Dear Clients,
If we had to pick one word to describe 2022, it was a “battle”. The Federal Reserve (Fed) was in a battle against inflation that took the Fed Funds rate from 0% to 4.5% and produced the worst bond market returns in decades. The war in Ukraine battled on and on, causing stock markets globally to decline with uncertainty, including the S&P 500 down nearly 20%. While neither of these battles are fully resolved, the final quarter of the year has at least brought some relief and small hints of optimism as we turn the page to 2023.
In the equity markets, we were tilted towards value stocks most of the year as a defensive move to capture higher dividend yields and avoid the high valuations in growth stocks as interest rates increased. Value significantly outperformed growth, driven by the excessively high starting valuations for growth stocks and the effect of rapidly rising interest rates. Beginning the year, the MSCI World Growth Index traded at 31 times expected earnings, versus only 14 times expected earnings for the MSCI World Value Index. This was a significant deviation in relative valuation. By the end of the year, the valuations had fallen to 21 and 12 times respectively. Despite this correction, in our view growth stocks still look somewhat expensive by historic standards, whereas value stocks continue to look reasonable.
That said, equity markets are forward looking, meaning they try to anticipate what will happen 6 to 9 months in the future. We believe the U.S. economy will enter a mild recession in that time frame, and that the market has already priced this news into current valuations. However, in a recession scenario the Fed will pause interest rate increases and eventually begin reducing interest rates. That is not yet priced into valuations because the market does not know the timing. But we do know that when it happens, growth stocks will begin to outperform value. So, we are proactively building our models now, to be ready for a tilt back towards growth when the time is right.
One of the most difficult aspects of last year was the sharp decline in bond prices. We all know that stocks can be volatile, but typically bonds are the ballast in the portfolio that stabilizes returns. The unusually large sell-off in bonds at the same time as stocks caused declines in even the most conservative portfolios. The 10-year U.S. Treasury Note yield, which effects everything from mortgages to car loans, increased from 1.49% to 3.83% during the year. Bond prices decline as yields increase, so the 157% increase in yields had a massive effect on bond prices. This was caused by central banks having to raise interest rates by far more than investors had expected at the beginning of the year because of runaway inflation. As it became clear that high inflation was not “transitory”, as the Fed initially believed, we positioned our bond exposure away from long term bonds and focused on the short end of the yield curve which is less impacted by rising rates. That helped, but we still suffered losses in the fixed income space. Going forward, the bond environment appears to be normalizing from the COVID stimulus and zero interest rate policies that disconnected prices from the normal business cycle. As a result, we are actively moving back into our normal strategic allocation to longer term bonds.
In conclusion, we expect 2023 to continue to bring more volatility as the “battles” we mentioned must continue to be resolved. That said, returns from equity markets over the next 3 to 5 years after a 20% correction are typically above average. The typical economic and business cycles that were disrupted during COVID, and disrupted again through massive stimulus, appear to be normalizing. With that backdrop, and our continued focus on long term investing, we believe 2023 is the time to return to our more typical strategic asset allocation in the portfolios, but with some minor adjustments depending on how the economic and interest rate environments unfold.
As always, we appreciate your trust as a client and are available at any time to discuss your specific portfolio and financial circumstances.
Best regards,
Dodd Disler, CEO