While it was a challenging year for markets, we did see a nice fourth quarter across the board as the S&P 500 gained 7.6%. Foreign stock markets performed even better in the fourth quarter — developed international stocks (MSCI EAFE Index) gained 17.3% and Emerging Market stocks (MSCI EM Index) were up 9.7%. For the full year, developed international stocks were down 14.5% in dollar terms (almost four percentage points better than the S&P 500), while EM stocks were down a bit more than the S&P 500 with a 20.1% drop. These annual returns were despite the U.S. dollar (DXY Index) appreciating 8.3% for the year, which reduces dollar-based foreign equity returns one-for-one. In the fourth quarter, however, the dollar dropped 7.7%, providing a tailwind to EM and international equity returns for U.S. investors.
Turning to the fixed-income markets, core investment-grade bonds (Bloomberg U.S. Aggregate Bond Index, aka the “Agg”) had a solid fourth quarter, gaining 1.9%. But this was still the worst year for core bonds in at least 95 years, with the Agg dropping 13.0%. The key driver, of course, was the sharp rise in bond yields; the 10-year Treasury yield ended the year at 3.9%, up from just 1.5% a year prior. High-yield bonds (ICE BofA Merrill Lynch U.S. High Yield Index) had a strong fourth quarter, up 4.0%, but were down 11.2% for the year.
Alternative strategies and nontraditional asset classes generally outperformed traditional stock and bond indexes. Flexible/nontraditional bond funds (Morningstar Nontraditional Bond category) were down roughly half as much as core bonds.
For 2022, our balanced portfolios performed well relative to their benchmarks. In portfolios allocated to our sector rotation strategy, which consists of a portion of the U.S. Equity allocation bucket, we saw outperformance vs. S&P 500. This was primarily led by the addition of energy and materials while selling technology sectors during the first quarter of the year. Our allocation to alternative investments outperformed core bonds and stocks and added to overall portfolio diversification.
INVESTMENT OUTLOOK & PORTFOLIO POSITIONING
Inflation and monetary policy remain the financial markets’ key macro focus. U.S. inflation data have improved, suggesting we’ve seen the peak in inflation for this cycle. But core inflation remains far above the Federal Reserve’s 2% target, and the Fed’s message is that it intends to maintain restrictive (tight) monetary policy throughout 2023. On the economic growth front, key leading indicators deteriorated further in the fourth quarter, which along with tight monetary policy points to a likely recession in the year ahead.
Our portfolios are built using long-term “strategic” allocations that are matched to a client’s risk tolerance and goals. So, while our investment approach is not based on short-term stock market forecasts, we do assess shorter-term (12-month) downside risk in our portfolio construction and management. We continue to believe that the current price of the S&P 500 does not adequately discount the likelihood of a possible earnings recession.
Analysis of past data on recessions, earnings declines, and stock valuations suggest a real possibility of further double-digit declines in the S&P 500 from current levels. Foreign stock markets are also at risk from the U.S. and global recession, but given their cheaper starting valuations, the medium-term expected returns are reasonably attractive.
Given the sharp rise in yields, bonds haven’t been this attractive in more than a decade. When estimating returns for core investment-grade bonds (the “Agg”) over longer periods, the starting yield is a good approximation of subsequent returns. At year-end, the Agg was yielding 4.7% and our 5-year expected return for core bonds is now in a range of 5% to 5.6%. Moreover, we expect core bonds to deliver a positive return if a recession plays out, providing valuable downside protection while riskier assets such as stocks get hit.
We believe 2023 will likely present us with some excellent long-term investment opportunities. Unfortunately, we also expect a recession and the potential for stock market volatility.
While challenging, long-term investors must stay the course through these rough periods. The shorter-term discomfort is the price one pays to earn the long-term “equity risk premium” – the additional return from owning riskier assets such as stocks that most investors need to build long-term wealth and achieve their financial objectives.