Many investors consider 2022 to have been a disaster as almost all asset classes finished the year with negative returns. However, it may be better to think of it as the year that yields returned to normal.
The investing period from the start of the pandemic until the end of 2021 was not normal and the returns investors realized in that period were mainly a function of the increase in money supply from governments and global central banks.
But even before the pandemic, markets weren’t “normal” as globally yields were kept suppressed. In hindsight, the massive value of bonds that had negative yields was far from normal.
This period of ultra-low interest rates affected all asset classes and allowed valuations to explode in the riskier areas of the investing universe (SPACs, speculative tech, NFTs, etc.). For bond investors, during these years, the trade was simply to be long duration and be content that even through returns were low, there wasn’t inflation to worry about.
Everything changed in 2022 as global central banks finally decided to turn off the taps and address the inflation threat that had exploded onto the scene.
As we put 2022 in the rearview mirror, let’s look back at what the central banks have accomplished. In the U.S., the Federal Open Market Committee embarked on an aggressive rate hiking cycle, taking the Fed funds rate from 0% at the beginning of the year to 4.25% at the December meeting.
Other central banks followed a similar path, and with inflation looking to have peaked, are all signaling that they are near the end of their hiking cycle. Yet no one should expect rate cuts anytime soon—this is the new normal, and investors must adjust with the times as the playbook has changed.
The resulting returns for many investors last year were painful if they could not, or were unable, to adjust quick enough. As yields spiked, investors that had been overexposed to long-duration assets were hurt.
Moreover, growth stocks, which had become a crowded trade globally, were unwound violently with the Nasdaq falling in every quarter of the year, finishing down 33%, after 10 straight years of gains. But losses were not just concentrated in technology, as the traditional 60/40 portfolio posted its worst annual return ever.
However, 2022 returns must be taken in context of the last three years. The fake or manipulated gains of 2020 and 2021 had to be unwound. In many cases, that work is close to complete as during the year many markets came close to levels last seen in 2019.
This year, most expect central banks to pause their hiking plans and return to neutral, but that doesn’t mean we’re going back to an investing environment similar to the one before 2022.
Yields should remain elevated for some time. Just because inflation has dropped from 8% to 6% doesn’t mean its threat is over. Getting inflation down to the 2-3% target level is going to be tougher and will take time.
This is gamechanger when looking at where to allocate capital. The risk-free rate—by which all investment choices are compared against—is now over 4%, after sitting at zero for years. Cash is no longer trash: when money market instruments yield over 4%, it’s a viable investment once again.
In the fixed income world, investors experienced their worst returns since the 1930s. The only way to outperform was to stay short duration and avoid the long end of the yield curve. The question as we enter 2023 is whether we have seen a peak in bond yields.
The US 10-year bond yield moved from 1.5% to 4.5% during the past year. With inflation remaining close to 7%, it is unlikely we see it fall back much from these levels, as historically bond yields are higher than the rate of inflation. Consequently, investors may want to consider remaining with a shorter-duration positioning.
Real assets were one of the few asset classes that saw positive gains in 2022 and look to continue to do well in the next year. It all really comes down to supply and demand.
There just isn’t new supply available for many commodities. With Russian supply restricted in many parts of the world and China demand ready to increase as they move beyond their Covid zero policies, prices should remain elevated through the next year (which will be another hurdle for inflation to fall).
Within equities, value outperformed growth last year and should once again. Many of the winning stocks from the last cycle (e.g., FAANG) have fallen over 50% from their highs while the stay-at-home winners from the pandemic (e.g., PTON, ZOOM, SHOP) are down much more.
But they remain far from value, and as cycles end, it’s very uncommon for the previous leadership stocks to resume their position as the winning sector. With broad equity indices remaining heavily exposed to the growth factor and these names, we should expect to see an environment in which active security selection and sector rotation outperforms.
Back at home, the Canadian market outperformed the U.S. market for the first time in many years. This has a chance to continue as the S&P/TSX remains underexposed to technology and is overweight on cyclicals. The largest risk to the Canadian market would be in the financials should a prolonged recession emerge.
Similar to the Canadian story, international equities look strong in comparison to the U.S. markets. Their valuation discount remains at historic levels and any change in sentiment towards these regions should cause impressive gains, as many investors have ignored this area for years.
With so many cross currents underneath the surface, one prediction that should seem a safe one to make is that volatility will remain elevated.
In addition, the pandemic pastime of retail investors gambling on meme stocks has shifted to a focus on index options trading, resulting in the creation of single-day options on many of the broad indices and volumes close to all-time highs. The December options expiry saw the largest number of contracts trade ever in a single day. This is not an environment conducive to a period of calm markets.
Putting it all together, 2023 looks to be another challenging year for investors. A recession seems difficult to avoid at this point, but the good news is that fact should surprise no one and be fully priced into valuations. One of the positive surprises in 2022 was that corporate earnings held up much better than feared.
In order for equites to show a positive price performance this year, they will need to show growth. Valuations have been compressed back to normal levels but don’t seem ready to expand without a collapse in yields. If earnings fall, it will be difficult to see prices higher.
On the positive side, investor sentiment remains very bearish, which can be seen as a good contrary indicator. It’s difficult to find an outlook note for the coming year that is at all optimistic. That may end up being the correct call, but the market has a tendency of doing what makes the most people wrong.
With many positioned for a negative year, anything good is a positive surprise. Good news is good once again! It will be a year for headline watching with the hope that the North American economy has a soft landing and a mild recession. Inflation being more transitory and falling quickly would be a welcome outcome for central bankers.
On the earnings front, anything coming in ahead of expectations if companies are able to maintain operating margins is not being forecasted and would be cheered by analysts. Maybe most important of all, a lessening of global tensions between Russia and China with the west would increase investor optimism. If any, or all, of these events come to pass, markets may be on a verge of a good year, as at the moment no one is calling for that.
In the world of the new normal, we all must be prepared for the unexpected.
— Greg Taylor is the Chief Investment Officer at Purpose Investments
Sources: Charts are sourced to Bloomberg L.P.
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