Investment strategy team

Conventional wisdom states that stocks rise when bonds fall, and vice versa. But in 2022, equities and bonds fell together as rapidly rising interest rates put downward pressure on both markets.

This was particularly painful if you were expecting your bond portfolio to provide a buffer during stock market volatility. While some of 2022’s economic challenges are still in play, we’re seeing opportunities as well.

Challenge (for now): Inflation

This past year’s inflation run-up was fueled by a sharp rise in prices for goods, which then broadened to include higher prices for services. But historically, once inflation peaks, it tends to decelerate at a steady pace. That was the case even in the 1970s and ’80s.

We believe easing supply shortages, moderating consumer demand and excess retailer inventories should lead to a slowdown in goods inflation. Price increases for services tend to be more slow-moving, but they also should shift in the right direction this year.

Housing inflation is the biggest services component, but home prices are cooling under the weight of higher borrowing costs. And a gradual easing in labor market conditions should keep downward pressure on wage growth, which tends to drive inflation for other services.

Challenge (for now): Interest rate hikes

In rate-hiking cycles since the late 1970s, the stock market averaged a nearly 4% gain during the period of the final three Fed rate hikes. Larger gains came when the Federal Reserve stopped hiking rates, producing an average return of nearly 15% after 12 months and 35% over the two years following the last rate hike.

The Fed is holding rates at restrictive levels even as inflation pressures recede to avoid reigniting any smoldering inflation embers. Despite this, we think economic conditions will warrant the Fed signaling an easing in monetary policy ahead. We think the Fed’s actions this year will move from challenge to opportunity for stock and bond market performance.

Opportunity: Bonds

We believe bonds will play their more traditional role for portfolio diversification this year and perhaps offer outsized returns as well. With aggressive interest rate hikes in the rearview mirror, there is potential for price appreciation if bond yields peak and start to trend lower.

Look for opportunities to complement your CDs or one- or two-year Treasury bonds with longer-duration investment-grade fixed income. These bonds not only offer the opportunity to lock in higher yields for a longer period, but also provide exposure to higher-rated credits, which may hold up better if economic growth softens.

Before investing in bonds, you should understand the risks involved, including credit risk and market risk. Bond investments are also subject to interest rate risk such that when interest rates rise, the prices of bonds can decrease, and the investor can lose principal value if the investment is sold prior to maturity.

[ADA description: This graph shows the total return of a traditional 60/40 portfolio of stocks, with 60% stocks represented by the S&P 500 and 40% bonds represented by the Bloomberg US Agg index. Since 1980, years with a 10% or more drawdown in balanced portfolios have been followed by stronger returns.]

Opportunity: Equities

In 2022, value and defensive sectors led the stock market. Aside from energy, the top-performing sectors were consumer staples, health care and utilities. These are traditionally considered defensive because they can outperform during economic downturns and inflationary environments.

While you may see these sectors continue to lead during a mild downturn, equity markets have historically been forward-looking, recovering anywhere from three to six months before the end of a recessionary period.

Market leadership may broaden throughout this year to include areas that do well in a recovery period, including cyclical sectors, quality growth and parts of the technology space. Overall, we see a more balanced equity market leadership emerging between defensive and cyclical sectors in 2023.

Keep moving forward

As inflation moderates and the Fed pauses its rate-hiking cycle, we would expect last year’s down market to make way for a potential new bull market ahead. We would also expect some market volatility along this path, which may cause your portfolio allocations to deviate from their targets. Rebalancing can help you stick to your long-term plan and stay aligned with your financial goals. Talk with your financial advisor about this strategy and others that can help position your portfolio for the journey ahead.