What Happened in 2022, and What’s Next?

Many investors may not realize it, but for most of the past 40 years, the wind was at their backs when it comes to returns on their investments. For the most part, it was an extended period of low inflation and low interest rates, which set the stage for long bull markets for stocks and bonds. Then came 2022. Even well-balanced portfolios were hit hard in a macro-driven market roiled by war, inflation, and worries about a looming recession. More uncertainty and volatility are on the horizon for 2023.

For perspective on the past year and guidance for the future, I turned to three Morningstar research leaders.

Preston Caldwell provides U.S. macroeconomic analysis and outlook for equity research clients and Morningstar.com readers alike. Russel Kinnel leads Morningstar Analyst Ratings committees in North America and is the longtime editor of the Morningstar FundInvestor newsletter. Marta Norton’s wide range of research and investing experience serves clients of Morningstar Investment Management and makes her a popular resource for the financial media.

Caldwell, Kinnel, and Norton help investors apply lessons learned in 2022 to investing for the long term. Our discussion took place on Nov. 21; it has been edited for length and clarity.

Tom Lauricella: Preston, let’s start with you. This is one of the most macro-driven markets that I can remember. The big surprise has been inflation. What are the lessons here?

Preston Caldwell: First, I wouldn’t revise long-term expectations upward in reaction to this episode. If you take an average of U.S. inflation from 2010 up through 2022, that’s still right in line with the Fed’s 2% target. There was an undershooting of the 2% target throughout most of the 2010s, and now we’ve seen an overshooting. Those kind of cancel out.

Inflationary risk remains alive and well, but in the long run, deflationary risk is also going to be alive and well. If we ever return to a situation—and it’s quite possible—where the Fed is up against a zero lower bound of interest rates and the economy is depressed, there will be another deflationary episode. In the long run, we do expect that to be a possibility.

Lauricella: In the wake of the financial crisis, we had quantitative easing and very low interest rates for a very long time, but we didn’t have an outbreak of inflation. What is the difference this time?

Caldwell: We had an extraordinarily strong monetary policy response this time, but we also had that in the 2010s. One big difference: Fiscal policy was much more aggressive this time around than last time. In hindsight, it’s clear that the stimulus that was passed in early 2021 was unnecessary.

The other factor is the supply-side hit. The pandemic produced a large negative impact on the productive capacity of the economy. This was unprecedented, so it was hard to estimate the size of that supply-side impact in advance. When I think about what I got wrong in underestimating the inflationary surge, it was mainly about the supply side. I was anticipating a quicker return to normal there and also in terms of the composition of demand, which was skewed by the pandemic. Consumers tilted their spending much more to goods, away from services, due to social distancing. That skew exacerbated the inflation problem because goods prices have accounted for the bulk of the inflationary surge so far.

And then, of course, we can’t ignore the impact of geopolitical issues, which are always black swans, or gray swans at least, and the impact of the war in Ukraine that we’ve seen on driving up energy prices.

Warning Signals

Lauricella: Marta, we had simultaneous bear markets in bonds and stocks, which seems to have been a huge surprise to so many investors. If you think back to late 2021, were there warning signs?

Marta Norton: The most obvious warning sign is the fact that stocks and bonds have not had a constant negative correlation over time. In fact, if you were to look at rolling 12-month correlations between stock and bond markets, they’ve been very regime-dependent, and they’ve shifted meaningfully over time. And in fact, bonds were returning attractive returns at the same time as stocks were returning attractive returns for much of the 2010s. It only caught investors off guard when it went negative—when both were disappointing. The largest warning sign was where valuations were for both the broad bond market and the broad stock market. They were both very unattractive.

Hindsight makes everything seem so crystal clear, but there’s no question that there’s a relationship between interest rates, fixed income, and equities. How strong that relationship is and how it’s going to play out over time are the question marks. One of the questions that we’ve been grappling with internally, with growth stocks in particular, is how much performance was fueled by a very accommodative monetary policy regime that extended for a very long time. It will be one for the history books to decide.

Lauricella: Is it possible that TINA [there is no alternative] was a much bigger driver of performance than we appreciated? Something was clearly driving investors to just pile into those stocks, even though valuations weren’t making logical sense.

Norton: Right, and it depends on who you ask about that, because a lot of people thought maybe they weren’t so far off fair value. It depends on how you incorporate interest rates into your valuation assessment for equities and fixed income.

If I can take off my hindsight perspective, which is so hard to do, I think the scale of the losses in fixed income was pretty surprising—even within safe, secure assets at a period of uncertainty. When we think about the war, when we think about the concerns about China, all the different things going on in the market, the fact that Treasury markets still sold off to the degree that they did is probably the biggest surprise.

