2022: A Year to Remember – And Try to Forget!
January 27, 2023
2022 Market Overview
2022 has come to a close, and with it ends one of the most challenging years for both equities and bonds in well over a century. To be clear, there have been other years (e.g., 2008) that were much worse for stocks. But it is extremely rare to have both stocks and bonds decline by double digits, so much so that 2022 may well have been the worst year for a balanced (i.e., 60/40) portfolio since the US Civil War.
For those who have been invested in stocks for more than a year, things aren’t so bad: the S&P 500 is still up over 8% since the start of 2021. But the same cannot be said for fixed income investors, most of whom must now go back over 5 years to see a positive return on their bond investments. The decade-plus experiment in ZIRP (zero interest rate policy) revealed that investors desiring fixed returns and safety ended up receiving neither once the policy was finally ended.
Ultimately, it was the termination of zero interest rates that explains 2022’s asset price declines. The US Federal Reserve led the way with its interest rate increases, but it was quickly followed by nearly every other major central bank in their efforts to combat inflation. In total, nearly 300 rate hikes occurred globally during the year, raising the level of risk-free rates and causing a massive repricing lower of asset values. By year end, stocks, as measured by the MSCI ACWI (All-Country World Index), finished the year down -18.4%, while the Global Aggregate bond index fell by nearly as much: -16.3%.
2022 (in red) really was an outlier year for stock and bond returns.
Last year, international stocks finally outperformed their domestic counterparts for the first time in 5 years—a surprising occurrence given the upheaval caused by the war in Ukraine and the resulting energy crisis in Europe. However, cheaper valuations helped to better shelter these equities from the impact of higher rates, while a mild winter and good planning has so far mitigated the effects of Russia’s shutdown of its gas pipelines to the EU. Emerging markets, meanwhile, were not so lucky, continuing their losing streak as Chinese equities suffered from a collapsing real estate market and the country’s zero COVID policy.
Among sectors, Energy was by far the standout, finishing the year up +33% after soaring +36% in 2021. Meanwhile, Technology, Communication Services, Consumer Discretionary and Real Estate were the biggest laggards, with each experiencing declines in excess of -20%. Surprisingly, most other sectors were only down by single digits. In addition, “value” stocks outperformed the tech heavy “growth” sectors.
In fixed income, bonds were challenged across the board last year owing to rapidly rising interest rates, but it was the longest maturity bonds that suffered the most. As an extreme example, Austria’s 100-year bond issued in 2020 is now down over -55%. Most other intermediate and long-term bonds also experienced double digit declines, but there were some relative safe havens in very short duration investments. Higher yielding securities also performed relatively better, aided by a benign credit environment.
KCS portfolios were aided by our individual stock and bond selections, our tilt towards international equities, and our shorter-term positioning among our bonds. We also benefitted from the generally higher yields on our bonds relative to our benchmark. Detracting from performance was our slight underweight to Energy, our overweight to Communication Services, and weakness in some of our longer-duration preferred securities.
Good News Is Bad News
In normal times, strong economic data would be cheered, sending stocks higher, and in 2022, the economy was particularly strong in one very important area: jobs. Last year, the US added 4.5 million jobs, making 2022 the 2nd best year for job growth ever, only behind 2021’s 6.74 million added jobs. Unemployment remains at record lows of around 3.5%, and job openings continue to be plentiful at nearly 2 openings for each unemployed person.
But last year, good economic data was bad news, met with consternation as it kindled concerns of prolonged inflation and higher interest rates. At 7%, 2022 had the highest rate of inflation since 1981. And while it already feels like long ago, it’s important to remember the causes of current runaway prices. They include the pandemic and its accompanying supply chain disruptions, repeated fiscal and monetary stimulus, the war in Ukraine with its resultant energy shortage, international trade frictions, and economic reopening challenges. Each of these factors played a significant role in creating today’s inflationary environment.
Thankfully, we believe the worst of inflation is behind us. Most commodity and transportation costs have already reverted back to their 2019 levels, while shelter, a major inflation component, is recently showing signs of easing. We expect inflation will continue to moderate, and that we will see a CPI of around 3% by the end of 2023.
Recession 2023: Yes or No?
For months, the big question on everyone’s mind has been: “Will we have a recession this year?” Unfortunately, we have no clear answer. Fortunately, it really doesn’t matter. Why not? Because the word “recession” is just a label for a particular economic environment, one in which the economy is generally shrinking rather than growing. Recessions come in all shapes and sizes, from severe, as in 1982 and 2008, to very mild, as in 1990 and 2001. But for an investor, what matters is the reaction of the stock and bond markets, not the depth of the recession. And it turns out that there is only a loose correlation between the severity of a recession and the depth of any associated stock market decline.
Stocks don’t always fall during recessions, but they are always significantly higher a year or two later.
If there is a recession this year, we expect it to be mild. More importantly, we don’t expect a collapse in corporate earnings, and for the stock market, this is what matters most. (Rising interest rates, as we saw last year, also hurt stock prices, but most of that is already behind us.) Earnings will almost surely fall from their recent peaks, but we don’t believe the decline will be great enough to affect stock prices any more than they already have.
This does not mean, however, that all the stock price declines are behind us and that equity prices will move straight up throughout 2023. Even if the major equity indices end the year higher than they started—and we believe they will—there will certainly be downdrafts during the year as stocks struggle to regain their footing. Bond prices, meanwhile, will follow the Fed, with a modest price recovery once the market senses that the Fed is finally done raising interest rates for this cycle. But don’t expect bond prices to recover to anywhere near their late 2021 highs. Rather, recovery in bonds will come primarily from the higher interest rates they now pay.
