Despite continued volatility, U.S. markets eked out positive returns in the fourth quarter of 2022. Equities were broadly higher in the fourth quarter with the S&P 500 and Dow Jones Industrial Average (DJIA) up 7.1% and 15.4%, respectively, in Q4 2022, while the tech-heavy Nasdaq Composite Index decreased 1.0%. That said, for the full year, equities posted their worst year since 2008 with the S&P 500, DJIA, and Nasdaq Composite down 18.11%, 8.78% and 33.03% for 2022, respectively. International equities did not fare better, noting the MSCI EAFE Index, as represented by Europe, the Middle East and the Pacific, was down 16.8% for the year. Fixed income securities were similarly impacted given the higher interest rate environment. For the full year, Bloomberg Barclays Intermediate Aggregate Bond Index, which broadly tracks U.S. investment-grade bonds, was down 9.51%. However, it increased 1.72% for the fourth quarter of 2022, which was its first quarterly increase since Q3 2021.
Looking ahead to the New Year, many of the risks that weighed on investor sentiment last year remain top of mind. Consequently, this sentiment could result in continued volatility as we move through 2023. Objectively, the key macro risks that dominated 2022 have seemingly worked their way into asset prices, an adjustment that could limit downside risk. Notably, COVID-19-related shutdowns impacting economic output are abating and while geopolitical risks surrounding Russia-Ukraine and China remain heightened, ostensibly the consequences and outcomes of those risks have been adjusted. Stateside, midterm elections have concluded, thereby lifting an element of uncertainty, and stubbornly high inflation has been met with rounds of interest rate increases by the Federal Reserve.
Moving through 2023, we expect sentiment to improve as confidence in the economy builds with incremental data points that show a path towards normalization. In particular, we expect to see positive momentum build as widespread supply chain constraints that persisted during and leading out of the pandemic continue to abate. This should provide added certainty to C-suites when making business decisions, ultimately resulting in increased output. While Chinese foreign policy tensions remain a concern, the recent relaxation of COVID-19 restrictions should result in economic output returning to pre-pandemic levels as infection rates subside over time, all else being equal.
While the Russia-Ukraine conflict remains fluid and implications of the war are unknown, the conflict placed upward pressure on prices, particularly in energy markets. Newcastle thermal coal futures (the benchmark for the top consuming region of Asia) is up more than 150% since the beginning of 2022 due to strong demand and tight global supply for coal used in energy production. Natural gas—measured by the Henry Hub (NYMEX)—peaked at US$9.71 per mmbtu in August 2022 and has since retreated 57.8% to $4.10 per mmbtu on December 31, 2022. Similarly, WTI crude oil peaked in early June 2022 at US$122.11 per barrel and ended the year at US$80.45, down 34.1% from its peak. In the U.S., the retreat in oil and natural gas prices has, in part, eased inflationary pressures for the time being.
The U.S. dollar is also alleviating inflationary pressures. The dollar strengthened across most major currencies during 2022, its largest rally since 2014. As measured by the WSJ Dollar Index, the U.S. dollar increased approximately 9% on a year-over-year basis. In fact, in late September this relative strength had not been higher dating back to 2001, and while it has given back roughly half this gain since then, it remains elevated. Given the ubiquity of the U.S. dollar in global trade, elevation of the standard has placed pressure on international economies. This strength bodes well, though, for inflation domestically, as a stronger U.S. dollar improves purchasing power for Americans given cheaper import prices.
While inflation is running at multi-decade highs, we believe that it has peaked and is retreating, albeit slowly. Anecdotal evidence is showing the Fed’s actions are tempering demand. Consumer confidence is fading, retail sales growth is slowing, and corporations are adjusting staffing levels to meet lower levels of demand, all while housing prices and demand are easing. Instigated by the Fed’s aggressive monetary policy tightening cycle, mortgage rates have more than doubled in the past twelve months with 30-year fixed mortgage rates peaking in November at over 7% for the first time in over two decades. The increases have resulted in a more cautious buyer and housing prices have accordingly adjusted lower.
Inherently, the Fed’s actions are intended to cool the economy. A higher interest rate environment should reduce demand and lower economic output. While it is impossible to predict the magnitude and duration of an economic contraction, the probability of some level of recession is high. Traditionally there are long and variable lags between when the Fed tightens and when those measures impact the economy. Therefore, it is hard to predict when an economic contraction will occur. However, for the aforementioned reasons, we believe a recession is likely.
While we are mindful of a potential recession, we continue to believe equities remain compelling and, since the onset of the bear market in November 2021, valuations have become increasingly compelling. To put valuations into perspective, based on one-year forward earnings multiples, the S&P 500 currently trades at 24.7x normalized EPS compared to 40.4x at the end of 2020 and to 33.9x on December 31, 2021. * While overall valuations are more attractive, we believe that active security selection in a portfolio context offers attractive potential returns above broader market index returns.
Evolve’s active equity investment strategy is rooted in focusing on companies that have strong business fundamentals, healthy balance sheets, and capable management teams that can grow their businesses profitably through the full business cycle so that those companies will compound their businesses, and, accordingly, their share prices, at a greater rate than the overall market. We only purchase positions in these companies when they trade at attractive valuations, and when they are relatively unattractive, we sell those positions in a mindful, deliberate fashion.
From a fixed income perspective, we believe that bonds are becoming more attractive. The current hawkish stance by the Fed could result in further downside; however, we believe that upside outweighs downside risk.
*Data compiled from S&P Capital IQ
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