This time last year I wrote a note with our expectation – 2022 would be a more volatile year. This was due in large part to the uncertain path of interest rates, inflation, and the unwinding of the Federal Reserve balance sheet. We can often forecast a storm building as we see clouds forming and rolling in. We rely on weather forecasters, and the apps on our phones, to predict severity, and how much snow or rainfall we should be prepared for. Only when the storm has passed can we assess the true impact. 2022 proved to be a volatile year, a little more so than we originally expected. However, as of the time of this writing, the market has managed to weather it. We also saw Russia invade Ukraine, disrupting energy markets and further complicating supply chains. Not on our bingo card for 2022 at the start of the year.
The major theme of 2022 was inflation and the Federal Reserve’s attempt to reign it in by raising the reserve rate and unwinding their balance sheet. They pushed an unprecedented amount of rate increases into the market. This in turn thrust an unusual amount of volatility into the bond market. To compensate for interest rates moving higher, the price of those bonds must move down. 2022 will prove to be one of the worst return years on record for the bond market. The pain withstood this year was required to restore the bond market to one which resembles one with more normal characteristics. Today the fixed income market offers a yield not seen since prior to the global financial crisis.
How did we get here with regard to inflation? For most of us, 2022 was a return to more normal times as we reemerged with society and learned to live in a world with COVID. We became more comfortable going out, taking that trip, and returned to a time when we did not have to remember where we placed our mask. Unfortunately, financial markets are still dealing with the fiscal response to the pandemic. In response to the pandemic and shutdown of the economy, a significant amount of money was printed and thrown into the economy. This was accomplished in the form of both direct payments and fiscal support to state and local governments. At first, most of the money sat in individual bank accounts, moving up saving rates. As the economy began to open and normalize, this money was put into the economy and increased the demand of goods. Central banks around the world did what was needed at the time to combat a seize up of liquidity at the onset of the pandemic. There will be plenty of Monday morning quarterbacking about the amount of money created to combat the pandemic. This will be hindsight bias, and not a fruitful exercise. What is done is done and we move forward. High demand, with cash to spend, was chasing a scarce amount of goods while moving through a supply chain which could not meet the demand surge or manage through how different countries used their own tactics to fight the spread of the virus.
2022 has been about trying to remove some of that liquidity, or put a better way, remove some of the excesses in the system created by the pandemic response. The Federal Reserve has limited tools which act to drain liquidity. First, as the economy was overheating, they started raising the overnight lending rate between banks. As these increases work their way through fixed income markets, rates across different fixed income instruments move higher. The Federal Reserve also became a buyer of securities again and in a big way during the pandemic. This helped to provide liquidity to the market. Beginning in the summer, and picking up steam in the fall, they began to sell those securities held on their balance sheet. Buying securities in the open market is seen as a tool to provide liquidity and spur demand, while selling securities is a tool the Fed uses to drain liquidity and curtail demand in the economy. The move from quantitative easing (buying) to quantitative tightening (selling) may turn out to be one of the most significant changes in monetary policy since the 1980s. The experiment of quantitative tightening (QT) we believe, will put more volatility into the financial markets in 2023. The buying program took the Federal Reserve balance sheet up to over $8 trillion and we have never experienced an unwind to this magnitude.
We expect the Federal Reserve to slow, then eventually stop raising rates in the first few months of 2023. This will allow them to step back and assess the slowing tactics put into the market already. Fiscal policy changes work on a lag and take time to feel the full effect of the action taken to date. While one measure to slow the economy will stop, we still see the unwind of the balance sheet and the selling of securities remaining in place.
As mentioned above, this year has not been your typical year in fixed income; with bonds having experienced what could be considered equity like downside. We feel the set up going forward is for bonds to act as a more traditional part of the asset allocation mix. We needed movement off the zero/low interest rate policy as this was unsustainable.
Equities had an equally volatile and challenging year. Rising interest rates played a part here as well. As rates rose and the appetite for the riskiest parts of markets waned, unprofitable, high growth companies sold off the hardest. We went through a valuation correction, with growth stocks enduring the most of the selling. We saw a shift to the value side of the market, outperforming growth for the entire year as of the writing of this article and a reversal of years of growth outperforming value. Investors began to favor areas of the market with more tangible asset basis like energy and industrials, as well as the safety of dividend paying stocks.
In the short to near term, we do not see the clouds abating just yet. Markets still will face uncertainty and depend on inflation coming down and the health of the labor market. As the monthly data comes in, the market will try to interpret how the data will influence the Federal Reserve and the market’s expectations for the path of interest rates. Thus far, the economy appears to be slowing as the Federal Reserve desires. We have seen many economic datapoints rollover this year like the Leading Economic Indicators Index, the ISM Manufacturing Index, Consumer Confidence Survey® as well as most associated with the real estate market. One area which has remained strong is the labor market. This presents a conundrum for the Fed. The labor market is tight with record low unemployment and high job openings. While wage growth has lagged inflation, the setup remains for wage growth to be elevated above normal for as long at the current setup exists. As the Fed tries to slow demand, conventional wisdom would dictate they want to see some deterioration of the labor market. We have started to see announced hiring freezes and layoff announcements. We expect to see more as we move through 2023.
Historically financial markets will anticipate a turn in the economy before we see it reflected in economic metrics. Both the bond and equity markets are forward-looking and will likely anticipate a turn in the economic outlook months in advance.
Understanding an investor’s risk/reward tolerance is a must. Therefore, we feel it is paramount for clients to maintain the appropriate risk-based asset allocation. Investors vary in the amount of risk they are willing to take on in return for a specific level of return. As volatility rises, we as investors often put a bigger magnifying glass on the risk part of this equation. For that reason, we feel it is prudent to maintain a diversified portfolio with exposure both here and abroad as well as across the market cap structure. We always keep in mind how the current situation may change our long-term thinking, and act accordingly.
Have conviction. Act with purpose.
As we gather with family and loved ones this holiday season, consider the rewards which surround us, the road we took, and the storms we weathered, to achieve that which we cherish.
If you have any questions or concerns, please contact your Atlas Wealth Management Advisor. They will be happy to discuss your specific situation with you.