December Market Review
Both equity and bond markets reversed course from November’s rally as a vigilant Federal Reserve and projections of higher rates for longer weighed on prices.
The SPX fell -5.77% with all sectors lower on the month. The Nasdaq led US equity markets lower falling by -8.66% and the Dow Jones Industrial Average fell by -4.09%. Consumer discretionary stocks were the weakest sector falling over -11% in December. In a defensive month, utilities fell the least, down only -0.53 basis points.
Bond prices also fell in December, but only retraced a portion of their November gains. The US yield curve steepened slightly last month as shorter bonds fell less than longer-duration issues. U.S. 2 Year Treasury notes rose 12 basis points last month, ending the year with a yield of 4.43%. The bell-weather U.S. 10 Year Treasury note rose 27 basis points to end 2022 with a yield of 3.88% (still lower than the October 24th high close of 4.244%).
Investment grade corporate bonds fell as interest rates moved higher. Interestingly, risk premium spreads did not move significantly, despite equity market volatility. This allowed corporate bonds to perform similarly to treasury bonds. Lack of issuance was a factor, as daily volatility was elevated, and year-end rolled in. While high yield fared better than investment grade markets for most of 2022, junk bonds underperformed high grade in December.
Municipal bonds were the best-performing fixed income asset class in December as broad performance benchmarks were slightly positive despite treasuries falling. Year-end buyers in the secondary market flowed in as tax loss selling subsided, and primary issuance was scarce. The belly of the curve (5–10-year sector) performed the best. In 2022, the safe-haven nature of municipal bonds was apparent through better relative performance to taxable bonds.
It was quite the fitting end to a tumultuous year, as the Federal Reserve Policy was a key focus for markets in December, if not for all of 2022. While the FOMC, downshifted at the December 14th meeting, raising short-term interest rates by only 50 basis points, markets received a new wave of “hawkishness”. Before the Fed announcement, risk markets and bond prices were enjoying several weeks of dovish tones. Fed Chair Powell acknowledged that a slowdown of the pace of rate hikes would be prudent, but expressed concerns that strong employment data could fuel service sector inflation. In addition, the FOMC had heightened “dot plots” for the terminal funds rate with no inclination to cut rates in 2023 (diverging from market consensus). As the markets interpreted the statements, interest rates moved sharply higher during the second half of the month (U.S. 10 Year Treasury notes moved from 3.45% on December 15th to 3.88% by year-end). This catalyst also put a damper on any “Santa Claus rally” in stock markets.
Data Recap
Despite headlines of a slowing economy, economic data released last month was somewhat benign. Non-farm payrolls increased more than estimated (263k versus expected 200k), and average hourly earnings increased. Consumer sentiment and small business optimism remained robust. Even some housing numbers beat expectations including housing starts and new home sales. Signs of economic slowdown showed up in manufacturing data and retail sales figures. Unlike the October data for inflation, November stats did not show clear signs of slowing (PPI, CPI).
Markets took notice of reports of broad corporate layoffs in multiple sectors. Salesforce, Pepsi, Morgan Stanley, Goldman Sachs, Twitter, Facebook, and Google are examples of some of the companies that announced upcoming job cuts and hiring freezes.
One briefly positive catalyst last month came as China canceled its zero-Covid policy and announced a “re-opening”. This included the removal of its in-bound quarantine rules. Investors remain cautious about the re-opening as earnings reports in the first quarter of 2023 look to be somewhat grim.
While equity markets have endured past calendar-year drawdowns like 2022, fixed income markets have not. The performance of fixed income markets in 2022 displayed a historic transition from a long-term bull market period in interest rates and total return for fixed income. The commonly referred to fixed income benchmark, the Bloomberg Aggregate index was down over -13%. This marks the worst bond performance in generations, with data going back to the early 1970s. Before last year, 1994 was the worst year for bond market performance with a decline of -2.9%. The sharp drop in bond prices due to the Fed raising rates by 4.25% in nine months, along with shrinking their balance sheet beginning in June, was and will continue to be a dominating force in financial models, borrowing costs, and valuations for the foreseeable future.
The sharp moves lower in fixed income may certainly create opportunities for investors in the new year. We believe the primary bond market tailwinds for next year will be:
A buffer of income generation despite where bond prices move in the short term as cash rates are currently above 4%
A flight to safety in the base case of a recessionary environment, as risk assets are challenged
Liquidity
The Piton team continues to offer customized portfolios and solutions to meet your needs through all market and interest rate environments. Please let us know how we can help you and your clients, we are here to serve as an extension of your team.