The fourth quarter offered some encouragement in an otherwise grim year for equity and fixed-income investors. Central banks around the world continued to aggressively tighten monetary policy through the end of 2022. However, investors are hopeful the pace of rate hikes will slow in 2023. Inflation retreated from recent highs as the U.S. Consumer Price Index reported a 6.5% annual gain as of year-end. This compared with 9.1% at its latest peak in June.
As interest-rate differentials narrowed between the United States and other countries, the U.S. dollar depreciated after surging for much of 2022. The dollar’s depreciation eased struggles for foreign-currency-denominated investments.
Despite gains in all major asset classes in the fourth quarter, only commodities—driven by record energy prices—finished the year with a net positive return. Investors must weigh sluggish global growth projections, pending rate increases by central banks, and China’s reopening as we enter 2023.
Every quarter, Morningstar’s quantitative research team reviews the most recent U.S. market trends and evaluates the performance of individual asset classes. We then share our findings in the Morningstar Markets Observer, a publication that draws on careful research and market insights.
Here are some of the findings from our latest quarterly market review.
Markets Pricing Higher Rates by Mid-2023, Followed by Rate Cuts
As of mid-January, futures markets were pricing a federal-funds rate (solid green line) peaking at about 5.0% in summer 2023—up from a 4.5% expectation at the end of September 2022 (dotted green line)—followed by rate cuts. The market expects a higher European Central Bank terminal rate compared with September, followed by aggressive easing in the second half of the year. Expectations for the Bank of England came down dramatically as U.K. financial markets stabilized in the fourth quarter.
Asset-Class Winners and Losers
The colorful pattern in this “quilt chart” illustrates how unpredictable the ups and downs of markets can be. Despite recording the worst return over the last 15 years, commodities led the way among asset classes in 2022. Rising rates, high inflation, and reduced growth expectations globally created a difficult environment for both equity and fixed-income markets. Large stocks were notably last in 2022 after topping all asset classes in 2019, 2020, and 2021.
Who’s Poised to Benefit From China’s Reopening?
Using Morningstar country indexes, we can see which countries’ constituents are most exposed to China, and perhaps which regions will benefit most from a reversal of China’s “zero-COVID” policies. Several Asia-Pacific neighbors have the most revenue exposure, though the degree of that exposure has changed over the past three years. Brazil and Chile have seen a pronounced increase in constituents’ revenue share attributed to China, as have some European countries, albeit to a lesser extent.
Volatility Was a Key Feature of Global Rates Markets in 2022
After a tranquil 2021, global rates saw an explosion of volatility in 2022. Most benchmark sovereign 10-year yields rose by 200-300 basis points or more, with swings of 50-100 basis points in both the third and fourth quarters. Japan joined the party at the tail end of the year as the Bank of Japan surprised the market by loosening its yield-curve control policy. With central banks continuing to step away from the bond market, 2023 may be another bumpy year for rates all over the world.
Stocks Lost Less Than Bonds for the First Time ... Ever
Rarely do stocks and bonds both post negative returns in a given year, but when they do, stocks always take a deeper dive than bonds. That is, until now. U.S. long-term government bonds recorded their worst calendar year on record in 2022, posting a negative 26% return. Large-cap stocks lost “only” 18%. Bonds couldn’t escape the double whammy of unexpectedly rapid inflation and aggressive central-bank tightening, which are particularly challenging conditions for fixed income.
U.S. Margins Squeezed in High-Labor-Cost Sectors
Strong U.S. wage inflation ate into corporate earnings margins in 2022, especially for service sectors in which labor is the predominant cost. Large corporations in technology, communication services, and financial services announced a wave of layoffs in 2022 after a roaring year of hiring in 2021. In contrast, energy and, to a lesser extent, basic materials and industrials are relatively less exposed to higher labor costs, helping insulate margins in those sectors.
Factor Profiles Revert to First-Half Trends After Deviating in the Third Quarter
Looking at the factor profile chart below, it seems that the third quarter was something of an anomaly. Value, high-yield, and low-volatility funds were among the best performers in the fourth quarter, similar to the first half of the year, but noticeably at odds with the third quarter. That said, the best performers were consistently biased toward small-cap and lower-quality stocks through most of the year. There was a slight tilt toward momentum in the fourth quarter, however.
The author or authors do not own shares in any securities mentioned in this article.Find out about Morningstar’s editorial policies.
