Historic Fed Rate Hikes and Decades-High Inflation Weigh on Stocks and Bonds

2022 Year In Review & 2023 Market Forecast

Easing inflation pressures and a resolution of the fiscal turmoil in the UK fueled a strong rally in stocks and bonds early in the fourth quarter, but hawkish Fed guidance, disappointing economic data, and rising global bond yields weighed on markets in December and the S&P 500 finished 4Q22 with only modest gains that capped the worst year for the index since 2008.

Positive momentum for stocks and bonds continued in early November thanks to a growing

number of price indicators that implied inflation pressures had finally peaked. The October CPI report (released 11/10/22) and several other official inflation statistics showed the first solid decline in consumer price data for the year. Both stocks and bonds enjoyed solid gains in response to the data because while inflation remained far too high on an absolute level, markets hoped these declines would result in the Federal Reserve not raising interest rates as high as previously feared.

Those hopes were boosted after the Thanksgiving holiday when Fed Chair Powell stated that interest rates would only need to rise “somewhat” higher than previous projections. Investors took that “somewhat” remark as a sign that previous estimates for rate hikes were too aggressive and that extended the rally into early December. The S&P 500 ended November at multi-month highs with another solid monthly gain of 5.6%.

Investor optimism faded in December as global central banks signaled that they were still committed to hiking rates, economic data showed clear signs of slowing growth, and several negative earnings announcements raised concerns of an earnings recession in 2023. First, at the December meeting, the Fed revealed that they expected rate hikes to take the fed funds rate above 5% (from the current 4.375%), which was higher than market expectations.

Then, economic data released in mid-December, including regional manufacturing indices and the November retail sales report, showed economic activity was slowing.

Q4 and Full Year 2022 Performance Review

Performance was mixed during the fourth quarter as the Dow Jones Industrial Average

rose sharply, while the S&P 500 and Russell 2000 were solidly higher. Like most of 2022, however, the Nasdaq lagged and fell slightly in the fourth quarter. Expectations for higher rates, slowing economic growth and underwhelming earnings weighed on the tech sector

in the fourth quarter, which was the case for much of 2022. Conversely, less economically sensitive companies that trade at lower valuations than tech stocks outperformed again as investors continued to shift towards defensive sectors amid growing recession fears. On a full-year basis, all four major indices posted negative returns, with the Dow Jones Industrial Average relatively outperforming while the Nasdaq badly lagged the other major indices.

By market capitalization, large-caps slightly outperformed small-caps in the fourth quarter, but modestly outperformed throughout 2022. Concerns about future economic growth and higher interest rates (which can impact smallcaps disproportionately due to funding needs) were the main drivers of this. Small-cap stocks showed some resilience in the fourth quarter with the Russell 2000 index registering a solid gain as investors’ hopes for a peak in inflation and ultimately interest rates, led to some dip buying in the segment.

From an investment style standpoint, value massively outperformed growth all year and

that trend continued in the fourth quarter. Underwhelming earnings weighed on tech stocks in the final three months of the year, while concerns about slowing economic growth combined with rising bond yields hit richly valued tech stocks throughout 2022. Value stocks, meanwhile, were viewed as more attractive in the market environment of 2022 due to lower valuations and exposure to business sectors that are considered more resilient.

The tech sector and those sectors with overweight exposure to high-growth companies badly lagged in over the course of 2022. In the fourth quarter, communication services were only fractionally positive while the consumer discretionary sector posted a negative return on weakness in high-growth internet and consumer stocks. For the full year, those same two sectors posted the worst returns in the S&P 500, as investors shunned richly valued, growth-oriented tech companies.

Q1 and 2023 Market Outlook

Markets ended 2022 on a negative note and December losses ensured 2022 was the worst year for stocks since 2008 and the worst for bonds in multiple decades, as both asset classes posted annual declines for the first time since the 1960s. These losses were driven by decades-high inflation, a historic Fed rate hike campaign and geopolitical unrest. But while those factors were negatives for asset prices in 2022, it’s important to note as we enter 2023, the market is approaching a potentially important transition period that could see each of these headwinds ease in the months ahead.

First, inflation has shown definitive signs of peaking and declining. The Consumer Price Index has fallen from a high of 9.1% in June to 7.1% in November, while other metrics of inflation have registered similar declines. Now, to be clear, inflation remains too high in an absolute sense, but if price pressures ease faster than

expected, that will present a positive surprise for markets in the first several months of 2023.

Second, after aggressive rate hikes in 2022, the current Fed hiking cycle is likely nearly complete. In December, the Federal Reserve signaled that it expected the peak interest rate to be just 75 basis points higher than the current rate. That level could easily be reached within the first few months of 2023 and the Fed ending its rate hike campaign will remove a significant headwind from asset prices.

Finally, while both economic growth and corporate earnings are expected to decline in 2023, those negative expectations have been at least partially priced into stocks and bonds at current levels. As such, if the economy or corporate America proves to be more resilient than forecasts, it could provide a positive spark for asset markets in early 2023.

As we start the new year, we should expect financial media commentary to be focused on the 2022 losses and current market risks, including earnings concerns and recession fears. But the market is a forward-looking instrument, and while there are undoubtedly economic and corporate challenges ahead in 2023, some of those best-known risks are partially priced into markets already, and the truth is that there are potential positive catalysts lurking as we start a new year.

More broadly, market history is clear: Declines of the magnitude we saw in 2022 are usually followed by strong recoveries, not further weakness. The S&P 500 hasn’t registered two consecutive negative years since 2002, while bonds, represented by the Bloomberg U.S. Aggregate Bond Index, have never experienced two negative consecutive years. And that reality underscores an important point, that market declines such as we witnessed in 2022 have yielded substantial long-term opportunities in both stocks and bonds. At Brixton Capital Wealth Advisors, we understand the risks facing both the markets and the economy, and we are committed to helping you effectively navigate this challenging investment environment. Successful investing is a marathon, not a sprint, and even intense volatility is unlikely to alter a diversified approach set up to meet your long-term investment goals. Therefore, it’s critical for you to stay invested, remain patient, and stick to the plan, as we’ve worked with you to establish a unique, personal allocation target based on your financial position, risk tolerance, and investment timeline. We remain vigilant towards risks to portfolios and the economy, and we thank you for your ongoing confidence and trust. Please rest assured that our entire team will remain dedicated to helping you successfully navigate this market environment. Please do not hesitate to contact us with any questions, comments, or to schedule a portfolio review