After declining for most of the year, both bond and stock markets produced positive returns in the final quarter of 2022. Almost all asset classes contributed positively in the fourth quarter. Nevertheless, the year overall was one of the worst on record for investors as the Fed continued to withdraw large amounts of liquidity from the system in the most aggressive tightening cycle since the 1980s.

A bullish narrative fueled stocks in the fourth quarter as inflation slowed and investors sensed a Fed pivot on the horizon. However, that notion faded as it became apparent that the Fed will likely remain hawkish into 2023 as some pockets of inflation remain sticky—specifically within the service sector.

Throughout 2022, stocks lost value even with five separate bear-market rallies. Energy was the only sector solidly in positive territory, while the utility sector managed a small positive return. There was a huge spread in sector leadership, with energy up 65% and the next-best sector, utilities, up 1.5%. Other defensive sectors did relatively well, including health care and consumer staples. Growth sectors including technology, communication services and consumer discretionary underperformed drastically amidst higher rates and the popping of the stay-athome bubble. Emerging markets were hurt by a strong dollar. Finally, bonds were unable to provide their usual shelter from equity volatility amidst a backdrop of seven interest rate increases.

The year was characterized by increased market volatility and GDP growth slowing from the white-hot economy of 2021. In the US and abroad central banks continue to raise short-term interest rates to slow consumption and inflation. Growth in the US was supported by private fixed investment, despite the slowing housing market and decreased government outlays. Consumers contributed handily by driving the savings rate down from 7.5% at the beginning of the year to 2.4%—its lowest level since 2005. The labor market added over 4 million jobs, pushing the total number of jobs past the pre-pandemic high. But 10 million job openings remain, supporting higher wages—in direct opposition to the Fed’s tightening campaign.

Going forward, most economists expect GDP to stall or decline slightly in the coming year as consumer firepower wanes and corporations lose the top-line pricing power that has been driving revenue growth. Additionally, housing and its huge multiplier effect on economic growth is expected to continue to contract due to a lack of affordability.

The Fed remains resolute in their campaign to crush inflation at the expense of the labor market, meaning they will allow unemployment to rise while trying to get prices under control. The discrepancy between market expectations for Fed policy and the Fed’s own guidance has never been more pronounced, with the market expecting rate cuts in 2023 despite Fed officials’ persistent message of “higher rates for longer.” The majority of Fed members currently see the peak Federal Funds rate for this cycle between 0.50% and 0.75% north of its current rate of 4.5%.

Over the past 12 months, stock valuations have adjusted downward and are now trading at more reasonable values for the current environment, yet they remain unsettled. Corporate earnings and margins are likely to deteriorate as the lagged effect of higher rates filter into the economy. The effect of tightening takes times to impact economic growth, a slow grind, and we expect that to play out in 2023 through reduced earnings growth. The outlook for bonds is much more promising, offering investors substantially higher income along with depressed prices.

Tandem constructs portfolios by adhering to a structured investment management process, continually monitoring for risks. Success for clients results from a disciplined approach to investing in all markets. While the current environment is challenging for investors, a long-term focus remains essential.