The bear market in equities rallied in the fourth quarter, as inflationary numbers showed the first signs of easing off of peak inflation experienced during the summer. The S&P 500 rose from the lows reached late in the third quarter, recovering around 7% during the last quarter of the year. The S&P 500 closed out 2022 down 18.13%. The Technology-heavy NASDAQ lost 32.5%, while the DOW Jones Industrial Average lost 6.8% in 2022. The Russell 2000 Small Cap Index was down 20.4% over the same period. International developed market equities, as measured by the Morgan Stanley Capital International Europe, Australasia, and Far East Index (MSCI EAFE), closed 2022 down 14.45% in US dollar terms and lost 7% in local currency. The MSCI Emerging Markets Share Price Index closed 2022 with a loss of 20.09% in US dollar terms.
2022 saw high valuation technology, internet commerce and growth shares in general lag the overall market. S&P 500 sector results through 12/31/22: Energy 65.43%, Utilities 1.56%, Consumer Staples -.62%, Health Care -1.95%, Industrials -5.51%, Financials -10.57%, Materials -12.27%, S&P 500 -18.13%, Real Estate -26.21%, Information Technology -28.19%, Consumer Discretionary -37.03%, and Communication Services -39.89%. Rising energy prices saw oil and natural gas levered names lead the market as the only sector posting positive returns other than the defensive Utilities sector that posted nominal gains. Defensive and value sectors, such as Consumer Staples, Health Care, and Industrials provided some relative safety.
Based on current consensus earnings forecasts, the forward 12-month P/E ratio for the S&P 500 is 17.3X, slightly more expensive than the ten-year average P/E of about 17.1X. Currently, the market is estimating 5.1% earnings growth and 10.7% revenue growth in 2022, but analysts have already trimmed 2022 earnings forecasts down by 6.1% since the end of the third quarter. The average historical S&P 500 trough earnings multiple off of peak earnings has been 14.5X. This implies further downside for the S&P 500 in the single digits if we assume earnings will slow with higher interest rates, elevated inflation, dollar currency strength, and reduced economic growth hitting corporate earnings in the future. Calendar year 2023 earnings guidance from managements will be a primary focus in the weeks ahead in order to provide some clarity on rising rates and inflation’s impact to corporate earnings.
During their December 2022 meeting, the Federal Reserve initiating another 50 basis point fed funds rate hike. The December meeting marked the seventh interest rate hike in 2022, as the fed funds rate now sits at 4.25%-4.50%, the highest since 2007. Latest economic projections show an economy that is slowing following unprecedented stimulus during the pandemic. GDP grew 6.9% in 2021 and is expected to grow 1.9% in 2022 and .5% in 2023, revised down from 2.8% 2022 GDP projections in March, as inflationary pressures are beginning to slow discretionary spending and eroding corporate profit margins. As measured by the Consumer Price Index, annual inflation rose 7.1% in November, down from the 40-year high of 9.1% in June; indicating that we have probably seen a peak in inflation. All in, The Fed is willing to slow economic growth by increasing borrowing costs as it fights historic levels of inflation. Current forecasts are predicting a Fed Funds Rate around 5.0% by the end of 2023, 50 basis points higher than third quarter projections. Additionally, current consensus is starting to price in something greater than a soft landing for the economy. Bloomberg’s one year out recession probability forecast is now 100%, up from 60% at the end of the third quarter.
The 10-year treasury staged a historic sell-off during 2022; starting the year at 1.51% and ending the fourth quarter at 3.88%. Current intermediate treasury rates are now back to levels last seen in 2009. Longest duration bonds underperformed shorter duration issues as yields rose across all maturities. Long treasuries lost 29.26% in 2022, while intermediate treasuries lost 7.77%. In a risk-off trade, higher credit quality outperformed the lowest credit quality issues. Aaa rated bonds within the Barclays U.S. Aggregate Index lost 13.98% in 2022, while Baa rated bonds lost 18.61% during the same period.
The Bloomberg Dollar Spot Index strengthened 5.9% in 2023 as the Fed initiated five interest rate hikes and currency markets were jolted by the invasion of Ukraine. Light crude oil futures rose 14.6% in 2022 as the Ukrainian invasion further constricted oil and gas supply. WTI oil futures rose from $70.38 at the end of 2021 to $80.26 at the end of the year but have fallen from the highs of $112 seen in June of this year. 30-year mortgage rates rose from 3.27% at year-end 2021 to 6.66% at the end of the year, while 30-year treasuries rose 206 basis points from 1.90% at year-end 2021 to 3.96% at the end of the third quarter.
