A difficult year ended with a thud for U.S. stocks. After a 14% rally in October and November, the S&P 500 Index dropped 5.8% in December to close out the year with an 18.1% loss, its largest annual decline since 2008. Foreign stock markets held up much better in the fourth quarter — developed international stocks gained 17.3% (one of their best quarters ever). For the full year, developed international stocks were down 14.5% in dollar terms (almost four percentage points better than the S&P 500). These annual returns were despite the U.S. dollar appreciating 8.3% for the year, which reduces dollar-based foreign equity returns one-for-one. Our client portfolios on the whole held up better than the overall market as we continued to stress the importance of maintaining material exposure to value and dividend focused managers, while not chasing the growth and tech led performance of recent years. We continue to believe exposure to both styles is the best path over the long term.
Turning to the fixed-income markets, core investment-grade bonds had a solid fourth quarter, gaining 1.9%; however, this was still the worst year for core bonds in at least 95 years, with the index dropping 13.0%. The key driver, of course, was the sharp rise in bond yields; the 10-year Treasury yield ended the year at 3.9%, up from just 1.5% a year prior. High-yield bonds had a strong fourth quarter, up 4.0%, but were down 11.2% for the year. Municipal bonds were down 8%.
Investment Outlook and Portfolio Positioning
Inflation and monetary policy remain the financial markets’ key macro focus. U.S. inflation data have improved, suggesting we may have seen the peak in inflation for this cycle. Core inflation, though, remains far above the Federal Reserve’s 2% target, and the Fed’s message is that it intends to maintain restrictive (tight) monetary policy throughout 2023. On the economic growth front, key leading indicators deteriorated further in the fourth quarter, which, along with tight monetary policy, likely point to a recession in the year ahead. On the positive side, most believe it should be milder and shorter-lived than the 2007-08 and 2000-01 recessions. Analysis of past data on recessions, earnings declines and stock valuations suggest a real possibility of further declines in the stock market from current levels.
Given the sharp rise in yields, bonds are looking relatively attractive for the first time in a while. Moreover, if a recession plays out, we expect core bonds to deliver a positive return, providing valuable downside protection should riskier assets like equities be adversely affected.
As 2022 has reminded investors, we should “expect the unexpected, and expect to be surprised.” This is expressed in our portfolio construction and investment management via balanced risk exposures and diversification.
We believe 2023 will likely present us with some excellent long-term investment opportunities. Unfortunately, our base expectation is for some degree of a recession and the potential for continued stock market volatility.
While challenging, it is critical for long-term investors to stay the course through these rough periods. The shorter-term discomfort is the price one pays to earn the long-term “equity risk premium” – the additional return from owning riskier assets such as stocks that most investors need to build long-term wealth and achieve their financial objectives.
As always, we thank you for your trust and welcome questions you may have.
JOEL ISAACSON & CO., LLC