Happy New Year!
As we close the books on 2022, it is difficult to overstate how exceptional the last few years have been. It was a year driven by a trifecta of high starting valuations across the asset classes, unexpectedly strong consumer price inflation, and a pronounced global monetary tightening cycle. The pandemic shock that started three years ago created the most important synchronized economic slowdown that has ever been seen. The abrupt slowdown itself, coupled with the massive and necessary policy responses, have brought the global economic system drastically out of equilibrium, with one period of extremes leading to another. In 2021, easy monetary policy and economies reopening created an inflationary wave that forced a strong monetary policy reaction during most of 2022. Canadian and U.S. Central Banks both raised their target rates by roughly 400 basis points during the year, a move whose speed and magnitude has very few parallels in history. Additional complexity and market headwinds came from the Russian invasion of Ukraine and China’s focus on a zero-COVID policy it is now scrambling to get away from.
The result was a very difficult year for investors, with both fixed income and equity markets delivering strongly negative returns. Highlights include the S&P 500’s fourth largest calendar year loss since 1940, a widespread decline in global equity prices, and nowhere to hide in bonds outside of 1-3 month Treasury bills. Crypto was a complete disaster, with Bitcoin and many other digital currencies declining by at least 60%. Below the surface, the market rotation was significant, with market leaders of the last 10 years like growth and technology names suffering the most, while the energy sector outperformed, supported by the global energy reconfiguration happening amid the Russian invasion.
We’ve seen persistent inflation levels that haven’t been seen in 40 years. From a policy perspective, the U.S. Federal Reserve has rightly focused on trying to reduce the rate of inflation to avoid another episode like we had in the 1970s. To combat inflation, the Fed has raised rates seven times and the new Fed Funds rate (upper bound) stands at 4.5%. Stock markets have reacted accordingly with the Nasdaq Composite (USD) down 32.5% and the S&P 500 Index (USD) down 18.1%.
The four main drivers that pushed inflation to multi-decade highs are all reversing course. Supply-chain problems have faded, commodity prices have declined, monetary stimulus has turned to tightening and fiscal stimulus has been reduced. For these reasons, inflation will continue to soften to 4%-5% year-over-year by mid-2023, but then the hard work begins. A surge in labour supply is unlikely, so avoiding a wage spiral higher will require a reduction in demand for labour. This will very likely lead to a recession whose severity and duration may be moderate, but not insignificant. As a result, it appears both the U.S. Federal Reserve and Bank of Canada will probably be ending their respective hiking cycles in the first quarter of 2023 and, crucially, staying at their terminal rates for the remainder of the year if inflation cooperates and growth slows.
As we enter 2023, there is room for cautious optimism for investors. The adjustment has been painful but provides a much more compelling investing environment going forward. We are nearing the end of the tightening cycle, and there are signs that the fall in inflation will continue, if not accelerate. Fixed income markets are probably the most attractive they have been in a long time, China – and, more broadly, emerging markets – offer very compelling valuations, and technology will only continue to increase its influence on our economy and our lives. Equity valuations have normalized, interest rates are significantly higher and credit spreads are wider. While there is still a lot of uncertainty on where inflation will land and how significant the ongoing economic slowdown will be, investors are now paid significantly more to accept risk than they were at the same time last year. Overall, expected returns going forward are now much more convincing across the board, enabling investors to build more robust and better diversified portfolios than they have been able to do in the zero-rates period we have exited.
In conclusion, although there are many storm clouds on the horizon, I’m confident that the uncertainty has created plenty of opportunities for long term investors. Remember, it’s important to stay the course and as Warren Buffett always said, “be greedy when others are fearful”.