Bonds are Back

Market Update for the Quarter Ending
December 31, 2022

It was a miserable year for bonds. The bond market meltdown of 2022 has gone down in history as the worst ever, with the Bloomberg U.S. Aggregate Bond Index down 13.1%. To find losses anywhere near as deep, you’d have to go back to the 12-month period ending March 1980, when the index was down 9.2%. The index was created in 1972, but in the decades prior it is difficult to find any period as challenging as the one we just experienced[1] [2].

Much of the loss can be explained by historically low bond yields entering the year. As of December 31, 2021, the 2-year and 10-year U.S. treasuries yielded only 0.7% and 1.5%, respectively. Bonds usually generate most of their return from yield, rather than appreciation. These near-record low yields would provide no cushion, or margin for error, should bond values depreciate from rising interest rates. The fact that the Federal Reserve raised interest rates throughout 2022 at the fastest pace in decades to fight inflation created the perfect storm of losses in the bond market.

However, the forces at play that caused recent losses are now positioned quite differently. Yields are sharply higher, with the 2-year and 10-year treasuries yielding 4.4% and 3.9%, respectively, as of December 31, 2022. The Fed is nearing the end of their “front-loaded” interest rate hiking cycle and may actually stop raising rates altogether in coming months.

Going forward, the math is quite favorable for bonds given that yields are substantially higher and the fact that longer-term, market driven interest rates may have already peaked in October. In fact, the Bloomberg U.S. Aggregate Bond Index returned 1.9% in the fourth quarter and is up about 6.5% since bottoming out in October. Interest rates should remain volatile in the near-term, but we believe the next 12-24 months look quite attractive for high quality bonds.

Stocks rebound since bottoming out mid-October

Stocks formed a new bottom in October, just surpassing the prior market low set in June. In October, investors worried that sticky inflation would force the Fed to continue hammering rates higher. But, it became clear throughout the quarter that peak inflation is behind us, and stocks rallied with the exception of some growth and technology companies. The tech-heavy (and lower quality) Nasdaq Composite Index declined 32.5% in 2022 and fell 0.8% during the quarter. Growth and technology companies continued to lag more traditional value-based sectors such as energy, banking and industrials.

The S&P 500 index declined 18.1% for the year, but gained 7.6% during the quarter. Small and mid-sized companies suffered similar fates. The Russell 2000 Small Company Index declined 20.4% last year, but returned 6.2% for the quarter. We do favor the higher quality S&P 600 Small Cap Index, which we added to at the October market low. This index was down 16.1% for the year, but up 9.0% in the fourth quarter.

International markets surprised many investors due to overly pessimistic expectations based heavily on backward looking performance. However, severe pessimism can be a springboard for superior future returns. With the restrictive and uber-strong U.S. dollar likely peaking in October near 20-year highs vs most foreign currencies, the impact on foreign holdings was quite positive. A weaker U.S. dollar not only supports U.S. companies, which have close to a quarter of all revenues generated overseas, but also aids foreign investments due to the benefit of holding companies in appreciating foreign currencies. Developed international markets, as defined by the MSCI EAFE Index, declined 14.4% for the year, but gained 17.3% during the quarter. The more speculative MSCI Emerging Markets Index declined 20.1% for the year, but increased 9.8% during the quarter.

The inflation fight is last year’s news

Headline Consumer Price Index (CPI) annualized inflation topped out in July at 9.1% and has steadily fallen over the last 6 months to 6.5% in December. Inflation has been sticky and has stayed higher for longer, and is the impetus behind the Fed’s restrictive policy and rate hikes. The Fed has continued to talk tough to ensure that peak inflation is behind us, but recent data shows inflation may be falling faster than many anticipate. Inflation over the second half of the year was considerably less than during the first half.

Media and politicians generally reference the trailing year-over-year CPI data because it is easy to understand, but we prefer to consider more recent trends to get an idea of what inflation will be moving forward. A rolling 3-month analysis shows a much more volatile and sensitive view and highlights the most recent data and trends. The chart below illustrates “core” CPI (all items less volatile food and energy) annualized on a rolling 3-month basis. The trend is firmly lower since June and showing that inflation is on the decline. This is bullish for both stocks and bonds because it provides cover for the Fed to slow or even pause rate hikes.