Lauricella: Russ, what are some of the key lessons for investors looking back at growth funds, in particular, which took an absolute drubbing?

Russel Kinnel: An obvious one is, don’t chase performance. The biggest losers this year were the funds that were up around 100% in 2020. There’s always danger in getting speculative. You should treat huge returns as a red flag. A lot of the fundamentally driven growth funds have lost much less. It’s not pretty, but they’ve lost a lot less. Fundamental investors look for companies that can endure. They look for earnings that are real and not “meta” pretend earnings.

Going into 2022, growth had amazing long-term returns. Just as we’d had a long time without a real bond market correction, we’d had a long time with very good returns for growth. That set us up for disappointment.

Lauricella: Of course, value funds are down as well, as everybody’s taking a beating. But we have seen some differentiation of performance there. What are the takeaways?

Kinnel: On a sector basis, energy and utilities have done the best, so the funds that favor those have done the best: equity-income funds and deep-value funds have held up much better, while relative value funds have done worse. Back in 2020, the reverse was true. The deep-value funds got absolutely crushed then because the economy just slammed on the brakes.

And now if you go out to three-, five-, and 10-year returns, value’s ahead of growth on the three-year and close to growth on the five and 10. It’s a reminder that these things can level up rather violently.

Balancing Risks

Lauricella: This speaks to the importance of downside protection to long-term returns. It’s something that people don’t think a lot about in a big bull market.

Kinnel: Downside protection keeps you in the market. Diversification is key because it can help limit the downside. In 2008-09, a lot of investors bailed because it was so gloomy, and then they missed a very strong recovery. The markets didn’t wait for the economy to be great again; they looked out at the future. We may see that again. We saw the markets rally on a good inflation number, even though that’s not going to stop the Fed from hiking. But a couple more might.

The rallies are just as unpredictable as the selloffs. Anything that keeps you in the market is incredibly valuable. If you look back at long-term performance, it doesn’t really matter so much if you were in a 65/35 or a 60/40 mix [of equities and fixed income]. Whatever kept you in the market led you to a very respectable return.

Even in a market like this, where just about everything’s in the red, there’s still value in owning the stuff that lost less. Even when things are rallying and you’re having really strong performance, you still need to think about downside protection, because the future is always harder to predict than we grasp.

Lauricella: How viable is the idea that you can protect a portfolio against a spike in inflation?

Kinnel: It depends on how you define protection. You can reduce the impact of inflation with some inflation-protection strategies, but I don’t think the goal should be to inflation-proof your portfolio. You might end up locking in very low returns if you do that.

The goal is, again, downside protection, keeping losses from getting too far beyond what you can stomach, rather than buying so much insurance that you’ve locked out any upside.

Long-term TIPS funds may have disappointed people who didn’t realize there’s also interest-rate risk. And, of course, rising inflation and rising interest rates often go hand in hand. Short-term TIPS did very well. Bank-loan funds held up well. If you held enough in commodities and energy stocks, the big winners, they would have limited your losses or maybe even allowed you to make money.

Lauricella: Marta, how does Morningstar Investment Management think about this?

Norton: I’m of a few different minds. If I take a very investor-goal-centric approach, ultimately, I’m invested in the market to meet financial goals. I don’t meet them if I don’t beat inflation. So, in one way, at the core of what you’re trying to do as an investor is to get ahead of inflation.

But it’s very dependent on time period. If you think that beating inflation means that, in a market like this one, you’re ticking ever higher with every move higher in the inflation trends, then you’re going to be disappointed. Maybe an annuity is the better choice for someone with that mindset. But if you’re of the mind that you have to beat inflation by a particular margin over five or 10 years in order to meet a financial goal, then being invested in public markets can help you get there.

Portfolio managers have to think about inflation protection and how asset classes are going to behave in different environments. But they also have to think about absolute downside protection, like Russ is suggesting. And then they have to find opportunistic valuation-based sources of return. We will own and we’ll run strategies that have inflation protection as part of the mandate, but we don’t expect it on a daily basis.

Caldwell: We should distinguish between protecting in an inflationary scenario against volatility in asset prices and protecting against deterioration in the intrinsic value of our portfolios. Protecting against price volatility is going to be very hard, because the response of asset prices to any particular inflationary episode is all over the map, historically.

For example, we’ve had a big stock selloff this year. The 1970s were also a poor time for U.S. equities. But in other inflationary episodes, even hyperinflationary episodes in other countries, equities have provided protection. If you look at the underlying cash flows that are delivered by equities, those cash flows tend to grow in line, in nominal terms, with inflation. Equities have, in the long run, given insurance against inflation, because the real value delivered by those equities have remained constant, even as inflation went up. And that’s what investors should focus on, in spite of all the price volatility.

