Market Commentary Q1 2023

2022 in Review

Investors found nowhere to hide in 2022: it was the worst year for equities since the Great Financial Crisis of 2008 and bonds recorded their lowest annual return since 1976. January 3, 2022 saw the S&P 500 index hit a record high capping a rally that began when Barack Obama was still president. But the first day of trading in 2022 was actually the end of over a decade-long stock market rally with the S&P 500 rising more than 800 percent since the first quarter of 2009.

Diversification, the investors’ ally, proved ineffective as the dominant market narrative broke down; namely that low inflation, low interest rates and unprecedented government intervention in markets and the economy would continue ad-infinitum and carry no consequences or tradeoffs. The fact that diversifying between bonds and equities did little to protect investor portfolios is symptomatic of just how unnatural market conditions were in 2022.

Looking under the hood, investors were simultaneously hit by demand and supply shocks that sparked runaway inflation. Markets mistook inorganic “sugar-high” COVID-era fiscal and monetary stimulus for real demand and extrapolated trends inappropriately into risk asset valuations making them highly vulnerable to a reset after equity markets rallied in 2020 and 2021 and bond yields reached multi-decade lows.

2022 saw markets recalibrate and re-price risk assets with concerns mounting as to whether a more hawkish Federal Reserve (Fed) had the potential for a policy mistake: overtightening just as growth stalls and driving the economy into recession. To fight against inflation at its highest point since 1983, the Fed would rather trigger a shallow recession now versus a deeper one later despite the potential for collateral damage to the economy and markets.

We believe we are currently in the eye of the hurricane. Exiting the eye will likely result in more turbulence ahead for financial assets. 2022 saw the first phase of the storm revolving around inflation, interest rates and asset valuation compression from peak levels. For 2023, unfortunately, the second phase might be about higher unemployment, declining corporate profits and falling economic output, which can be a challenging investment backdrop. We do see opportunities emerging following some of this downside potential in capital markets, rewarding patient investors during a year likely to be rife with change.

Watching the Fed

The Fed and most global central banks began the process of tightening central bank policy rates in 2022 with resulting economic growth slowdowns in China, Europe and the U.S. The Fed raised their target Federal Funds Rate from a range of 0 percent to 0.25 percent to 4.25 percent to 4.5 percent as it sought to counter a combination of multi-decade high inflation and multi-decade low unemployment.

The Fed also began the process of “quantitative tightening” or shrinking its near $9 trillion balance sheet by not reinvesting roughly $95 billion per month of maturing agency mortgage-backed securities and Treasuries.

As a result, Treasury prices plummeted in 2022 and yields soared with the two-year yield rising by 370 basis points (3.70 percent) and the 10-year yield up 237 basis points (2.37 percent). Predictably, the two-year minus 10-year Treasury yield gap entered a sustained yield curve inversion early in Q3. By the end of 2022, the gap stood at 55 basis points (0.55 percent) and fears of a 2023 recession rose accordingly. For the year, the diversified Bloomberg Barclays Aggregate bond index fell by 13.01 percent.

Not Yet Out of the Equity Woods

The speed of equity market resets has taken investors by surprise but, overall, we believe it has been an orderly and rational process in terms of where we stand at the start of 2023.

Most of the damage has been a negative 25 percent compression in asset valuations due to higher real interest rates which reduce the future value of earnings. While corporate earnings have been resilient so far, we expect earnings to struggle going forward.

U.S. equity market valuations hit 21 times forward earnings at the beginning of 2022 but, by year-end, had re-rated to the 15-16 times long-term average and a 30 percent valuation premium had been removed. We believe the re-rating back to long-term valuation levels is a healthy development despite the pain of equity market contractions because lower valuations carry lower expectations and a better risk/reward proposition after speculative excesses have been removed. In 2022, markets were priced for perfection and investors were complacent—extrapolating easy money as a sustainable “new normal”.

In terms of corporate earnings, consensus market expectations for 2023 appear optimistic based on the macro challenges ahead. We expect significant ongoing downward revisions to 2023 estimates based on demand destruction from higher prices, mean reversion from outsized earnings during the COVID pandemic, operating leverage exhaustion, and negative impacts from a strong U.S. dollar.

Additionally, we expect that lower margins will result from higher labor and input costs, lingering supply chain issues and weaker productivity. We believe consensus expectations for 2023 are too optimistic based on these macro challenges and we remain cautious regarding equity risk assets as prices have yet to reach the point to fully compensate for risk despite 2022’s pullback. The fundamental earnings backdrop is still too optimistic and needs to be reset. An earnings recession as economic growth slows could lead to further downside movements in equity markets.

