Year in review: the end of the ‘great moderation’

For much of the past 30 years markets have enjoyed a benign backdrop of low inflation, falling interest rates and sustained economic growth. This has been a supportive environment for both bonds and equity markets. In 2022, however, this changed. After several decades of more muted business cycles, the ‘great moderation’ drew to an abrupt close.

The immediate catalyst was the swift change in central bank monetary policy, as inflation started to bite. Inflationary pressures had started to build as economies reopened after the pandemic. Supply chain disruption during the pandemic created shortages, which collided with a sudden increase in demand. An under-investment in energy, particularly fossil fuels also contributed to inflation through higher oil and gas prices.

Stock markets started to turn in January after minutes from the Federal Reserve’s Open Market Committee (FOMC) showed a change in tone. The war in Ukraine exacerbated the situation, as Russia launched its ‘special military operations’ in February. Governments around the world – but particularly in Europe - were forced to confront their reliance on Russia for much of their energy needs. Commodity prices soared, creating inflationary pressures across all major markets and forcing central banks to raise borrowing costs.

This new era changed the outlook for financial markets. Areas such as technology, where low interest rates had flattered their valuations, were weak, while investors favoured companies in the energy and materials sectors, which were less sensitive to interest rate movements and inflation. It was a significant reversal in the market environment that had prevailed for over 30 years.

The war in Ukraine shifted an inflation problem, brought about by supply chain disruption and the post-Covid recovery, to a full-blown cost-of-living crisis. Central banks were slow to act initially dismissing inflation as transitory – thinking it was all linked to the pandemic, but it soon became clear that rising prices would be considerably more persistent than originally expected.

Central banks had no alternative but to raise interest rates, with the commensurate hit to growth. The IMF now forecasts that growth will be just 3.2% in 2022 and 2.7% in 2023, though its forecasts have been subject to significant revisions all year. This is the “the weakest growth profile since 2001 except for the global financial crisis and the acute phase of the COVID-19 pandemic”[1]. At the beginning of the year, it had forecast growth of 4.4%[2].

Investors spent much of the year looking at jobless numbers in the US or the strength of the housing market, hoping for a clue as to when inflation would peak. By and large, they are still waiting. US CPI inflation cooled to 7,7% in October, its lowest level since January[3], but still a significant way ahead of the Federal Reserve’s 2% target.

Where inflation has led, interest rates have followed. For much of the year, financial markets have been watching every move from the Federal Reserve (Fed). It raised interest rates six times in 2022[4], taking the Fed funds rate to 3.75-4% and pushing mortgage rates in the US to 16-year highs. More interest rate rises are likely in 2023 as the central banks in developed markets looks to curb rising prices.

For the early part of the year, financial markets had optimistically hoped that the Fed would be forced into tempering interest rate rises by a weakening economy. The Federal Reserve’s belief that inflation was transitory changed in June and the narrative from the Fed reflected that with Fed Chair Jay Powell saying his commitment to curbing inflation was “unconditional”[5], making it clear that the central bank would risk recession to curb price rises. Part of the problem was the ongoing strength of US employment – jobless numbers remained low in spite of mounting economic pressures.

The rest of the world largely tracked the Federal Reserve. Latin America was a little ahead on rate rises, while the UK and Europe trailed, but the direction of travel was the same. Only China and Japan stood apart. Neither saw significant inflationary pressures emerge and have been able to sustain loose monetary policy.

2022 has been a year most investors would rather forget, with bond and equity markets seeing significant falls and uncomfortable volatility. Importantly, holding a portfolio of bonds and equities provided little protection, as both asset classes proved correlated to high inflation. Investors had to turn elsewhere – infrastructure, for example – to find alternative sources of income and capital growth.

Notably, the year also saw a considerable rotation from growth to value, ending the long dominance by the technology sector. In particular, many of the stock market darlings of the previous decade saw weakness – Meta Platforms, Amazon, Alphabet and Netflix. Regulatory pressures are mounting and, in some cases, their business models seem compromised. At the same time, investors had assumed the strong performance of areas such as ecommerce during the pandemic would persist in a normal environment. It didn’t, earnings fell and share prices were hit hard.

Energy was perhaps an obvious victor at a time when commodity prices were high, though share price rises slowed, in the second half of the year as governments demanded a share of their windfall profits. Nevertheless, the sector remained the best performing in 2022. The mining sector benefited from a renewed push into infrastructure development. Countries with large resources exposure, such as Brazil, also had a strong year.

The year also produced some surprising winners. Indian equities, for example, were strong, fuelled by the country’s improving economy, ongoing reform agenda and relatively minimal exposure to inflation. They were a notable contrast to Asia’s other big beast, China, where stock market performance was poor. Investors turned their backs on the world’s second largest economy on fears over growing autocracy and government interference, ongoing Covid restrictions and its indebted property sector.

It was a good year for UK blue chip companies. The UK stock markets outpaced most of its international peers. The significant bias in the year’s popular sectors – mining, commodities, oil and gas – was helpful, as was the rotation away from growth sectors such as technology, which are only lightly represented in UK equity markets. Sterling’s weakness against the US dollar also flattered US dollar earnings. This improved performance for many of the UK’s large multi-nationals.  

It was a grim year for bond markets, which had to contend with rising inflation and interest rates. Having started the year with a yield of around 1.5%, the US 10-year bond yield hit a peak of over 4.2% by October[6], though this had started to moderate by the end of the year as investors increasingly priced in a recession. In November, the US government bond yield curve inverted - where longer-term interest rates are lower than short-term interest rates - suggesting investors believe the Federal Reserve will slow the pace at which it raises interest rates. This has typically been a precursor to recession.

Where the US led, other bond markets followed. The UK has its own idiosyncratic problems, when an ill-judged ‘mini-budget’ under new Prime Minister Liz Truss in September 2022 crashed the pound and caused a spike in UK borrowing costs. It prompted her resignation and a hasty reversal of almost all the measures from incoming Chancellor Jeremy Hunt. He announced a range of tax rises and spending cuts to shore the UK’s international reputation for fiscal responsibility once again. For the time being, UK gilts have settled at a more normalised level.

Rising yields meant significant losses for investors. Most bond investors saw double-digit falls in their bond investments over the year and at points, some, longer dated, UK government bonds were down by as much as 40%[7]. This has been very difficult, with many investors holding bonds as a low-risk, ‘safe haven’ asset class in their portfolio. It may be little reassurance, but bond prices have recovered from those lows and yields are now at more reasonable levels reflecting the interest rate environment more accurately. They may once again be able to fulfil their traditional role in portfolios – as a source of income and a diversifier from equities.

With most major economies at or near recession, there may seem to be little immediate cause for optimism. However, inflation appears to be nearing its peak, company earnings are holding up, stock market valuations look far more realistic today and, most importantly, there are opportunities for active managers in every environment. Stock markets typically turn some way ahead of the global economy, so we believe it will be important to stay invested.

Sources

[1] World Economic Outlook October 2022, imf.org, 11 October 2022

[2] World Economic Outlook January 2022, imf.org, 25 January 2022

[3] US inflation cools to lowest level since January, Financial Times, 10 November 2022  

[4] Here’s what the Federal Reserve’s fourth 0.75 percentage point interest rate hike means for you, CNBC, 2 November 2022

[5] Fed's inflation fight is 'unconditional,' Powell says, Reuters, 23 June 2022

[6] U.S. 10 Year Treasury Note, marketwatch.com, [accessed 5 December 2022]

[7] Refinitiv / Evelyn Partners