Data source: monthly core CPI data

Headline CPI inflation is falling even faster than core CPI due to declining energy prices. Food prices continue to increase, and services inflation remains elevated, while goods inflation is actually falling. The challenge in future quarters could be the opposite of inflation, which is deflation. Deflation is much worse than inflation because consumers stop spending altogether if they believe that prices will be lower in the future. The considerable rate hikes throughout 2022 are only beginning to impact the economy and supply chain bottlenecks are less of an issue, so this is worth monitoring over the next 12-18 months.

Earnings uncertainty

Possibly even more important than the Fed’s actions will be the corporate earnings outlook, which should become much clearer as management teams report earnings throughout January and February. 2022 earnings have been solid so far, but more details surrounding 2023 forward guidance is what investors are looking for at this point, as the market is always looking 6-12 months ahead. Management teams have shied away from providing detailed guidance during Covid due to the abundance of unknowns, so there is still great uncertainty for what lies ahead.

Analysts have already cut expectations for full-year 2023 earnings by nearly 9% from the peak target level back over the summer. If we are searching for a reason for stocks to challenge the October bottom, and possibly go lower, it would likely be a deterioration in 2023 earnings expectations.

There will certainly be winners and losers, and the energy sector will likely see the best earnings growth in 2023. One factor which is favorable heading into 2023 is the declining U.S. dollar. Fundstrat data and analytics estimates that the weaker dollar could boost earnings by 5-8% in the coming year. Other tailwinds include China reopening from extreme zero-Covid policies and supply chains easing[3].

For those intending to watch from the sidelines and wait for more certainty in earnings, Fundstrat estimates that since 1930, the bottom for stocks is, on average, 11 months ahead of the bottom for earnings. Thus, by the time earnings trough and start to increase, the stock market has historically already appreciated.

Finally, once we gain sufficient certainty surrounding 2023 earnings, it will be mid-year and 2024 earnings will become critical. Even if we see an earnings recession, we would expect that earnings will eventually resume the growth trend experienced since the 1980’s.

Global Asset Allocation Strategy

The strategy remains balanced, with a slight overweight to high quality small and mid-sized domestic companies. These companies remain “on sale” and currently priced at about the cheapest valuations of the last 20 years. Small companies also trade near the biggest discount to large companies on record. Just over a third of total stock exposure is invested in small and mid-sized domestic companies. We added to these positions in the first half of the year, and again at the October bottom. It should be noted that most of our small and mid-sized stock exposure is considered higher quality, in the form of the S&P 400 ETF and the S&P 600 ETF. Underlying companies must be profitable in the most recent 5 quarters.

We also selectively added to international positions in October to make sure we remain at target allocations. International companies were decimated through the first 9 months of the year for a variety of reasons as pessimism became extreme. However, the dollar’s pivot and turn weaker provided a massive tailwind for these companies and they became the biggest winners over the last 3 months. Europe’s warmer weather in the midst of the energy crisis combined with China’s sudden abandonment of Zero-covid policies also helped. The valuation of international companies remains quite low and would suggest stronger performance lies ahead. About a third of all stock exposure is international.

Entering 2022, with bonds set up for unfavorable results, we moved just over a third of the bond portfolio to “bond alternatives”, which are market neutral stock strategies, merger and acquisition arbitrage, event driven approaches, and other more conservative investments that could take the place of bonds and limit downside should rates increase. These positions were down nominally, but significantly outperformed bonds.

Remaining bonds were mostly short-term in maturity. These bonds were down substantially less in 2022, as they matured (or will be maturing soon) and were reinvested at the suddenly higher rates. As it turned out, inflation stayed higher for longer and the Fed countered more aggressively than anticipated, and interest rates increased substantially in a short amount of time. The move to bond alternatives and reliance on short-term high quality bonds paid off.

However, going forward, we favor traditional, high quality, and slightly longer-term bonds over the bond alternatives given that yields are considerably higher. We added to bonds twice during the fourth quarter (in mid-October and late-December) and mostly eliminated the bond alternatives. We also extended bond duration to lock in higher yields for longer and provide greater ballast should we experience an economic hard landing. As detailed above, bonds are primed for better results due to higher yields and because we are likely on the back-end of the rate hiking cycle. The Fed may actually decrease interest rates over the next 12-18 months.

