Twelve years after the financial crisis ushered in an era of low interest rates, low inflation and exceptionally high real (net of inflation) equity returns, a year of reckoning finally arrived. The Federal Reserve badly overestimated the economy’s liquidity needs during the Covid pandemic, and the resultant inflation proved to be more than temporary.
The Federal Reserve raised interest rates seven times over the past year. Yields on Treasuries across the maturity spectrum rose sharply, steadily pushing down bond prices. In 2022 this resulted in a 13% decline in the benchmark Bloomberg Aggregate U.S. Index, its worst year on record. The stock market was also adversely impacted by the persistent rate increases. The benchmark S&P 500 index was down 18% on the year, while the more aggressive growth-oriented NASDAQ Composite index declined 33%.
The good news for fixed income investors is that interest rates on intermediate, high-grade credit now sit in a range of 4%-5%, substantially higher than the 1.25% yield at the start of 2022. Balanced portfolios will enjoy meaningfully higher income growth from their fixed income and cash positions in the year ahead. This income will help stabilize portfolio returns should interest rates continue to rise.
Equity markets have a much wider variability of potential outcomes in the year ahead. We expect the Fed to continue raising rates while also selling assets to reduce the size of its bloated balance sheet. One major risk is that the Fed will overtighten, leading to an economic recession and a material decline in corporate operating profits. Bullish investors are hoping the Fed can slowly reduce inflation without stalling the economy.
We think the likelihood of the Fed over-tightening is higher than their chance of successfully navigating an economic “soft landing”. Strategically, this means we will continue positioning equity holdings away from highly cyclical industries and more toward lower leveraged, higher yielding and relatively stable securities. We expect continued higher than average volatility in the equity markets looking forward, and like previous periods of elevated share price risk we will look to err on the conservative side.
We believe the year 2022 will be remembered as the end of a four decade era of declining interest rates and above average real equity returns. Forty years ago when then Fed Chair Paul Volcker oversaw a series of rate increases that ultimately broke the back of high inflation, the level of Federal government debt to Gross National Product was roughly 30%. As Fed Chair Powell seeks the same ultimate outcome, the current level of Federal debt to GNP is roughly 130%. This 4X growth in relative debt will likely lead to a much slower long-term rate of U.S. economic growth as otherwise potentially productive government spending will instead be directed by necessity toward the payment of interest.
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