Due to an almost unprecedented barrage of restrictive Federal Reserve monetary policies, stock and bond prices plummeted throughout 2022. The past year’s Fed policy initiatives included seven large interest rate hikes, relentless quantitative tightening and an historic shrinking of the money supply.

As of this writing, the S&P 500 has declined 19.66 per cent, the MSCI World Stock Index fell 19.52 per cent, the Nasdaq has fallen 33.82 per cent and the Bloomberg Aggregate Bond Index is down by 12.97 per cent. Historically, 2022 was a very unusual year when both stocks and bonds posted meaningful declines at the same time and so for most investors this will be a forgettable year.

Fed Reserve chairman, Jerome Powell has clearly pivoted from being overly dovish to being overly hawkish.

Now, operating in damage control mode, he is attempting to rescue his reputation following one of the worst monetary policy errors in central banking history.

The Fed’s uber easy money policies which began the depths of the 2020 pandemic eventually caused the highest inflation in forty years. Meanwhile, Washington continued to toss dry logs on the inflationary fire with extreme deficit spending.

From full speed ahead, Powell and his colleagues have thrown the monetary gears sharply in reverse thereby spiking financial market volatility. The Fed’s near-term goal is to engineer a recession and thereby break the back of the inflation he has caused.

And now a recession appears imminent as key economic indicators continue to head south.

For example, the leading economic indicators (LEI’s) in the US have been heading lower since March of this year. In fact, with the exception of February, month-over-month LEI’s have been running negative all year long.

The LEI index is comprised of ten economic components whose changes tend to precede changes in the overall economy.

Components of the LEI include manufacturer’s orders for consumer goods and materials, building permits, money supply (M2) and the spread between long and short-term interest rates. The LEI index tends to lead economic growth by about seven months.

While increasingly restrictive central bank monetary policies have been the major pain point for the year’s sloppy markets, other factors were also at play.

Russia’s unprovoked war in Ukraine, China’s heavy-handed zero-Covid policy, global supply chain disruptions and cryptocurrency blows ups added to volatility and downward pressure on higher risk assets.

Importantly, investors returned to basics in 2022. During the central bank “free money” era, which was taken to extremes in 2020 and 2021, several atypical asset classes reached various states of irrational exuberance. Crypto coins, non-fungible tokens, special purpose acquisition vehicles and meme stocks were all the rage when the monetary spigots were flowing.

However, this year marked a serious reversal in overhyped and perhaps overvalued assets as investors returned to focusing on fundamentals such as earnings, cashflow, dividends and valuations.

Many of the more speculative assets have declined as much as 80-90 per cent while value and dividend paying stocks have held up relatively well.

As the economy continues to downshift, equity markets have been exhibiting classic signs of defensiveness below the surface.

For example, the best performing sectors on a year-to-date basis have been energy, electric utilities, healthcare and consumer staples. Demand in these sectors tends to be resilient against economic weakness. For example, consumers need healthcare regardless of economic conditions.

Looking ahead, investors can expect further volatility as central banks around the world continue to raise interest rates in their efforts to cap inflation.

From this point forward, the larger rate increases should now occur in non-US markets which are just now beginning to catch up with the US’s over tightening programme.

For example, in December Japan announced an increase in the allowable trading range of its ten-year bonds, effectively relaxing its historic yield curve control policy. The Japanese two-year yield rose above zero for the first time in 15 years. Meanwhile, over in Europe, the ECB is echoing Powell’s refrain to do whatever it takes to snuff inflation.

The good news for the markets is that much of the recession scenario appears to be already baked into asset prices. Indeed, the recession expected early next year will be one of the most widely anticipated ones in modern history.

In my experience, asset prices tend to react more dramatically to unexpected rather than expected events. While markets have the potential to retest their June and October lows, buyers will likely emerge at those more distressed levels. Remember, the markets often tend to climb the proverbial “wall of worry.”

More important than the overall direction of the equity markets, is which securities investors need to own.

Heading into 2023, investors will want to be positioned in higher quality companies trading at reasonable valuations.

We like select companies in the healthcare, electric utility, information technology and energy sectors. Dividend-paying companies had spectacular outperformance in 2022 compared to their non-dividend-paying counterparts and I expect this trend to continue as free money continues to evaporate.

We also see opportunity in the bond markets. Throughout the year, the US Treasury yield curve became increasingly inverted as investors forecast that interest rates must eventually peak. In the last months of the year, short-term Treasury yields rose, but longer-term issues saw yields moving lower.

During Q4, the Federal Open Market Committee increased its policy rate by 0.75 per cent in the November meeting, then 0.5 per cent in the December meeting.

In December, Fed chairman Jerome Powell indicated that the Fed Funds terminal rate will likely be around 5.1 per cent, up from the 4.6 per cent estimate back in September. According to the FOMC dot plot, which is a survey of FOMC members’ dot projections, rates will keep moving higher next year, but will shift lower in 2024.

In this environment, we continue to like the front end of the interest rate curve but are beginning to warm up to longer duration securities. Indeed, many longer-dated investment grade bonds and preferred issues, yielding six per cent and higher are offering equity-like returns with the benefit of high current income and lower volatility.

Bryan Dooley, CFA is the Chief Investment Officer at LOM Asset Management Limited in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.