It has been 15 years since the strategy has benefited from yields at this level. The cash money market rate is 4.27% and we have allocated close to 5% to this position. We are manually sweeping cash into the highest paying money market available multiple times per month to boost returns.

Focused Equity Strategy

After several years of growth outperforming value, 2022 was a year where growth got hammered while value was much more defensive and only down slightly. The S&P 500 Value Index declined 5.4% for the year, while the S&P 500 Growth Index declined 29.5%. The 5-year performance gap still favors growth, but historically buying companies at lower prices (value) tends to win out. The two strategies do tend to fluctuate in terms of performance and sequence of returns. Growth outperformed value in the 1990s, while value outperformed growth for the following decade. Growth, buoyed by lower interest rates and free money, outperformed once again in the 2010’s and during the pandemic. It would appear that we have seen another inflection, if the past year is any indication. Of course, past returns do not always predict future results, so we shall see if that performance persists.

There are five factors that have been shown by academics to explain short-to intermediate-term divergence of performance. Two are growth and value, as we have discussed here and in past newsletters. The others are “quality” – usually defined as stability and strength of the company – capitalization (or size), and country of domicile. Focused Equity tends to have a value bias, though we incorporate some growth into our stock evaluations, and we have a strong quality bias. International and mid-sized companies sometimes find their way into our portfolios, but that has not been our focus. However, given the continuing valuation disparities we may do more in this area in the future. High quality companies generally out-performed on a relative basis in 2022.

We executed a set of trades in October. We sold AT&T (T) and bought Verizon (VZ). This was driven in part by tax-loss considerations, as most accounts were showing tax losses in AT&T. Both companies are in telecommunications with the two of the nation’s three largest mobile phone networks, as well as local wireline and business telecommunications networks. AT&T had recently divested its Warner Media Group, though still has a small investment holding in DirecTV and operating exposure to Mexico wireless. We believe Verizon looks slightly better on valuation, its balance sheet (less debt), and business mix with less dependence on declining local telephone businesses. Otherwise, the two are very similar.

We also sold some or all of the SPDR and/or iShares S&P 500 ETFs (SPY and IVV) in many accounts, mostly to realize tax losses but also to reposition these ETFs into the iShares Core S&P 600 Small Cap (IJR) and the iShares Core S&P Value (IUSV) ETFs at roughly 2% each. We did this to gain both small cap and value exposure given what we believe have been unfair performance and valuation discrepancies between those types of companies and those in the S&P 500.

Looking ahead to 2023

Investors are increasingly pessimistic heading into 2023 and many economists are predicting an economic recession. Stock and bond declines of 2022 are fresh in the minds of most and recency bias makes more favorable expected returns hard to imagine. And, with good reason, as the “average” 60/40 stock-to-bond “balanced” strategy lost 16.0% in 2022, which is barely better than the 22.0% decline seen in 2008, and second worst on record going back to 1976[4].

But, since World War II, it is rare to see back-to-back negative calendar years in the stock market. Since that time, stocks have declined in 21 calendar years, but only 3 times in 2 consecutive years. Subsequently, some of the best performing stock market years follow these “down” years[5].

Stocks should remain volatile in 2023. There is a chance that stocks decline further and challenge the October bottom if earnings disappoint. This would be painful in the short-term, but likely provide an excellent entry point for compounding stronger long-term returns. Bonds are statistically set up for better performance in the year ahead and should be supportive of stocks. As always investors should take a 3-5 year time horizon to keep perspective – and even longer if possible. The 2022 crisis has now shifted to opportunities, and probabilities for above-historical mean returns are greater.

As always, we would be happy to discuss our thoughts on markets and the economy in greater detail. Please reach out with any questions at any time!

All the best,

The Team at APW, LLC

[1] “2022 was the Worst-ever year for U.S. bonds.” Greg Iacuri;; 1/7/23.
[2] All performance data generated from Factset.
[3] Fundstrat 2023 Market Outlook
[4] “The 60/40 Portfolio Crumbled. Time to Rebuild.” Laurence Strauss; Barron’s; 1/9/23.
[5] Macrotrends S&P 500 TR historical annual returns