The S&P 500 posted its first quarterly gain of the year, returning 7.6% in the fourth quarter, and narrowly pulling out of bear market territory to end the year. The Fed continued its aggressive fight against inflation with 0.75% and 0.50% rate hikes. In an unprecedented year, stocks and bonds moved in unison, both posting double-digit losses. The Universal Bond Index finished the quarter higher but concluded 2022 with its worst year in history.
The Federal Reserve (Fed) recommitted to future rate hikes in 2023, and short-term bond yields exceeded longer-term yields throughout the last four months of the year. International equities outperformed domestic for the first time since 2017, driven by dollar weakness in the quarter that boosted international returns. Like the Fed, the European Central Bank reiterated their commitment to taming inflation through interest rate hikes. Emerging market equities recovered as China posted its best quarter of 2022, up over 13%, as officials announced moderation of its zero-COVID policy and the reopening of borders. Looking into 2023, consumer sentiment remains low, and investors are hoping for a catalyst, such as multiple months of falling inflation, to signal recovering markets.
The S&P 500 started the fourth quarter strong, moving out of bear territory in October and continuing the rally in November. The index gave back some returns in December and ended the year just out of bear market territory. During the first part of the quarter, economic data such as lower inflation and fewer job openings sparked hopes that the Fed would cool the pace of interest rate hikes. However, in December, the third quarter gross domestic product (GDP) was revised higher (3.2%), and the labor market proved resilient. Although the Fed sparked optimism by raising interest rates by 50 basis points (0.50%) in December after four straight 75 basis point hikes, their aggressive commentary in the same meeting damped the year’s strongest quarter for stocks and thwarted the Santa Claus rally. The Fed increased their ending target rate expectation from 4.75% to 5.25% and extended the period they planned to hold rates steady from late 2023 into 2024.
In an encouraging turn of events, nine of the eleven sectors in the S&P 500 finished the fourth quarter in positive territory, with six sectors posting double-digit returns. Energy and industrials led the charge as the war between Russia and Ukraine continued, and manufacturing and the labor market held strong for most of the quarter. On the other hand, consumer discretionary was the worst-performing sector as investors felt the effects of inflation, higher interest rates, and the possibility of an impending recession.
Value stocks outperformed growth stocks, and large capitalization stocks outperformed small-cap stocks in the quarter. This is typical as fears of a recession increase and investors flock to the perceived safety found in value stocks. Despite reprieve in the fourth quarter, value stocks finished the year in negative territory, and growth stocks posted their worst annual returns since The Great Recession in 2008. The value of the dollar weakened in the fourth quarter, helping large-cap stocks which secure a larger percentage of revenue from international sales.
International markets logged their best quarter of the year in the quarter. Like domestic markets, non-US stocks posted significant positive returns in the first two months of the quarter. However, unlike the US, international markets were able to maintain performance better in December thanks to the US dollar’s weakness, which bolstered international returns. The Euro, Yen, and Pound all moved higher for the quarter, recovering some of the losses realized early in 2022. For the first time in five years, international markets outperformed domestic markets, with the S&P 500 posting -18.1% and MSCI EAFE (a proxy for developed international stocks) returning -14.5%. The UK had a tumultuous quarter, with inflation surpassing 10% in October as the fifth prime minister in six years took office.
In December, concerns that the Bank of England (BOE) will prolong interest rate hikes intensified. Elsewhere in Europe, the European Central Bank (ECB) raised interest rates by 75 basis points for a second time. Business and manufacturing activity continued to shrink, indicating a possibility the ECB would slow the pace of rate hikes. However, in December, the ECB reiterated hawkish sentiment to tame inflation through 50 basis point increases at the next five meetings.
Chinese stocks plummeted to start the quarter as President Xi Jinping was reelected and continued the zero-COVID policy. During the second two months of the quarter, officials stepped in to assist the struggling housing market. Citizens protesting mass lockdowns prompted China to lift the country’s COVID policies, and markets rallied on the outlook for a better economic backdrop. Chinese stocks finished the quarter up 13.5%, pulling the MSCI Emerging Markets Index up 9.7%. Several other emerging market countries also aided the index’s growth in the fourth quarter. South Africa and South Korea posted double-digit gains on the heels of growing economies.