Fixed Income Outlook: Passing the Baton – A Shift from Interest Rate Risk to Credit Risk

While bond prices fell across the board in 2022, the positive result is an investor-friendly environment featuring some of the highest yields on investment-grade fixed income assets since 2009. Investors, however, should be thoughtful in security selection and should benefit from a focus on higher-quality securities.

In terms of bond market risk, the story has flipped from interest rate risk in 2022 to credit risk in 2023 as the lagged effects of Fed policy tightening may weigh on overall economic growth and, ultimately, may impact bond credit fundamentals. Very simply, interest rate risk stems from rising interest rates causing bond prices to decline. Credit risk stems from the yield spread above that of a risk-free asset, such as a U.S. Treasury, increasing as a result of deteriorating credit fundamentals thereby causing bond prices to decline.

In 2023 interest rate risk should diminish and may even become a tailwind for bonds due to an anticipated end to the Fed’s tightening cycle sometime in 2023, decelerating economic growth weighing down bond yields, and inflation declining from near multi-decade highs although probably still elevated relative to pre-pandemic levels.

As a result, we are no longer negative on interest rate risk—in fact we are comfortable with interest rate risk—however we are concerned with credit risk and hence advocate an up-in-credit quality bias across all fixed income asset classes.

• Our U.S. Treasuries rate outlook acknowledges that markets have priced in two to three Fed rate hikes during the first half of 2023 for a total of 50 (0.50 percent) to 75 basis points (0.75 percent) of additional rate hikes. We anticipate this to be followed by a fairly aggressive Fed Funds rate-cutting cycle beginning in late 2023 or early 2024 and picking up steam in 2024 with over 100 basis points (1.0 percent) of rate cuts priced into the markets in 2024, assuming inflation continues to decline.

  Given the long and variable lags that changes in monetary policy have on the real economy, once the Fed reaches their terminal rate, or stopping point, the lagged effect of their last rate hikes likely won’t be felt in the economy, by some estimates, for another six to 12 months.

• Short maturity interest rates are influenced by Fed Funds forward expectations and are pricing a path to roughly a 5 percent Fed Funds rate by mid 2023. That leaves the Fed Funds rate roughly 2.5 percent into restrictive territory. As such, we expect short rates are unlikely to move substantially higher unless inflation proves even stickier and requires a more aggressive Fed Funds policy than current expectations.



• Intermediate and long maturity interest rates are influenced by many factors. Notable variables pushing rates lower include slowing economic growth; declining inflation and inflation expectations given slowing growth and aggressive Fed policies; and increased demand from domestic investors seeking attractive yields.

  On the other hand, rates can be pushed higher and bond prices can sell off due to weak foreign demand given a strong U.S. dollar or higher yields abroad, high currency hedging costs, and better economic growth combined with persistently sticky inflation. Ultimately, the slowing economic growth influence should win out and intermediate and long rates are at the high end of their range and may modestly decline as the year progresses.

  If inflation proves stickier, short rates may trend modestly higher, but that will result in more aggressive Fed policy actions which should weigh on the growth outlook and continue to weigh on longer maturity yields.

Parsing the Fixed Income Spectrum

• In Corporate Credit we prefer higher credit quality and less cyclical bonds and issuers which tend to perform better in a period of slowing economic growth. We are less favorable towards below investment-grade (i.e., high yield) which tends to underperform during a recession.

  Corporate balance sheets appear to be robust but several factors including slowing growth, stock buybacks and M&A activity may lead to declining credit fundamentals. Companies that have not refinanced near term debt maturities or need to raise additional debt funding will likely pay higher interest rates in the year ahead (relative to the past couple of years) thereby impacting credit fundamentals.

• Our Securitized outlook is favorable towards agency mortgage-backed securities (MBS) as we believe interest rate pressures will stabilize in 2023 leading to declining interest rate volatility which is favorable for mortgage-backed securities. Other advantages of agency MBS are virtually zero credit risk given an implicit government guarantee and minimal new issue supply pressure as well as little interest rate-related prepayment risk given current mortgage rates that are substantially higher than the vast majority of outstanding mortgages.

  Agency MBS should be a key beneficiary of our thesis of passing the baton from interest rate risk (which agency mortgages have) to credit risk (which agency mortgages do not have).

