Investors are looking forward to putting 2022 behind them. The S&P 500 has experienced its third bear market in the last four years.
The bond market, usually a safe haven during those downturns, is in the midst of one of its worst years on record. The traditional 60/40 portfolio is almost certain to end the year with its second worst year in over 50 years, with 2008 being the worst.
The question investors are asking: Will 2023 be better or a repeat of this year? We think there is reason to be optimistic.
It is unlikely that the bond market will experience a similar drawdown in 2023. A bond’s total return is heavily dependent on the starting yield. Yields have risen significantly throughout 2022 and most market participants do not anticipate this to repeat. The Federal Reserve is still forecasting interest rate hikes into the early part of next year.
However, starting at much higher rates in 2023 versus the beginning of 2022, there is positive return already baked in. Unless the Fed is going to raise interest rates higher than expected, we anticipate bond returns will range from slightly negative to slightly positive next year (depending on the type of bond you invest in). This should bring relief to investors as bonds offer decent yields for the first time in several years. It is not the time to abandon the 40 in the 60/40 portfolio.
There is less certainty in the direction of the stock market. Prices follow earnings over the long-term. However, there are periods where prices overshoot or undershoot earnings. Inflation and interest rates are other factors impacting prices. In 2022, we experienced higher than expected inflation and interest rates, as well as record S&P 500 earnings.
A case could be made that record earnings should support record prices, all else equal. If it were only that easy! Interest rate increases have led bonds to become a viable alternative to stocks, with inflation being the main driver of these increases. These rapid increases force the math to change on what is a “fair” price to pay for stock earnings. It is our belief that this valuation reset between bonds and stocks is the main driver of the poor stock market performance this year. Historical data indicates that prospective equity returns are significantly higher in the years following +20% S&P 500 drawdowns. We think it wise to make sure the 60 in the 60/40 portfolio is topped up as we head into 2023 and beyond.
What about inflation and worries of recession? Inflation was at its highest level in four decades when the June report showed the Consumer Price Index (CPI) at 9.1%. We now have had four consecutive months where CPI has slowed, albeit still at 7.7% year-over-year.
Oil is now down year-to-date (through Nov. 18), home prices have started to come down, and used car prices continue to level off as well. The headline CPI number appears on the path downward, but the mix underneath will be changing.
The Federal Reserve has indicated that one of their goals in the fight against inflation is to have the unemployment rate rise. The rationale, to them, is that this will help alleviate pressure on wages and reduce overall economic demand/activity. We think it will be a difficult task for the Fed as businesses are still seeking workers to meet demand. Employment is up over 500,000 jobs since that message from the Fed.
Fed Chair Powell also said that a “soft landing” is looking less likely and has consistently delivered the message that there will be economic pain. Our belief is that this message means the Fed wants to push the U.S. into recession, as this is historically the only way to crush demand enough to bring down inflation. The Fed has indicated they will consider the lag associated with interest rate hikes flowing through the economy. Our hope is that they follow through on this. Businesses and households can adapt to higher rates, given enough time.
Despite these worries, your financial goals should remain the most important factor to consider when looking at your investments.
If you are just beginning to invest or are in your prime working years, you should embrace the opportunity to buy stocks at lower prices. If you are in retirement, your bonds are finally offering yield. When working with clients in or close to retirement, we point to their total cash and bond investments as the next X years of spending.
This ballast is different for each client, but important in maintaining a large enough equity allocation to support those later years of retirement. Now is the time to review – not abandon or drastically alter your asset allocation.
Andrew Messerschmidt, CFA, is an Investment Officer at Cedar Rapids Bank & Trust. His direct line is (319) 743-7136.