Quarterly Market Update: 2023 Q1

Market Summary: 2022 Year in Review

Asset prices rallied higher in the fourth quarter of 2022, but it was too little too late to lift the major indices out of double digit losses for the year. The year-end optimism came about from improving inflation numbers and the prospect of less aggressive rate hikes from the Federal Reserve in 2023. For most of 2022, the increases were 75 basis points (0.75%) but the final increase in December was 50 basis points. Investors are expecting the Fed’s first move in the new year to be only a 25 basis point increase. The major theme for 2022’s market volatility and losses was The Federal Reserve’s rate increases and quantitative tightening. These two tools used by the central bank have tremendous effects on the capital markets and liquidity. It is why 2022 was the first year in modern history where both US equities and US fixed income suffered double digit percentage losses.

Past performance is no guarantee of future results. Diversification does no ensure a profit or guarantee against a loss. Source: Fidelity Investments (AART), Haver Analytics, as of 12/31/22.
Market returns year to date as of 12/31/2022

US stocks suffered the greatest losses with a -19.53% return in 2022, much of that was due to growth stocks collapsing after years of phenomenal gains. After years of lagging domestic stocks, international equities performed relatively better with a -15.86% return. Fixed income investments offered no respite from stock volatility, losing 13.01%. Bond prices react inversely to interest rate movements and more so when rates move upwards so quickly in such large increases in basis points. In nearly all years that equities fell, bond returns were positive as investors flee risk assets for a flight to quality. However, 2022 was an exception to that pattern.

“SECURE 2.0” and What It Means to You

Congress and the President passed new legislation dubbed “SECURE 2.0” that will have a significant impact on investors of all ages. The new rules affect a wide range of accounts such as employer sponsored plans, IRAs, and 529 college savings plans. There are too many changes to fully discuss in this market update, but some significant ones stand out.

For Retirees

Required minimum distributions (RMD) for tax-deferred accounts used to start when the account owner turned 70.5 years old. Then that changed to 72. Starting January 1, 2023, the age to start RMDs will be 73 and increases to age 75 by the year 2033. The penalty for missing an RMD used to be a steep 50% of the missed amount but will drop to 25%.

Employer Sponsored Plans

Employers will now be required to automatically enroll new employees in their 401(k) with a minimum of a 3% contribution. The new rule applies to new 401(k) and 403(b) plans starting in 2025, but businesses with 10 or fewer employees or new companies in business for less than three years would be exempt. This is meant to encourage employees to save for retirement as it is more difficult to get them to opt-in rather than opt-out.

529 College Savings Plans

One of the biggest concerns about saving in a 529 account is your child does not go to college. The new legislation addresses this issue by allowing 529 assets to be rolled into a Roth IRA for the beneficiary. There are some caveats for this new rule however. The account must be in existence for at least 15 years. Standard Roth IRA contribution limits apply and the aggregate lifetime limit or rollovers is $35,000.

US Debt Ceiling

Every couple of years, the US debt ceiling has become the hot topic and cause for concern. While we’d like to say it has no bearing on investor sentiment, the truth is it does create volatility in the markets. The very thought of not raising the debt ceiling and forcing the United States to default on debt is scary and unimaginable. It is the fact that it would create such a catastrophic financial situation that the debt ceiling has been used by Congress as a negotiation tactic. The federal government’s authority to issue new debt expired on January 19, 2023. As of now, we are on borrowed time with the Department of Treasury taking “extraordinary measures” to prevent the United States from defaulting on debt. For now, that has worked to calm investors’ fears and we’re seeing a positive January for stocks and bonds. Treasury Secretary Janet Yellen believes these extraordinary measures may be effective until sometime in June. As we approach this next deadline without reaching a compromise, equity markets may see a sell-off similar to 2011 when the US received a credit rating downgrade and the S&P 500 lost 17%. So why shouldn’t we be worried? Because for decades, they’ve always ended up raising the debt ceiling. But if we believe it to be different this time and it’s a different Congress, then just understand the actual negative ramifications would be felt most by groups like Federal workers, beneficiaries of entitlement programs, national defense programs, and Federally funded state programs. Equity markets may temporarily feel the pain, but it would be more a technical hit rather than an economic downturn.

Looking Forward

2022 proved to be a challenging year for investors on all fronts. Nearly all asset classes lost money. The traditional strategies of asset allocation and diversification didn’t do much to prevent significant losses as the standard 60% stock / 40% bond portfolio returned roughly -16%. As mentioned earlier, bonds offered no salvation since they suffered their biggest losses ever. So where’s the silver lining in all of this? We know exactly the root cause of the sell-off and volatility. The Federal Reserve’s goal to fight persistent inflation may very well produce a recession in 2023. Chances for a soft landing are slim and now the sentiment is there will be a recession, but a mild one as we still have a tight labor market and the economy continues on fairly unscathed. The Federal Reserve moves slowly and often times telegraphs their actions with their press conferences and released statements. We should expect to see a slowdown in their pace of interest rate increases. Now that rates have been normalized, the Fed has the ability to cut rates in the event of a recession whereas that was not an option when rates were at near zero.

Source: FactSet, FRB, Refinitive Datastream, Robert Shiller, S&P, Thomson Reaters, J.P. morgan Asset Management

Stock valuations are still lower than the last couple of years, but are not as attractive as after the Great Recession. As equity prices moved up in the last quarter of 2022, valuations are now just at the long term average; not quite a bargain, not quite expensive. The chart above is the S&P 500’s forward price/earning ratio. If earnings start to disappoint, then that affects the ratio and makes stock prices look unattractive. As shown below, the median gain for the S&P 500 one year after a bear market was 23.9%. At some point when stocks fall enough and the economy starts improving, investors start buying.

Source: Dow Jones Market Data & The Wall Street Journal. Past performance is no guarantee of future results.

The bond market offers more clarity than the equity market since bonds have more defined risks and rewards. Fixed income prices have been negatively impacted by soaring interest rates, which makes existing bonds less attractive. But as the Fed slows down their rate hikes and bonds get closer to maturity, their prices recover, assuming their credit rating doesn’t change negatively. Investors also start seeing bonds as viable investments as their prices are depreciated and their yields start becoming more attractive.

A perfect scenario for 2023 would be a recovery in the equity markets, despite a likely recession, and a rally in bond prices as interest rate risk wanes. If we don’t see any gains in stocks, we may still see bonds do their job and offer diversification to a balanced portfolio.

Wei Trieu, CFP®

View posts by Wei Trieu, CFP®
Wei Trieu is the founder and wealth advisor of Key Focus Wealth. He is a CERTIFIED FINANCIAL PLANNER™ professional who works directly with clients to develop and implement financial plans.
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