For the first time all year, the Bloomberg US Aggregate and broader US Universal indexes posted quarterly gains, returning 1.9% and 2.2%, respectively. Despite the slight reprieve, bonds still posted their worst year in history.
The yield on the 10-Year US Treasury increased 0.05% during the quarter, ending at 3.88% after crossing above 4.0% and below 3.5% in the same span. Longer-term inflation expectations dropped during the quarter, which helped end the consistent jump in yields that persisted in prior quarters. Short duration yields, closely tied to Fed rate moves, increased even more, with the 2-Year Treasury rising 0.19% and ending the year at 4.41%. With shorter maturity-bond yields persisting above longer-maturity bond yields, a recession is becoming more likely. However, the unprecedented drop in bond markets has led to an increase in yields (bond yields and prices move in opposite directions) which introduces higher return potential for bonds in the future.
After two quarters of negative GDP showing tighter monetary policy may be working, the third quarter GDP came in positive and was revised higher in December (from 2.9% to 3.2%). Although economic strength is seen as a positive in normal environments, it proves concerning when inflation is rampant and aggressive monetary policy tightening has already been employed. Investors seem to agree that a recession is on the horizon, though the depth and duration remain hotly debated.
The labor market remained strong throughout the quarter, with unemployment claims staying low (3.7% unemployment rate as of November) despite best efforts by the Fed. More jobs than expected were created, private sector hiring increased, and hourly wages continued to grow during the fourth quarter, all contributing to the US workers’ ability to spend in the face of elevated inflation.
The Fed continued its campaign to reduce inflation throughout the last quarter of the year. After a fourth 0.75% hike in November, inflation came in lower than expected and prompted the first 0.50% hike of the cycle in December. The good news was fleeting, however, as the Fed reinforced its hawkish sentiment and plans to continue hiking rates in 2023 with no cuts until 2024.
This past year was one of the worst years for diversified portfolios in history as bonds and stocks both suffered double-digit declines as inflation hit a 40-year high and the Fed hiked rates to the highest level in 15 years. Inflation and the Fed’s campaign to tame it will continue into the coming year, though to a lesser extent. The Fed’s rate hikes have pushed short-term bond yields above longer-term yields— “inverted yield curve”— which has been a signal of recessions in the past.
Consumers are also starting to show the strain of inflation as well. Consumer spending, which makes up about two-thirds of the US GDP, turned negative in the fourth quarter. Leading Economic Indicators dropped below 50, which has also been a reliable recession signal. There is now a broad consensus that a recession is on the horizon. However, there is no consensus on the depth and intensity of the looming recession.
We believe a recession is likely to develop, but it will be mild by historical standards. Job openings still exceed unemployed persons by a record-wide margin. There has never been a recession with unemployment starting this low. It is unlikely that unemployment will rise sharply even during a recession as aging workers continue to exit the labor force. Consumers are in a better position to withstand an economic downturn as household debt is much lower than prior to previous recessions.
After declining 18% in 2022, the S&P 500 Index seems to have already priced-in a mild recession. Bonds fell sharply as well, but bond yields stabilized late in 2022. Although its likely earnings will fall in 2023, historically, the S&P 500 still posted an average return of around 9% during years of falling earnings as investors are forward-looking and tend to discount earnings declines before they occur. Stocks should produce positive returns in 2023 even if we have a mild recession, especially heavily discounted international equities. In addition, investment-grade bond yields of 4% and higher offer the most attractive yields in 15 years.
This information is for educational purposes and is the opinion of Aldrich Wealth LP (“Aldrich Wealth”). Facts and figures are believed to be from reliable sources, but no liability is accepted for any inaccuracies. Nothing in this commentary should be construed as an investment recommendation. Past performance does not guarantee future results and all investments involve risk. Aldrich Wealth is an investment adviser registered with the US Securities and Exchange Commission.
Meet the Expert
Partner + Chief Investment Officer
Darin Richards, CFA®
Aldrich Wealth LP
Darin joined the Portland wealth management firm in 2004, bringing more than a decade of investment and financial consulting experience with him. As chief investment officer for Aldrich Wealth, Darin is responsible for developing, and implementing our investment philosophy and leading the investment committee. He works directly with some of our most complex and largest clients and also…
- Series 7 and 63 security exams
- Chartered Financial Analyst (CFA®)