Key takeaways

• 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. 

Inflation isn’t the only thing slowing. Real GDP growth for 2022 is likely to be much lower than anticipated at the beginning of last year, but solid, if unspectacular, all the same. However, estimates for 2023 are coming down quickly as the Fed turns the screws. According to Bloomberg, the median estimate for real GDP growth among economists polled is only 0.3% for the year, dangerously close to a recession. Investors are betting on a downturn, accepting lower yields on longer bonds compared to short paper. This inversion means that investors expect the Fed to have to start lowering rates in the second half of next year as the economy falls into a recession. The New York Fed’s probability of recession index is at a level that preceded previous downturns. Saying that, these indicators have variable lags. For now, the employment picture is strong, and services spending has been enough to offset weakness in manufacturing.

A recession – and higher unemployment – seem to be the base case for many market participants.

According to FactSet, earnings expectations dimmed over the quarter, and analysts expect a negative comparison to last year's earnings per share (EPS) in Q4 (down 2.8% on 4% revenue growth). Weaker results in materials, consumer discretionary, and communication services are key drivers. This would still leave calendar year 2022 EPS up 5.1% on 10.4% top-line growth, not a bad outcome considering the gloomy market performance. Expectations for calendar year 2023 are surprisingly resilient with 5.3% expected EPS growth on 3.3% revenue growth, implying margin expansion at a time when the economy is teetering near a recession.

Overly optimistic earnings expectations, continued geopolitical tensions and an inflation-fighting Fed will likely underpin continued volatility. Policymakers are faced with contradictory signals – manufacturing weakness vs services strength, weaker leading indicators measured against relatively strong concurrent data, and strong wage growth vs waning pandemic savings. The net result is a noisy economy that’s drifting downward while the Fed tries to fine-tune its policies with imperfect information. While the timing is uncertain, this makes a recession our base case.   

Given all the ambiguities listed above, policymakers are dancing on a knife’s edge while investors are pricing a relatively painless result. A recession – and higher unemployment - seem to be the base case for many market participants, yet volatility and spreads declined during the last quarter. Bond investors are pricing treasuries to reflect recession concerns, but earnings estimates and spreads don’t reflect a downturn. Risk assets still are not incorporating a generous margin of safety as the Fed tightens into a slowdown. These conditions may set the stage for a capitulation if the data disappoint. The silver lining is that the Fed has raised rates to a level that provides relief for investors who have set aside some dry powder.