WESCAP Q4 2022 Quarterly Commentary: High U.S. Household Demand, Tight Labor Markets, & Unexpected Shortages
Portfolio results for the last quarter of 2022 were generally positive, although 12-month returns were almost uniformly negative. High U.S. household demand, tight labor markets, unexpected energy and supply chain shortages due to the Russia-Ukraine conflict and repeated Zero-Covid China lockdowns contributed to higher-than-expected inflation. The aggressive Federal Reserve interest rate hike policy to bring down inflation had a very detrimental effect on growth stocks, longer-term bonds, and foreign currencies. Some of this reversed in the last quarter, consistent with fading recession fears and the post-mid-term election historical trend of strong 6-month returns.
For the year 2022, the S&P 1500 growth stock index lost 28.6% versus losses of 18.1%, and 5.5% for the S&P 500 and S&P 1500 value stock indexes, respectively. Small-cap stocks showed a similar pattern. Our January 2022 forecast was correct that value stocks would outperform growth stocks in 2022. We also stated that, “Elevated stock and bond valuations could weigh on returns in both 2022 and 2023.”
Developed foreign markets stocks (e.g., Europe & Japan) outperformed the U.S in 2022. The EAFE index lost 14.4% in 2022 but the currency-hedged EAFE index lost a smaller 4.6% as this was not adversely affected by the decline in foreign currencies relative to the dollar. Quite a bit of our foreign stock investments were currency-hedged. Emerging markets stocks in 2022 lost 20.1%, largely a result of China’s Zero-Covid policy and currency declines.
U.S. publicly traded real estate (REITs) lost 25.0% in 2022. Higher interest rates hurt pricing more than improving fundamentals in rents and occupancy helped pricing. This bodes poorly for privately held real estate assets in 2023, including residences, as they tend to lag, but ultimately follow the same path as the REIT market.
Long-term Treasury bonds (Bloomberg/Barclays 20+ Yrs) lost 1.4% over the quarter and lost 31.1% for the year, all the results of higher interest rates. High yield and emerging market bonds all lost between 10% and 15% in 2022.
Alternative assets had varying results. Gold lost less than 1% in 2022 while commodities (Goldman commodities index) were up 26.0% for the year. Most hedged strategies (long-short, arbitrage) were close to or somewhat above break-even.
Even though inflation is trending down now, continued elevated interest rates could trigger a U.S. recession late in 2023 or in 2024. A focus on undervalued and defensive asset classes is recommended in order to avoid potentially large declines from some still overvalued assets or a possible recession. T-bills and money market funds are benefiting from higher interest rates and deserve a higher allocation to portfolios than in the recent past. Nevertheless, any recession will be a buying opportunity that we should be prepared to pivot into.
We will discuss some of these topics in greater detail in our upcoming 2023 Economic and Investment Outlook.