2022 in Review and a Look Ahead to 2023
By Kristy LeGrande, CFA, MBA and Frank Cornett, CFP®
Consistent negative headlines throughout 2022 were tough on investors. We experienced the worst bond market in modern history, by a wide margin. We also experienced the worst year for the S&P 500 since the global financial crisis in 2008 and the fourth worst period on record since the index expanded to 500 companies in 1957. The popular FAANG stocks of the 2010s, Facebook (Meta), Apple, Amazon, Netflix, and Google, were down an average of 46%. The S&P 500 recorded its third most volatile year in the last 40, as 87.3% of all trading days in 2022 had swings of more than 1%. As we look ahead into 2023, many questions remain unanswered, but we believe investors should focus what they can control: reaffirming investment objectives, understanding downside risk, rebalancing to policy targets throughout the year, and maintaining exposure to strategies that will do well in various economic outcomes.
Equity markets – reducing exposure now could result in missed up-side
No one can predict when the stock market will bottom. 2022 is also not the first time we have seen negative stock market returns. While past performance never guarantees the same results in the future, previous downturns have often been followed by strong subsequent returns, as depicted in the chart below. Down markets provide periods of opportunity over a longer time horizon. To ensure our clients experience the upside of economic expansion, we recommend maintaining current equity allocations, assuming that risk tolerance has not changed and long-term investment objectives remain intact.
Source: SSGA Student of the market
Diversified global equities are a pillar in most portfolios, providing growth over the long term. They can be critical in helping investors to meet long-term return objectives. The U.S. Stock market has cumulatively outperformed international markets for the last 15 years, and geopolitical tensions abroad have lead some investors to question the benefit of international equities in their portfolios. However, from a valuation perspective, many international companies are still more attractive than their U.S. counterparts. The U.S. stock market is trading just above its 25-year average, based on a price-to-earnings ratio (P/E) – essentially, how much an investor is willing to pay for every $1 of company earnings. Europe, Japan, China, and other emerging countries are all trading at or below their 25-year average P/E. Trading at these levels presents potential undervaluation, creating optimism and opportunity for positive future returns. International and emerging market equities should continue to play a role in portfolio construction moving forward.
Bond market yields are attractive once again
Interest rates have been at or near historic lows for the better part of the last three years, and expectations had been for rates to increase slowly over time. However, as inflation rose to 40-year highs in 2022, the Fed embarked on one of the fastest tightening cycles in history. In 2022 we saw seven rate increases totaling 4.25%. The listed rate hikes negatively impacted the face value of bonds, as the U.S. Bond Aggregate Index fell approximately 14% during the calendar year. But there is a sense of optimism in the bond markets, looking forward. While a rising interest rate environment decreases the bonds’ face value, as those bonds mature, the proceeds are reinvested into newly issued bonds that pay their investors a larger coupon (or yield) back. For example, 12-month bank Certificates of Deposit (CDs) currently pay a yield of above 4%. In years past, bonds have been primarily used as a tool to mitigate and potentially reduce volatility in portfolios; looking forward, we expect bonds also to provide attractive income generation.
Diversifying strategies provide protection in different economic environments
Investment advisors typically recommend a diversified portfolio to optimize its risk/return profile. Many of these strategies have lower volatility than equities and relatively low correlations to equities and bonds. It’s also helpful to think about these strategies in terms of their role in portfolios and how they typically perform in different economic environments. We believe a basket of inflation-hedging strategies – such as midstream energy, diversified infrastructure, timberland/farmland, and real estate – is prudent when constructing portfolios. They can add value to the portfolio should inflation continue at high levels and can also provide growth and income should inflation levels normalize.
We also utilize specific hedge fund strategies with the objective of providing better-than-bond returns over a complete market cycle. These hedging strategies are still attractive, but investors with a high allocation may consider reducing exposure into 2023, since the overall outlook for bonds is more promising.
In addition, allocation to the private markets – both equity and debt – can improve the overall risk/return profile of portfolios. Investors should pay close attention to overall portfolio liquidity as well as appropriate vintage year diversification.
Focus on what we can control
Investors can’t control geopolitical risks, economic outcomes, or market performance, amongst other factors, so we should focus on what we can control and what matters to portfolio performance in the long term. As we ease into our “new normal,” understanding our current place in the economic cycle, forward-looking portfolio construction becomes necessary. At Innovest, we value process over prediction and remain focused on the things that we can control and that ultimately matter in the end. We remain focused on confirming investment objectives and downside risk tolerance, asset allocation to appropriate markets, ongoing portfolio rebalancing, tax loss harvesting where possible, and providing excellent customer service. We are looking forward to working with you in 2023.