• Our Municipals outlook favors A-rated or above credits and avoids below investment-grade municipal bonds. Given the lag between declining economic growth and the deterioration of municipal credit fundamentals, it is prudent to upgrade quality ahead of a potential economic slowdown. Slowing economic growth and higher interest rates should weigh on lower credit quality issuers and municipalities.

  Sectors such as essential services revenue bonds and general obligation bonds issued by strong states and municipalities appear particularly attractive. We would avoid municipal sectors where rising costs, especially wages, may weigh on credit worthiness such as small healthcare-related municipals.

  We expect valuations to remain mixed within the municipal market and opportunities must be evaluated on an after-tax or tax-equivalent basis. These considerations highlight the need for investors to work with their advisor to determine the best after-tax bond options.

Strategies for 2023

While we believe a “garden variety” recession is mostly priced into current market levels, we still need to overcome significant challenges, including the risk of a deeper recession due to Fed overtightening as growth stalls. Because fighting inflation is the Fed’s top priority, the Fed is unlikely to support asset markets through looser monetary policy as it did in 2020 and 2021 by cutting rates to near zero percent.

Markets are in the process of adjusting to a new environment: the need to stand on their own without government support via cheap subsidized credit which severely distorted market prices, misdirected capital allocation, and led to unsustainable asset levels. 2022’s market jolt and reset are the resulting withdrawal symptoms.

While the typical economic growth/recession/recovery cycle averages around ten years, we are experiencing a mere two-year cycle as the COVID-spawned sugar high from fiscal and monetary stimulus measures wanes and the hangover period plays out.

On the good news front, employment levels remain healthy and declining shipping prices are helping unclog supply chains. Unlike the 2008 crisis, corporations and consumers are flush with excess cash and the banking system is well-capitalized.

In terms of risk asset allocation, we believe it is best to stay defensive and wait for better entry points to re-engage after we get past some key clearing events and/or when much cheaper asset prices emerge. We are tactically cautious amid tightening financial conditions, escalation of geopolitical risks from Ukraine to Taiwan, and a challenged growth versus inflation outlook.

Fixed income, where yields are near their highest point in a decade or more, may offer investors a chance to “get paid to wait” for new reentry points for equity risk assets. Specifically, we find opportunities in:

• Short maturity investment-grade bonds which feature minimal interest rate risk and high yields, due to the inverted yield curve. Investors, however, need to be aware of reinvestment risk and the potential for limited price appreciation should interest rates begin to fall.
• Intermediate and longer maturity investment-grade fixed income which allows locking in competitive yields for longer periods, minimizing reinvestment risk and may also result in significant exposure to changes in interest rates resulting in potential price appreciation or depreciation depending upon an investor’s interest rate and credit spread outlook.

For each of the short, intermediate and longer maturity fixed income options, we suggest a focus on higher credit quality issues, specifically U.S. Treasuries, Agencies, and Agency mortgage-backed securities; highly rated investment-grade corporate bonds and commercial paper; and highly rated taxable and tax-exempt municipal bonds.

As often happens in capital markets, the pendulum swinging between optimism and pessimism can extend too far in either direction. Given our macroeconomic and growth momentum concerns, we could see investors overreact and push asset prices lower, opening opportunities later in 2023. We will keep you posted on our viewpoints in what will likely remain a dynamic investing backdrop.

2022—Nowhere to Run, Nowhere to Hide

Nothing rattles investor decision-making more than unexpected and significant market volatility. While emotionally unnerving, pullbacks are a natural and inevitable function of a healthy market and, generally, don’t undermine the long-term potential of a well-diversified portfolio.

Corrections are the norm: when they do not occur, risks build up. The price of admission to the potential for compounding growth is a negative 20 percent equity bear market every few years. Not only should investors resist overreacting to negative and unexpected events but they should also avoid taking on too much risk when the waters appear safe and calm. A key question to ask investors and their advisors is “Are you being compensated to take on risk?”

Finally, we encourage investors to maintain a stay-the-course approach toward their long-term strategic goals and objectives and to focus on protecting and building wealth as well as proper diversification. Strategic and tactical asset allocation have pivotal roles to play to get to the ultimate destination. The beginning of a new year is a great time to work with your advisor to assess whether your portfolio needs to be rebalanced to take advantage of potential mispricings amid current volatility and economic dislocations.

The Private Bank at Union Bank offers personalized investment strategies, flexible solutions, and a wealth of resources from a partner you can rely on. Find out more about our investment solutions for wealth clients.

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