The year has come to a close, and it has proved to be a very challenging year for investors. After three years of above average returns, stocks produced disappointing results and lost ground during the year. Inflation persisted at much higher rates than many forecasted at the start of the year. Higher inflation forced the Federal Reserve Open Market Committee (FOMC) to raise short-term interest rates rapidly in an attempt to stabilize prices. Additionally, the war in Europe led to a rise in many commodity prices, exacerbating what was already a tight supply chain environment leading to more price pressures. Some recovery for stocks occurred in the final quarter of the year, but not enough to overcome the declines that occurred during the previous three quarters. The S&P 500 rose 7.55% for the quarter and fell 18.17% for the year. International stocks—as measured by the MSCI EAFE—added 17.40% in the fourth quarter and ended the year lower, falling 13.95%.

Because of rapidly rising interest rates throughout the year, bonds did not generate the protection they typically provide in years with negative stock returns. The 10-Year US Treasury began the year at 1.51 and rose to 3.88%, more than doubling. Short-term rates rose even more. The 2-Year US Treasury rose from 0.73% to start the year to 4.43% at year-end. This means there is finally some decent income to be realized from bonds even though the path to get here was very uncomfortable, especially for conservative investors who expect limited volatility in their portfolios.

Markets were extremely volatile during the year. Much of the volatility stemmed from the FOMC’s comments regarding the future path of interest rates. Although there were a myriad of other issues markets contended with in 2022, inflation and interest rates took center stage most of the year. The FOMC raised short-term interest rates seven times during the year, moving their target rate from just above zero to 4.25%, and several of the rate increases were 75 basis points – a hike at that rate last occurred in 1994. The last time overnight lending rates were above 4% was in December of 2007.

The US was not alone in their monetary policy shift in 2022, many other central banks increased rates including the European Central Bank, the Bank of England, and even the Bank of Japan. The wide-spread international changes in monetary policy had implications for both stock and bond markets. Investors are currently valuing once lofty growth companies using higher discount rates, lowering their current prices. Similar calculations are occurring with low coupon bonds as higher yielding options become available. In addition, the likelihood of monetary tightening causing economic growth to decline increases with every rate hike.

Though a recession has not officially occurred in the US thus far due to economic resilience, other regions are experiencing tougher conditions. The war in Ukraine continues and has had dire humanitarian consequences, the impact of which will reverberate for years to come. Though prices for energy and other commodities have declined since the early days of the conflict, the economic consequences resulting from the war have extended to the rest of Europe and complicate policymakers’ efforts to reign in price increases.

After two years of rolling lock-downs, China has relaxed its zero-COVID policy. This change comes at a time when infection rates are reportedly on the rise. The loosening of restrictions is likely to have a positive impact on supply chains and economic output, but due to less effective vaccines and low vaccination rates, many, and potentially worse, illnesses may result from the new policy.

Looking Forward

Stock and bond market volatility was elevated in 2022 – perhaps the most volatile year of the last 25 years. In the short-term, the large number of macro issues will likely generate continued bouts of volatility. Inflation has shown signs of cooling, and market participants will now wonder if the FOMC have raised rates enough. Fed Fund Futures markets anticipate the fed will raise rates two more times ending just below 5%. The sell-off in stocks appears to indicate that rates at this level will lead to a recession, but it is uncertain if or when that will occur and to what extent it will impact corporate balance sheets. So far, consumers and corporations have fared better than consensus expectations. Tighter credit conditions and increasing overextended customers may challenge this trend in the coming quarters.

There are certainly reasons for optimism as we head into 2023. First, as stocks have suffered a significant reset in prices, valuations look reasonable given current earnings expectations. Markets are fickle in the short-term and prices may revisit or fall below the lows seen last year but eventually fundamentals carry the day and they are solid. Looking out three to five years, stocks offer ample appreciation opportunities, often in conjunction with a tax-efficient dividend income that grows over time. We anticipate the market will soon look past current expectations of recession, and we want to be in position to take advantage of the inevitable recovery. As such, we increased our stock exposure in the 2nd and 3rd quarter and our portfolios are slightly overweight in equity classes at this time.

Second, we think inflation is likely to persist at higher levels in the future and may not return to pre-pandemic levels for quite some time. As a result, interest rates will likely stay at or above current levels for a while. We have already been taking advantage of the better rates, especially in the short-term by building high-quality laddered portfolios of US Treasury bonds where appropriate.

Finally, cash held in money market funds has been carrying the highest yields since before 2008. We are letting cash build so we can take advantage of any future dislocation that may occur in the stock or bond market. Whereas investing in any combination of stocks and bonds in 2022 led to disappointing results all around – over the next several years we believe patient investors will be well compensated for the risk they are taking.

Thank you for allowing us to serve you, it is an honor we do not take for granted. All of us here at Hills want to wish you a very happy and prosperous 2023. Here at Hills we are hoping for a slightly calmer, less eventful one – as least as far as markets are concerned. Regardless of what the future holds, we are here to answer your questions and make sure your current asset allocation is still appropriate for your circumstances. If it has been a while since you have visited with us, please do not hesitate to call or email and set up a meeting with your Hills Bank Trust and Wealth Management Officer.

Some trust products and IRA contributions/balances are not a deposit, not FDIC insured by any federal government agency, not guaranteed by the bank and may go down in value.