented stocks whose resilient earnings have been overly discounted.
Outlook: Cautiously Optimistic About 2023
2022 ended up being the worst year for balanced portfolios in over 50 years. The enthusiasm we feel for the “reset” in stock and bond valuations is somewhat tempered by our belief that the Fed will tend to be more aggressive than the market thinks, which will likely mean higher rates for longer. While interest rates starting at higher levels goes a long way to lower the risk of a repeat of 2022 fixed income returns, we believe that earnings will continue to decelerate (although less than current market consensus), and if inflation rears its head again, we could end up with a challenging first half of the year.
We continue to believe that a prudent path forward is to opportunistically add fixed income at higher yields, and to make allocations into inflation-sensitive equity sectors in markets as earnings come through. While this strategy may not perfectly time the bottom of market, we believe it is prudent to wait for signs of earnings confirmation before increasing our allocation to stocks.
Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.