Is it Next Year Yet? Lean Into Market Risks to Build a Bridge to 2023

• 2022’s most aggressive Fed policy decisions ever have led to the worst combined period of returns for both stocks and bonds¹
• With so much negativity, investors may have to wait ‘til next year for something to cheer about
• In the meantime, focus on quality/value, ultra-short bonds, and real assets to get portfolios to next year

“Wait ‘til next year” is a common refrain from defeated baseball fans who believe that next year will be different and bring them something to cheer about. As a lifelong Red Sox fan, it’s a sentiment I frequently shared in October — until 2004.²

With many asset classes and market sectors down big this year, investors are now embracing the hopeful words of baseball’s perennial losers.

Putting the 2022 market in context can help you position portfolios to get to next year.

The Most Aggressive Fed in History

If the Federal Reserve (Fed) raises rates another 75 basis points, as expected,³ at the November 2 meeting, the net change in the fed funds rate will be 3.75%. This would be the second largest net change ever in the Fed Funds rate in a single calendar year.

Another 75 basis point hike in December would push the net change to a calendar year record of 4.5%, as shown below. Even if the Fed hikes by just 50 basis points in December, 2022 would still be the most aggressive policy year ever.⁴

The Fed’s policy actions, heighted geopolitical risk, surging inflation, sluggish growth, and weak fundamentals, have pushed markets to the brink. And as of right now, 2022 ranks as the second-most volatile year ever, based on the number of days with either a gain or loss greater than +/-1% for the S&P 500 Index.⁵

These outsized market moves have occurred on 51% of the trading days so far this year, as shown below. This rate outpaces every other year since 1956, with the one exception of 2008 during the Great Financial Crisis (GFC).⁶

Interestingly, there has been a near even split between big up and big down days this year. Yet, the average negative return on the down days is -2% versus +1.9% for big up days, an indication of the negative skew associated with this risk-off market.⁷

A Bear Hug on Both Stocks and Bonds

This year has also featured the first ever double bear market, with both global stocks and bonds having fallen by more than 20% off their highs.⁸

While stocks have entered into bear markets four different times in the past 35 years, bonds have never joined them. For that matter, bonds have never had a drawdown in excess of 10%.⁹ That all changed this year given the pressure from rising rates and the other macro risks, as shown below.

And there’s more. Since 1972, stock and bonds have produced negative rolling 12-month returns in 12 out of 587 possible periods. Seven of those 12 instances have occurred this year — and consecutively. That is, every rolling 12-month return since the end of April has been negative for both stocks and bonds.¹⁰

In fact, the correlation of rolling 12-month returns between stocks and bonds is 95% in 2022, compared to a 6% correlation historically.¹¹ What’s more, the losses in both of the major asset classes have been abnormally large,¹² as shown below. So not only has the trend been anomalous, so has the magnitude — another double dose of trouble for portfolios.

How to Position to Get to Next Year

Unlike in baseball, where a team can sign a free agent, off-load a bad contract, or switch managers, there isn’t much we can do to change macro risks and alter the market’s trajectory.

Building a bridge to get to next to year consists of leaning into the risks pressuring asset returns and focusing on what has worked so far.

A ”Get me to 2023 Portfolio” could include:

• High quality value exposures designed to participate in the rallies but limit the downside, as the down days have been more frequent and larger — and volatility can be a drag.

Multi-factor blends of quality and dividend growers could replace portions of the core, as those factors have been rewarded this year.

• Ultra-short high-quality bonds to buffer equity and rate volatility, while picking up rate hikes quicker in coupon payments before the end of the year.

1-3 year corporate bonds have become increasingly attractive, as yields have risen as a result of the Fed’s actions, but duration risks are in line with historical averages and well below that of traditional bonds.

• Inflation sensitive exposures with strong momentum as the catalysts for painful core returns — inflation, rising commodity prices, supply chain constraints — are unlikely to abate before 2023.

The energy complex has exuded strong momentum this year as a result of the inflationary and supply chain backdrop, two drivers that are decidedly no longer transitory.

• Defensive sectors with positive earnings trends to navigate both wanning earnings sentiment and threats of recession.

Historical trends favor health care and utilities stocks in times of slowing economic growth.

As you wait ‘til next year, stay on top of market trends with our Strategy & Research Team’s timely analysis and fund insights.