COMMENTARY BY JERRY HERMAN, CFA®

As we sit in the darkest days of the solar year, we are encouraged to know that the days ahead will have more light – the days will be brighter. And for the financial markets we are optimistic that this will be true in the figurative sense as well. 2022 was a year of recognition and reality - recognition that the stimulus endeavors of prior periods needed to be unwound and the reality that the process could be painful. 2023 offers opportunities and optimism - opportunities being presented in sectors and asset classes that we haven’t seen for some time and the optimism that the Fed will get it right and avoid a deep recession, and global and domestic political and social tension will ease.  

In 2022, the forces of pandemic-induced supply chain disruptions, exceptionally high consumer demand for goods such as housing, autos, and appliances, and services like travel and entertainment, combined with an energy shock brought on by the Russia-Ukraine conflict, drove inflation to its highest level in four decades! In June, the inflation rate hit 9.1% and averaged just over 7% for the year, more than double the historical average of about 3%. To combat inflation, the Fed increased interest rates seven times during the year to 4.25-4.5%, levels not seen since 2008. 

The year was difficult for investors. Facing the headwinds of rising interest rates, a very tight labor market, and capacity and supply constraints in many areas, the S&P 500 declined 19% in 2022, and was down as much as 24% at one point, officially entering bear market territory (as defined by a market decline of 20% or more). The more industrial and value-oriented Dow Jones Industrial Average was down 9% for the year, while the tech-heavy NASDAQ was off 33%. 

Fixed income, the traditional ballast to a portfolio, provided little shelter. The US Bond Index (AGG) was down about 13%. Bond returns have been negative for two years in a row, only the third occurrence of this since 1926. A hypothetical blended 60% equity/40% bond portfolio (comprised of SPY and AGG) experienced a loss of about 16% in 2022, one of the worst on record and only the third time in history when both stocks and bonds were down in the same year. Volatility picked up as well – there were 46 trading days the S&P 500 moved +/-2%; the most in more than a decade.  

Entering 2023, the Fed remains front and center as it attempts to navigate the elusive “soft landing” – driving inflation down without throwing the economy into a deep recession. With this, we cite several key issues entering 2023. 

First, the markets must digest the damage that will be caused by significantly higher rates to ease inflation and how it will be reflected in financial market pricing. Many powerful voices suggest that a recession is foretold; but at the very least there is an increasing likelihood of recession. If the Fed tightens too much and recession emerges, its depth will be reflected in earnings and market valuations. In short, conditions for equities remain uncertain near-intermediate term, but we remind investors that historical average returns for equities are 10%, and they also tend to serve as a hedge against inflation. Patience is key.  
  
A second key thought is to revisit bonds. Higher yields on fixed income are a gift to investors who have long been starved for income. Today, yields are available on higher-quality corporate debt that exceeds the historical inflation rate average of about 3%. There appears to be opportunities in bonds for income-oriented investors that have not been seen for quite some time.   

And another key issue is the Inflation debate. For the decade ending 2020, the average rate of inflation was only 1.7%. Higher rates should help bring inflation down, but a simple reversion to the historical mean suggests higher inflation rates will persist above levels of the past decade. Moreover, worldwide capacity constraints caused by geopolitical conflict and fragmentation, Covid and other issues: on-shoring and self-sufficiency initiatives, combined with an aging US workforce, may keep employment conditions tight creating pressure on prices. With this, investors need to consider protection against inflation. 

Bottom line: The backdrop entering 2023 is challenging and there may be the need to adjust as the year progresses. For now, we suggest that specific opportunities include short-term government bonds for income as U.S. two-year Treasury yields have soared. There are some attractive areas within investment grade 
credit – higher yields and strong balance sheets suggest that investment grade credit may be a good place to weather a recession. U.S. agency mortgage backed securities (MBS) can be attractive for their higher income and because they offer some credit protection. And if inflation persists it makes sense to consider inflation-linked bonds. In equities, recession is a concern. For now we prefer areas such as healthcare, and among cyclicals energy and financials offer opportunity.  After years of underperforming, value stocks are preferred over growth.