We are in the midst of a difficult inflationary cycle. Asset values have dropped. The Federal Reserve has moved aggressively to reduce inflation, and we anticipate an economic slowdown. However, opportunities in stocks and bonds have recently increased, and although risk remains, significant income is back in portfolios for the first time in more than a decade.
2022: Perspectives and The Road Ahead
There have been worse years for stock market declines. These include 1931 and 1937 during The Depression, 1941 amidst World War II, and 2008 at the start of the Financial Crisis. But in all of these years, bonds either held steady or rose.
This past year, stocks and bonds both fell. Hard. How hard? The graph below shows their annual returns since 1871. 2022’s red dot stands alone. The second graph shows how the benchmark portfolio (60% stocks and 40% bonds) performed this past year relative to 100 years of history. Notice the depth - and rarity - of 2022’s red line.
Looking at bonds in particular, many fell by 20% or more this past year. The graph below depicts 50 years of returns for the US Aggregate Bond Index.Once again, 2022's blue line stands out.
As for Treasuries, the US 10-year Treasury began 2022 yielding a very low 1.52% and finished at a still low 3.88%. For perspective, its long-term average yield is 4.26%. So, while yields rose dramatically in 2022 (and bond prices fell), the current 10-year Treasury yield is currently slightly below the long-term average.
The Fed Funds rate currently stands at 4.33%. This is the overnight interest rate that commercial banks charge one another, and it impacts consumer loan and credit card interest rates as well as stock and bond prices. This past year, it rocketed from an all-time low of 0.0% in February to 4.1% in December. This is an extreme rate of change. Not since the 1970s have rates increased by more than 4.0% in less than a year. Perhaps the Fed waited too long to start raising rates and felt the need to move quickly. This short time span exacerbated bond price declines in the 2002 fiscal year.
The Road Ahead: Interest Rate, Stock and Bond Forecasts for 2023
Significant interest rate increases are rare, so it may not come as a surprise that market participants are predicting an end to interest rate hikes in 2023, with some forecasting that the Fed may actually lower rates by years’ end. Declining interest rates are often associated with economic contraction and recessions, but they tend to drive asset values up, not down. As such, any drop in rates this year could be bullish for both stocks and bonds.
But allocating capital in hopes that the Fed will reduce rates in 2023, knowing that it will only do so if the economy is shrinking quickly, seems foolhardy. The last time the Fed raised rates 400 basis points over the course of 25 months was during the 2004-2006 time span. It took the economy some time before it slowed, stalled and then fell apart and become the Global Financial Crisis. We will not fully know the impact of the rate hikes from 2022 until we are well into the middle of 2023. And we do not expect a Global Financial Crisis, but as money is reduced and pulled out of the economy, some projects and purchases will be paused or cancelled causing more economic slowdown.
Following the nearly 20% decline in 2022, US stocks now offer a better forward return than a year ago. Stock prices may rise if corporate earnings remain somewhat robust and a recession, if there is one, is shallow. This opportunity might be moderate, though, with most valuation metrics returning to normalcy after a lengthy period of extremity, which was largely due to 0% interest rates, low corporate tax rates, and lower wages. Rates are much higher now, wages are on the rise, and the economy is slowing.
Given this, it’s hard to imagine stocks multiples expanding much this year. The Fed may succeed in reigning in inflation while avoiding a recession. This would cause stocks to rally, but any opportunity must be carefully weighed against the real risk that inflation might not be easily tamed and the Fed may intervene to the point of economic contraction or recession. Hold quality stocks. And wait for a truly great opportunity to add to stocks.
Bonds may see more downside in 2023 as the Fed continues to tackle inflation, but nothing like 2022. Specifically, bonds may experience a more muted sideways-to-down movement in the first half of 2023 and start to rise in late 2023 and early 2024. But even if interest rates continue to increase in 2023, the total return for bonds is very likely to be significantly better than their historically dismal performance last year. And if we do see an economic contraction, and the Fed holds off on raising rates or even starts reducing them, bonds are set to produce a very good total return. So, while bonds torpedoed in 2022, they are quite likely to stabilize and begin providing reliable income again.
Income has returned to portfolios, which is welcome given that this has been missing since the Global Financial Crisis nearly 15 years ago. Overall, the forward expected return on portfolios has increased significantly. With quality bonds now yielding 5% or more and stocks at more reasonable valuation multiples, a balanced portfolio of stocks and bonds may offer a better risk-reward than anytime in recent memory.
Downside risk for stocks remains outsized, though, while bonds are more likely to provide stability and solid income. Investors should set aside plenty of cash for short-term needs, maintain quality portfolio assets, take advantage of market opportunities, and, most importantly, stay the course. The long-term investment portfolio mix of stocks and bonds should be well-positioned for the next 5-7 years.
Yes, 2023 will be a volatile year with many unknowns, and fighting the Fed is risky. The markets will do what they will. We can only control what we can and live life in accordance with our values.
Happy New Year to all, and best wishes for a great and meaningful 2023.
*The foregoing content reflects the opinions of Van Hulzen Asset Management DBA "Van Hulzen Financial Advisors" and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.