According to the Bureau of Labor Statistics, the November employment report showed 263k jobs gained during the month. The report surpassed estimates for a gain of 200,000 jobs. The November Jobs number reported unemployment at 3.7%, approaching the February 2020 pre-pandemic rate of 3.5%, a 50-year low. The labor force participation rate in November was 62.1%, up from the pandemic trough of 60.2% in April of 2020. For November, hourly earnings rose 5.2%, as wage pressures are contributing to inflation. The still hot jobs market, despite the Fed’s hiking policy, is keeping pressure on the Fed to raise rates higher and for longer than planned.
Retail sales in November decreased .6% from the prior month, worse than estimates for a .3% decline as consumers pulled back spending in response to inflationary pressures. Annualized retail sales were up 6.5% over the past year compared to the consumer price index’s measure of inflation up 7.1%. Gasoline sales’ hit to discretionary spending was still evident with a of 16.2% increase from the prior year but was down 4.9% from the end of the third quarter. Department store sales were down 3% from the prior year. E-commerce and mail-order houses ended the 12-month period with a 7.7% sales gain. Auto sales were up 1.3% from the prior year. Restaurant spending was up 14.1%, furniture store sales were down 3.2%, health care spending was up 4.5% and clothing and accessories were up .7%. Despite a return to spending on restaurants and services since the pandemic shutdowns concluded, we expect real consumption growth to slow over the coming months, especially for big-ticket items related to housing.
Equity markets rebounded off of June market lows during the fourth quarter as stock market bulls bought the first signs of a peak in inflation expectations on the belief that the Fed’s tightening cycle will end next year. In our opinion, equity market levels should reflect expectations on the future path of earnings and move away from the equity market’s current focus almost solely on levels of interest rates and fed action. While forward P/E multiples have come down following the current market correction; a key question is have they come down enough to discount a confluence of economic challenges as the Fed moves the economy away from the easy money and stimulus spending of the past decade? One reason for our caution is the disconnect between Wall Steet analysts, who have yet to price in any appreciable decline in forward earnings estimates for 2023 or 2024, with Wall Street strategists who are not yet convinced that current projections for earnings growth in both 2023 and 2024 will hold. We prefer to wait on the real possibility for downward earnings revisions, beginning with this quarter’s earnings season, before getting more constructive on equity markets. However, equity markets have discounted a considerable amount of economic uncertainty during the current bear market and are well through most of this painful correction.
Within the fixed income markets, March initiated a major shift in Fed policy as interest rate liftoff began in March while Fed meeting notes indicated $95 billion in monthly runoff of their $9 trillion bond portfolio beginning in May. With core inflation running above 6%, the path to higher interest rates has moved significantly since the beginning of the year. Treasury market rates have shot up following these developments as the 2-year treasury started 2022 at .73% and has risen to 4.36% today. The 10-year treasury rose from 1.51% at year end to 3.70% today while the 30 year treasury has moved from 1.90% to 3.81%. Fixed Income market strategists now see the fed funds rate hitting 5% by year end 2023, while remaining above 3% well out to 2025. The Moody’s Seasoned Aaa Corporate Bond yield, currently at 4.68%, is at the highest levels seen in a decade, but has fallen from recent highs in November as inflation is showing signs of slowing and investors are starting to anticipate a rate environment that might be peaking. In our opinion, the fixed income markets now offer yields that provide an alternative to equity only investing that has not presented itself in the last decade’s low interest rate environment. They also offer defensive positioning to higher probabilities for a coming recession and the potential for lower corporate earnings in the near term.
As always, we appreciate the opportunity to assist you in meeting your investment goals. Please let us know if you have any questions regarding your account or the capital markets.
Data Sources: Economic: Based on data from U.S. Bureau of Labor Statistics (unemployment, inflation); U.S. Dept. of Commerce (GDP, retail sales, housing); Institute for Supply Management (manufacturing/services). Factset (S&P 500 statistics); Performance: based on data reported in Bloomberg (indexes, oil spot prices, foreign exchange); News items are based on reports from multiple commonly available international news sources (i.e. wire services) and are independently verified when necessary with secondary sources, such as government agencies, corporate press releases, or trade organizations. All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied upon as financial advice. Forecasts are based on current conditions, subject to change, and may not come to pass. Past performance is no guarantee of future results. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.