Economic Flash: New Market Regime Takes Shape


January 2023

US Economy: Conflicting signals.

Data continues to present conflicting signals, with year-over-year core inflation cooling to 4.7% (off a 5.5% February peak), surprisingly high consumer confidence (108.0) and low unemployment (3.7%) each to the positive, with negatives in advance retail sales (-0.6%), industrial production (-0.2%) and annual existing home sales of 4.09 million matching pandemic lows.

US Stocks: Out with a whimper.

After a strong start to Q4, December was marked by ongoing uncertainty and increased investor pessimism that the Fed wouldn’t have the flexibility to slow its pace of raising interest rates. Mega-cap stocks such as Apple (-12.2%) and Microsoft (-6.0%) as well as Tesla (-36.7%) struggled while each contributed roughly equally to the decline in the S&P 500 for the full year.

Foreign Stocks: The US dollar giveth.

A continued drop in the US dollar (-2.8%) aided most non-US equities, giving a 3% boost to developed markets in particular. Other factors that helped: tech stocks, which tend to be more interest-rate sensitive, are a smaller component of emerging market indexes (8% vs. 26% for S&P 500), and some optimism about China’s economic reopening after Zero-Covid lockdowns.

Fixed Income: Munis strong but pricey.

After a November respite, US interest rates rose broadly, with some notable exceptions. Debt issued in local currencies (not US dollars) performed well on the back of the falling US dollar while municipal bonds continued to benefit from lower new issuance. Entering 2023, munis are expensive, yielding only 65% of 5-year Treasuries vs. more than 80% historically.

Real Assets: Natural gas plummets.

In a year marked by accelerated inflation expectations, real assets performed well but fell in December on indications that high inflation might be slowly winding down and amid a gathering of recessionary forces globally. Natural gas dragged down commodity indexes by dropping 33% in December, while oil was flat at around $85, down from a high of $128 in March.

Alternatives: Winning ugly.

Hedge fund strategies were generally flat for the month which still meant they outperformed most traditional assets. For the full year 2022, hedge fund strategies did an excellent job diversifying portfolios: While the absolute results weren’t anything to write home about, many strategies outperformed the S&P 500 by double digits.

Source of data: Bloomberg

Equities Total Return

U.S. Large Cap (5.8%) 7.6% (18.1%)
U.S. Small Cap (6.5%) 6.2% (20.5%)
U.S. Growth (7.6%) 2.3% (29.0%)
U.S. Value (4.2%) 12.2% (8.0%)
Int’l Developed 0.1% 17.3% (14.5%)
Emerging Markets (1.4%) 9.7% (20.1%)

Fixed Income Total Return

U.S. Agg. Bond (0.5%) 1.9% (13.0%)
TIPS (1.0%) 2.0% (11.8%)
U.S. High Yield (0.8%) 4.0% (11.2%)
Int’l Developed 1.0% 7.3% (21.7%)
Emerging Markets 2.1% 4.5% (9.4%)
Intermediate Munis 0.4% 3.0% (5.4%)
Munis Broad Mkt (0.1%) 4.0% (9.0%)

Non-Traditional Assets Total Return

Commodities (2.4%) 2.2% 16.1%
REITs (3.3%) 6.9% (23.7%)
Infrastructure (2.2%) 11.0% (0.2%)
Hedge Funds
Absolute Return 0.5% (0.3%) 0.9%
Overall HF Market (0.1%) 0.2% (4.4%)
Managed Futures (0.2%) (4.8%) 20.0%

Economic Indicators

DEC-22 SEPT-22 DEC-21
Equity Volatility 21.7 31.6 17.2
Implied Inflation 2.3% 2.2% 2.6%
Gold Spot $/OZ $1824 $1661 $1829
Oil ($/BBL) $86 $88 $78
U.S. Dollar Index 122.1 127.6 115.4

Glossary of Indices

Our Take

The new year often brings with it a sense of renewal or a fresh start. As investment professionals, it also provides for us with a natural inflection point to metaphorically flip through the pages of the old calendar, the hits and misses, and then plot out our expectations for the year ahead, including related portfolio adjustments.

In that spirit, one of the things we got right in 2022 was that we were entering a period of market regime change. We didn’t know exactly how that would play out, but we were keenly aware that many of the drivers that had been behind the remarkable results of 2020 and 2021 were fading away, while new catalysts were on the horizon. Among them, we noted the unusual dispersion of analyst market expectations, that much of the post-Covid recovery had likely been already priced into markets, that equity returns had been dominated by a handful of mega-cap tech stocks, rising geopolitical risk vis-a-vis China and Eastern Europe, that it would take longer than anticipated to repair fractured supply chains, and that the greatest risk to financial markets and the economy was the Federal Reserve and its response to sustained levels of higher inflation.

With all of that in mind, our highest conviction expectation for 2022 was that volatility would be a constant companion and not an occasional visitor as the pandemic “fog” lifted. Markets delivered on that expectation as the CBOE VIX measure of equity volatility jumped to an average of 25.6 over the course of 2022, about 20% higher than 2021 and the long-term average. That said, what didn’t play out as well as expected was our diversification across asset classes to lower risk, since virtually all asset classes lost value in 2022, a historic anomaly. To be clear, our real asset (commodities, infrastructure), hedge funds and even fixed-income exposures each generally outperformed global equities but the diversification from equities that those asset classes have provided historically didn’t show up as strongly in 2022.

Looking Forward

It seems that discussion of market regime change is now much more prevalent, with the characteristics of that new regime having become a little clearer. The endemic nature of Covid-19 appears to be solidifying as China emerges from onerous Zero-Covid protocols, opening up the possibility of further repair of supply chains and calming inflation. Inflation (both headline and core) appears to be easing albeit at a slow pace. And the Fed has so far been able to raise interest rates without destroying the labor market or sending the economy into deep recession. Still, interest rates may remain at current levels or higher for a significant period of time, which would indicate slower growth in the economy and corporate profits. This would suggest financial assets could very well continue to struggle.

That last bit may sound ominous, but the current investment environment is arguably compelling from multiple perspectives. This year was unique in that so many financial assets sold off in tandem. The consequence of that is that many assets offer valuations and/or yields that are more attractive than we have seen in many years. For example, international equities despite having held up well during a difficult year, remain at lower valuations relative to US stocks, are cheaper relative to their own history and appear to face less pressure from a strong US dollar. That said, because we build portfolio through a long-term lens for most of our clients, the changes that we make from year-to-year to our top-down asset allocations are typically modest and will primarily espouse the long-term principal of rebalancing. We also anticipate adding value to portfolios through the identification of new strategies, including possibly opportunities within higher-yielding corporate credit and the reinvigoration of the US supply chain. Overall, we think it will be a challenging year ahead with more potential to invest at attractive valuations.