In the fourth quarter of 2022, equity prices staged a rally to recover some of their losses for the year. The S&P 500 was up 7.55% in the fourth quarter, though the index still ended the year down 18.13%. Uncertainty surrounding inflation, the Federal Reserve’s course of action, and upcoming economic growth data have left the market range bound below its all-time highs. With the focus turned to the data, slightly lower inflation numbers were received positively, while strong labor market data was viewed more negatively, as many market participants expect that data needs to change before the Fed ends its hiking. In the quarter, the Fed increased the federal funds rate two more times, increasing the current target range to between 4.25% and 4.5%. In this high-rate environment, value outpaced growth in the quarter, with the Russell 3000 Value Index up 12.16% compared to a 2.31% return for the Russell 3000 Growth Index.
International equities outpaced domestic equities in the quarter. The MSCI EAFE Index surged 17.40%, surpassing the performance of the S&P 500 by almost 10%. After steadily strengthening throughout the first three quarters of 2022, the U.S. dollar reversed course in the fourth quarter, easing a headwind that had weighed on international markets. Additionally, some of the worst concerns regarding European energy stemming from the Russia-Ukraine war have not played out, as a warmer-than-usual winter and voluntary demand cuts have eased the hardship. European nations like Germany, Italy, and France all gained more than 20% in the period. Meanwhile, the MSCI Emerging Markets Index increased by 9.62%. The reversal of China’s zero-covid policies gave investors hope for the country’s re-opening, and the falling dollar provided benefits for emerging markets as well.
Fixed income also performed well in the quarter, with the Bloomberg U.S. Aggregate Bond Index ending up 1.87%. Corporate and municipal bonds both outperformed Treasuries, with high-yield corporate bonds returning over 4.75% in the period. The Fed has made it clear that it will continue its aggressive stance to bring down inflation, but the market seems to expect rates to come down a bit sooner. Inflation data has been slowly but consistently falling since June, with November’s CPI reading coming in at 7.1%.
Condor’s Market Outlook
With domestic equities up from their lows of the year, opportunity remains for investors focused on the long-term, though near-term volatility remains likely. Inflation continues to be a major concern for investors. While certainly still elevated, the last few readings have started to come down and the market’s positive responses to these readings have been notable. Additionally, interest coverage ratios are hovering around pre-pandemic levels, meaning companies are still financially well-positioned. While we expect corporate earnings will come down in the coming quarters, many high-quality securities do already seem oversold. We believe more opportunity exists for profit-making companies rather than the unprofitable growth names that thrived under the easy monetary conditions of the last few years.
While fixed income had a difficult year in 2022, the current environment is creating an attractive entry point for investors. While there is still debate as to how high the Fed will hike, interest rates are at levels not seen in years, allowing investors to earn a meaningful yield on their invested capital.
Much of the U.S. economic data does suggest that the Federal Reserve’s tightening is working. Home prices have slightly declined since June. Retailers have seen supply gluts rather than shortages. High inflation has stuck around for longer than the Federal Reserve and others had anticipated but has been cooling recently. However, the labor market remains strong, which is objectively a good thing, but does run counter to the historical relationship between inflation and unemployment. It also runs counter to the idea that the economy is slowing, which would allow the Fed to reverse its hikes. Wages continue to increase, and consumers are in good financial health regarding their use of credit. Delinquency rates remain at historical lows, and credit card balances, though increasing, have only risen to 2019 levels. The unemployment rate, a key macroeconomic indicator, is at its pre-pandemic level, while job openings are above their pre-Covid level but falling gradually. All told, the state of the labor market and its impact on the Federal Reserve’s decision-making will be an important development to watch in early 2023.
The housing market will likely continue to stall as long as mortgage rates remain as elevated as they are, and the same likely holds true for construction activity as well. There are signs of pent-up demand from potential buyers who have sat out in recent years waiting for prices to come down. These buyers should be ready to step in if prices fall further and this demand should limit any potential downturn, but housing does represent an area that could remain range-bound in the current rate environment as well.
The end to China’s zero-covid policy has the potential to be a boon for the global economy. The change in policy could cause economic activity in the country to rebound sharply, which could be very important in helping to offset the effect of slowing growth elsewhere in the world. However, China’s policy changes have been notoriously hard to predict and model. Even though the Chinese economy is massive, their policy unpredictability lends to our overweight view of domestic investments.
Moving into 2023, we remain cautiously optimistic. There is no denying that we are not fully out of the woods on inflation yet, and the global economy faces the threat of slower growth at least temporarily in the near future. However, due to the strength of the consumer, we believe that a recession may be avoided, and if there is a recession, it will likely be mild. It’s also important to consider that the market is a discounting mechanism and has spent the better part of the past year trying to price in a lot of this bad news. As we saw in the fourth quarter with positive returns across U.S. equities, international equities, corporate bonds, and municipal bonds, prices have come down and markets could be primed to rebound on any news that suggests that things are not as bad as expected. As always, we will continue to closely analyze economic data and corporate earnings as they come out and search for bargains throughout the market volatility to keep our clients best positioned for whatever the future may hold.