Perspectives

US equities started the fourth quarter with solid mid-teens gains on the back of decent earnings reports, a decline in oil prices, a drop in interest rates, signs of peak inflation, and hopes the Fed’s aggressive tightening was about to pause. However, this trend reversed in December as rates rose and the Fed made clear its tightening days were nowhere near done. US equities nonetheless reversed a three-quarter losing streak by posting their first positive quarterly return of the year. Non-US markets posted even stronger quarterly gains, as dollar weakness, a European energy crisis averted, and China reopening generated investor enthusiasm for these previously lagging markets. For the full year, major equity markets globally provided similar negative returns hovering around -20%.

Domestic large cap stocks, as measured by the S&P 500, gained 7.6% for the quarter. This helped mitigate some of the year’s losses, yet the S&P still fell -18.1%. Cyclically-oriented sectors, Energy, Industrials, and Materials posted the strongest relative performance in the quarter, with Consumer Discretionary and Communication Services trailing badly. For the year, Energy was the only sector to post a meaningful positive return, followed by near flat results from the more defensive Utilities and Consumer Staples sectors. Megacap dominant Communication Services, Consumer Discretionary, and Information Technology sectors were the year’s worst performing sectors.

The Russell 2000 Index of small cap stocks experienced similar monthly ups and downs, posting a gain of 6.2% for the quarter, while its full year decline was a rather dismal -20.4%. Quarterly leaders among small caps echoed those of large, with Energy, Materials, and Industrials leading the way. Energy was the only small cap sector in the black for the full year.

Large cap’s relative outperformance versus small in the quarter was driven primarily by the broad strength of larger cap Health Care names, which posted low double-digit returns versus a decline among smaller caps in this sector. For the full year, large cap’s relative outperformance was also driven by the more defensive nature of its Health Care names and the meltdown of small cap Biotech stocks. Value stocks regained the advantage versus Growth in the quarter, adding to their substantial full-year performance lead, as the value-oriented Energy and Financials sectors performed well, while the growth-oriented Consumer Discretionary sector lagged meaningfully. Style factors showed mixed performance results, with smaller caps favoring higher-quality attributes, while large caps had no meaningful style bias.

The Fed has made it abundantly clear it will keep rates higher for longer in order to get inflation in check. Aggressive tightening measures are being undertaken by central banks around the globe, with even final holdout Japan joining the fray. Complicating matters for the Fed is the resilience of the economy, with the unemployment rate staying quite low and wages still showing upward pressure. While monetary policy measures no doubt appear prudent, they act with a sizable lag, making the risk of a policy overshoot a more likely outcome. Thus, the fear is that central banks may send us into a deeper recession in their quest to control inflation. Interest rates have responded as one might expect with both an increase in rates as well as a rather sizable inversion of the yield curve. Such inversion has been a relatively good predictor of recession in past economic cycles. Indeed, higher rates have started to have the Fed’s desired impact on the economy, with higher mortgage rates substantially slowing the housing market, a noticeable uptick in hiring freezes and layoffs, and manufacturing surveys now in contraction territory. Inflation does appear to have peaked, but are the Fed’s actions enough yet to get inflation down to the target? Our best guess is that the pressures from the Fed will push us to recession around mid-year, but with the underlying strength of the economy likely keeping a recession rather mild.

These risks have been well articulated by economists, market strategists and the media, with equity markets having drifted down about 20% since hitting their highs over a year ago. Sentiment indicators are already at negative levels that have historically signaled favorable stock market performance.

Our continued focus on identifying well-managed companies with leading market positions and solid financial characteristics should serve us well in 2023, as it did in 2022, as it is these challenging economic environments that tend to separate the good from the bad.