A Fresh Start

A new year is synonymous with fresh starts, resolutions and positive outlooks. Typically, the markets ignore this flip of the calendar, but this year feels different. The start to this year has provided some relief from a challenging 2022. Stocks are up 15% since the lows at the end of September and up 8% year to date. Many fears that were prominent last year started to subside in the fourth quarter as inflation pressures began to ease, the dollar declined, China began to reopen and Europe experienced a milder than expected winter. The chart below shows the S&P 500 Index for the past two years, including the upward trend that began late last year. While we are long-term investors, it is interesting to explore the tailwinds that have resulted in easing financial conditions over the past four months.

Stabilizing Inflation

On Tuesday, CPI was announced. Overall, CPI rose 6.4% in January from a year earlier, continuing its descent from June’s 9.1% peak. Easing inflation gives central banks the ability to slow down their pace of interest rate hikes and equity markets have responded positively to those prospects. Consumer sentiment bottomed at the beginning of the fourth quarter and has begun to improve as inflation declined and uncertainties eased. As uncertainty lifts, equities prices tend to increase.

Declining Dollar

In 2022, the US dollar rallied to a 20-year high due to tightening global financial conditions before collapsing almost 8% in the fourth quarter. The rapidly falling dollar helped boost emerging markets whose companies tend to carry heavy dollar debt exposure. As financial conditions eased and the dollar declined, international equities rallied. Within the equities portion of our portfolios, we typically have a 70/30 split between domestic and international stocks. This 30% allocation has been a key contributor to returns over the past few months, not only providing meaningful diversification, but also better valuations and higher dividend income for portfolios.

Easing Conditions Abroad

Heading into the winter months, there were fears of a European energy crisis as prices dramatically increased due to lower supply. A mild winter helped to stave off those fears, and as a result, developed markets equities rallied. In the fourth quarter, the developed markets MSCI EAFE index surged over 17% and continues to have a strong 2023, up around 7%. In the emerging world, positive news regarding China propelled returns. The easing of the Zero-COVID policy and decreasing pressures of the technology sector’s regulatory reforms boosted investor confidence in a 2023 rebound.

Turbulence Ahead

Despite a positive start to the year, we don’t think we’re out of the woods just yet. In the near-term, we believe that recession risks are still present. Because of our murky outlook, we remain cautious. Leading economic indicators such as PMI levels and the inverted yield curve signal recessionary pressures in the next six to 18 months. While slowing inflation has provided optimism regarding a slowdown and ultimately even a reversal of the Fed's tightening regime, core inflation is proving sticky and employment remains persistently strong, which may extend the Fed’s tightening cycle longer than some investors expect. The markets are now pricing in two more 0.25% hikes with cuts possible at the end of this year or early next. Within portfolios we've sought to remain tilted towards “quality,” which means a tilt towards large cap names, value-oriented strategies and domestically focused investments.

Despite rockiness in the short term, our long-term outlook has much improved. Yearly capital market assumptions are one thing that indeed follow the turn of the calendar. Heading into 2022, forward return expectations were muted given high valuations. This year, our view for long-term stock and bond returns is more constructive due to lower starting valuations and higher interest rates. Long term investing is key to successful financial outcomes. With 2023’s fresh start, now is a good time to revisit your financial plan—plus the forward-looking expectations may provide a positive surprise.