Themes for 2023
In our first quarterly letter of 2022, we laid out five themes for the upcoming year, most of which have already played out. For 2023, we have five major themes:
First, we expect interest rates will settle into their “new normal” this year, ending up only a bit higher than they are now. In the US, we expect rates to peak before mid-year at a fed funds rate of around 5%, and then for rates to stay in that range for much of 2023. In Europe and Japan, we expect rates to peak a bit later, and at levels lower than in the US.
Second, we expect GDP to be sluggish in the first half of 2023 (which may or may not become an official recession), but to accelerate during the latter part of the year. This coincides with the Federal Reserve’s interest rate schedule, as they are expected to stop tightening before mid-year and possibly start easing again toward year end. We also think the reopening of China after its zero COVID lockdowns will lead to a resurgence of consumer spending, much like the one we experienced in the US, with implications for many goods and commodities. A resurgence of Chinese tourism will also aid the global economy.
Third, we think bonds and equities are now reasonably priced (and in some cases, downright cheap), with expected returns meaningfully higher than they were at the start of 2022. History suggests that 2023 will be a decent year for the major asset classes, as back-to-back down years happen only rarely. The one exception is Real Estate, which we think may struggle over the medium term as it continues to digest the implications of higher borrowing costs.
Fourth, the supply chain should finally normalize this year, but inflation may well remain elevated for much of 2023 year owing to persistent wage increases and somewhat sticky housing inflation. The labor component is the most worrisome— shortages seem destined to continue if we experience even modest economic growth, unless we address the problem more directly (e.g., with better immigration policy). Thus, we think that labor costs will keep inflation above the Fed’s 2% target for at least another year or two.
One thing could provide some relief: technology, especially as we appear to be on the cusp of several major advancements in areas such as autonomous vehicles, artificial intelligence, and industrial automation. We are keeping a close eye on several promising developments, and expect these advancements will garner greater public attention later this year.
Somewhat offsetting the above, however, are persistent geopolitical concerns, and we expect the world will continue to diversify away from China and Russia, potentially adding to costs. With the former, the motivation comes from periodically unreliable supply chains and concerns around Chinese government espionage. With the latter, we find it hard to envision a scenario in which Russia reintegrates with Western economies anytime soon.
Fifth and finally, we don’t think all of the bodies have been uncovered from our experiment with ultra-low interest rates. The move from zero to 4.5% has been unprecedentedly swift, and over time more players are likely to be exposed as vulnerable. We would not be surprised to see something “blow up” before year end, such as a European or Japanese financial company, which have been the longest-running abusers of negative interest rates over the past decade.
For investors, here are our main takeaways:
First, we think stocks will do well this year, especially as other investors realize that the sky is not falling. However, a return to the old highs (especially in some previously frothy tech stocks) is also unlikely within the next year, both in light of the new interest rate regime and a slowing economy in the near-term. We thus expect a decent year in equities, but not necessarily an outstanding one. Of the companies we track individually, our highest expected returns remain in specific value stock names as well as in the FAAM firms (Facebook, Alphabet, Amazon, Microsoft). We also see many international stocks—and especially non-US small cap—as particularly attractive, although it’s important to be very targeted among the latter.
Second, to capitalize on (and hedge against) persistent inflation, we prefer investing in companies with pricing power, such as those in the healthcare and technology sectors. These companies will be able to pass on higher prices to offset higher wages. Conversely, we are generally avoiding areas that will be negatively impacted by higher interest rates and inflation, such as Real Estate and many Consumer Discretionary stocks.
Third, we think that Energy stocks may continue to be attractive for a third year, due to the combination of cheap valuations, resurging global energy demand from a reopening China, and the value of energy security in a geopolitically tense world.
Fourth, we will continue tilting towards international and emerging markets. We believe that they are likely to outperform the US owing to their cheaper, and in some areas absurdly cheap, valuations that will become even more obvious as the global economy recovers later this year.
Foreign stocks have lower price/earnings ratios and higher dividends than US stocks.
Finally, in the bond market, we will continue to emphasize shorter durations and spread products in order to benefit from continued higher (and potentially still rising) interest rates. We are particularly fond of targeted high-yield bonds now, which offer attractive yields, strong interest coverage and declining obligations in real terms. At some point this year, we will lengthen our bond durations in anticipation of a more accommodative Federal Reserve. But that time has not yet arrived.
For both aggressive and conservative investors, 2022 was a year to forget. We expect 2023 to be better, with positive returns in most asset classes. Unlike late 2021, most assets are reasonably priced today, with better expected returns over the long run than a year ago. For stock investors, that is likely to mean a gradual recovery in prices during the year, though the big tech companies will no longer be the leaders they were in recent years. That leadership is more likely to be found in value stocks and non-US companies.
For bond investors, 2023 will be a most welcome reprieve from last year’s carnage, which was the worst since at least 1931. They should not experience significant declines in bond prices and moreover, will be collecting considerably more interest than a year ago. After 2022, bond investing is again providing meaningful returns, something we haven’t seen in many years.
We’ve said this may times before, but it bears repeating: investing is a marathon, not a sprint. Years like 2022 are very unusual, but down years in either stocks or bonds happen regularly, and investors needs to be prepared for them. This doesn’t mean being clairvoyant and being able to time the market, as we know that this is essentially impossible. Rather, it means being able to stay the course when everything is looking bleak, realizing that spring will come again. It always does.
The KCS Investment Team
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