Weather Patterns and Market Storms

Market Commentary | Q4 2022

An entire industry has arisen to predict upcoming weather, track what is happening currently, make historical comparisons, and write sensationalist headlines. While we are describing modern weather monitoring and reporting, we could just as easily be describing the financial media. The reality is that our weather, much like financial markets, is usually mild and uneventful. What sticks in people’s minds, however, are the extreme events. Following these storms or price declines, investors tend to overstate the probability that they will continue unabated or will recur soon.

2022 was one of those extremes. Both stock and bond investments declined simultaneously – a rare occurrence and a shock to diversified portfolios that have historically provided ballast during periods of market volatility. Instead of a muted effect, growth-oriented and stability-oriented investors felt similarly whipsawed. When we zoom out, we can see that both financial markets and the weather tend to follow some historical patterns over the long-term that give us confidence, but short-term storms can be distressing and damaging.

Most investors are more than happy to say goodbye to 2022. It was a difficult year that included the Fed aggressively pushing interest rates higher, an unexpected and ongoing war in Ukraine, inflation that is far less ‘transitory’ than expected, and a renewed Covid surge in China. This array of factors created a storm that pummeled the markets for the entirety of the year and marked a shift from the prior three years of strong returns.

The S&P 500 Index, which had gained +27% in 2021, dropped more than -18% in 2022. The Nasdaq Index, which includes tech and growth-oriented companies, had gained more than +21% in 2021 and subsequently declined by -33% in 2022. International stocks, as measured by the EAFE index, had grown by +11% in 2021 and then declined by more than -14% in 2022.

Bond markets didn’t fare much better. As interest rates were pushed higher, the value of existing low-rate bonds moved lower. The Bloomberg US Aggregate Bond Index dropped by -13% during 2022. The silver lining is that bonds now offer more attractive yields, creating new opportunities for additional income from bonds and cash within portfolios.

Real estate is another asset class that followed a similar pattern. Real estate investments, measured by the FTSE NAREIT index, gained more than +39% in 2021, before declining by -25% in 2022. This abrupt shift was driven primarily by rising interest rates on mortgages, which reduced the number of buyers and made housing particularly expensive for first time homebuyers. Single-family home prices will likely face continued pressure as the economy slows and unemployment rises, but real estate investors can also expect to earn higher income as inflation gets passed through to rental contracts for both individual and corporate tenants. As interest rates begin to stabilize, diversified real estate funds (housing, cell towers, data centers, medical offices, etc.) should resume their role as a productive diversifier and volatility dampener when paired with more traditional stock and bond allocations in a portfolio.

Turning our calendars to January reliably means the arrival of annual market forecasts from financial pundits and large investment banks. Much like a weather forecast provided 6-12 months in advance, we don’t expect a lot of accuracy from the 2023 forecasts currently being published. Last January, no one predicted a WWII-style land war in Ukraine or an 18-fold increase in the Fed’s policy rate, yet here we are.¹ Often, these ‘unknown unknowns’ have the greatest impact on markets and remind us again of the perils of attempting to time the market and the wisdom of remaining invested for the long-term.

Although it’s tempting to think markets start fresh every January, many of the stormy conditions that made last year so challenging are due to persist into 2023. The Fed may stop hiking rates, but it is unlikely to cut them prior to the end of the year. Inflation may continue to moderate, but is likely to remain far above the Fed’s target rate. The stock market may have a better year than it did in 2022, but it could be a bumpy ride.

One question that has been on everyone’s mind is whether the current slowdown will develop into a full recession. Opinions differ widely. In late December, economists participating in a Bloomberg poll said there was a 70 percent chance of recession in 2023.² In contrast, some investment banks and economists still expect the US to experience a soft landing in 2023, avoiding an official recession. The pace of cooling inflation will be central to the outcome.

Heading into 2023, global equities will likely remain in a metronomic swing driven by inflation data and investors’ perceptions of the Fed’s progress. Recent data shows that the inflation rate has been slowing in recent months, but remains above the Fed’s target level. The US economy may enter a recession even if the rate of inflation continues declining, or a recession may be the force that pushes inflation lower. In either case, historical comparisons show this doesn’t automatically mean bad news for stock prices. Prices in 2023 will depend in part on corporate earnings, which have been under pressure as inflation has impacted profit margins. If companies can pass through cost increases, they will be better positioned to maintain profitability.

While interest rates seem high in comparison to a year ago, they are, in fact, just starting to reach the more normal levels of past decades. If this normalization trend continues, high-valuation tech and social media stocks that were favored by ultra-low rates during the pandemic may continue to struggle, and higher quality or value-leaning sectors may fare better. Investors are forced to take a more discriminating approach to their portfolios as interest rates move higher. The higher the cost of capital, the higher the return on investment must be.

There is a sea change underway as investors no longer face the distortions of zero-percent interest rates, and certain asset classes are being impacted more acutely. Casualties over the past year have included the cryptocurrency and NFT boom, meme stocks, SPACs, and nosebleed stock and bond valuations for companies with minimal profitability. If investors take this opportunity to shift the emphasis back to stable businesses that are solving real problems in today’s economy, this current transition could position us for a more sustainable and profitable future.

When planning for the future, it is important to have a strategy that can handle the twists and turns of real life and the inevitable storms that will blow through. This could mean periodic years with significant market volatility and falling asset prices, as we saw in 2022, or it may be something more personal like a job loss or a family health event. Life is rarely linear. That said, temporary storms are not a reason to sell your house or shift your entire financial strategy. If you have sufficient income and liquidity to continue covering your regular living expenses, history indicates that we are better off sitting tight and waiting out the storm – even when the media sensationalizes an upcoming atmospheric river or economic recession.

Lower prices are unsettling, but they can also represent periods of opportunity. Many high-quality companies may effectively go on sale as the entire market declines in price, and we may see further downward price movement in 2023. Potential worries are always out there, and we aren’t ignoring them, but it is important to view price declines within the broader context of market growth over many years. Looking forward, we have significant confidence in the ability of innovative and productive companies to attract capital and reward patient investors with a long-term view.

Resources

¹ The target range for the Fed Funds Rate moved from 0.0-0.25% in January 2022 to 4.0-4.5% at the end of December 2022. New York Fed

² Economists Place 70% Chance for US Recession in 2023. Bloomberg