- Markets rallied during the quarter but not enough to prevent a bloodbath for the year.
- Risk assets are priced for a soft landing at the same time recession risks are rising.
- The Federal Reserve’s historic tightening allows investors to maintain some dry powder at a reasonable yield.
Rates were rangebound during the last months of the year, allowing risk assets to stabilize even as the economic outlook weakened.
Most asset classes enjoyed nice quarterly returns, but the good performance in the fourth quarter wasn’t enough to prevent a bloodbath for the year. With short-term treasuries closing December at over 4%, investors pummeled valuations on stocks and bonds that began the year with low yields. Performance for the year was a sea of red with the Nasdaq Composite down by about a third while the S&P 500 lost over 19%. As bad as these returns were, bonds rivaled these losses as the Federal Reserve (Fed) hiked rates by over 4% during the year. When the dust cleared, long bonds produced equity-like losses with the Bloomberg Long Treasury Index returning a negative 29% for the year and the Bloomberg Corporate Bond Index losing over 15%. Commodities were the best performers against the inflationary backdrop though most of the performance came in the first half. While the Bloomberg Commodity Index was up 13.75% for the year, the index ended over 17% below its June peak.
Most active market participants have never experienced a hiking cycle like this. At the beginning of the year, policymakers expected inflation to fall on its own as pandemic effects burned off. Instead, inflation broadened, and wage growth picked up. In response, the Fed raised rates seven times to increase the federal funds rate target by over 4% while signaling more to come. The last time policymakers increased rates this quickly was in 1979-1980. Investors will also get a better feel for the impact of quantitative tightening in coming months. The Fed’s asset reduction program reached its run rate in the fourth quarter and will add to tightening conditions.
Inflation rolled over but is still at an unacceptable level as the Consumer Price Index (CPI) fell from its June peak of 9.1% to just over 7% in November. Supply chain bottlenecks are receding, and interest rates are taking a bite out of the housing market and related spending. Unfortunately, inflation remains a problem in services as consumers pivot to spending their savings on experiences, eating out and higher rents. Companies are still having to pay higher wages to attract workers. The bottom line is that while the peak is almost certainly behind us, we don’t have clarity about where inflation will normalize. Until the Fed sees a clear path to core inflation below 3%, policymakers are likely to seek tighter financial conditions.