Lauricella: Folks who are not optimistic about inflation coming down point to longer-term trends, such as globalization. What do you see out there in terms of these macro global trends that allows you to think that we do still have plenty of global capacity, that it won’t be long before we get back down to 2%?

Caldwell: Less globalization means less productivity and growth in the manufacturing industry. That lowers the potential growth rate of GDP. And that can indeed be inflationary—if the Fed doesn’t adjust to it. As long as the Fed appropriately recognizes the impact of these secular factors, then it can do whatever is needed to achieve its 2% inflation target. If the Fed is doing its job well, then we wouldn’t expect those factors to play out in terms of inflation, even as they do play out in terms of slowing real output and real consumption for the U.S. economy.

Lauricella: Marta, how do you approach building a portfolio in an environment where we have such a high level of macro uncertainty, without necessarily having to be right about this very significant variable? This is a tricky period. Inflation could stay at 5% versus coming down to 2%.

Norton: It’s even more complex when you are a global investor because whatever inflation and rate trends we have in the U.S. are not necessarily going to be mirrored in the U.K. or in Europe, which have their own concerns around inflation, interest rates, and debt crises, and what have you.

We’re valuation-oriented investors, but we also think about how asset classes behave in different growth and inflationary regimes. As portfolio managers, we think about growth and inflation as four quadrants: high inflation, high growth; high inflation, low growth; etc. This is not unique to us. This is a framework that a hedge fund manager at Bridgewater uses, and it’s something that resonates with us as multi-asset investors.

We’re thinking about where these different asset classes fit. How do they behave in these different quadrants and complement other areas? As we think about constructing a portfolio, we’re thinking about exposure to those different quadrants, what the market is assuming around the probability of inflation and interest rates, what’s priced in, and then how we can offset that in our portfolio.

One example is energy. We were keen on energy for quite some time. We had energy, unfortunately, heading into COVID-19. But we increased it throughout the pandemic and then had a big energy overweight. We’ve decreased that meaningfully, but we haven’t decreased it all the way to where it should be based solely on our expected return for energy. On the off chance that inflation surprises the market, as it has throughout the course of the year, this is a reasonable place to be. But we’re looking at MLPs in European energy, specifically, and avoiding the U.S. names that have really skyrocketed over this period.

We’re thinking about valuation, yes, also how these different asset classes are going to behave if there’s a surprising event that shifts the regime from one area to another.

TIPS are appealing because they have that inflation hedge built in and because they’ve really suffered as the rate has increased. Not only do they have valuations in their favor, but they also have this inflation hedge. Today, it seems like the expectation is for slowing rates of inflation and a Fed that’s going to shift its policy stance, maybe at the end of next year. Should that prove wrong, what do we have in our portfolio to help protect us in that environment?

Navigating Fixed Income

Lauricella: We are in a very different environment for bonds than we’ve been in for a tremendously long period of time. Marta, how are you approaching the bond market?

Norton: It’s a tough question right now. We haven’t had selloffs of this magnitude on both equities and fixed income at the same time. Typically, we would be looking to add to the areas of greatest risk that have suffered the most. But fixed income has suffered tremendously, and it hasn’t necessarily been from spread widening as much as it has been from just a shift in rates, so some of the higher-quality stuff looks attractive to us—short-dated, investment-grade securities, which are not typically where you’d be looking when you’re coming out of a selloff.

Our portfolio managers are definitely buying more equities, especially those that have sold off the most meaningfully relative to their fair values. But they’re also adding to fixed income, so the equity/fixed-income split is not shifting a whole lot. How can we do that? People usually think just of bonds and stocks, but we own a lot of alternatives that have served us well over this stretch, so we have this funding source that can go either into equities or fixed income.

People are also interested in high-yield and emerging-markets debt, which has really suffered. But with spreads not widening as much as yields have gone up, you’re taking on a little bit more risk when you’re moving into those areas. People are adding on the margin there but not going as wild as they would be in a different type of market environment, especially if you consider that there may be recessionary risk and what that could mean for spread widening. We’d like to see spreads widen out a touch more before we got aggressive into that area.

Lauricella: Russ, it has been a long time since investors have been able to look to bond funds for yield. What should they be mindful of?

Kinnel: The yields on high-yield bond funds are certainly very attractive right now. It’s mind-boggling, considering where we’d been for so long. But the Fed is raising rates and pushing hard to get us into recession, and high-yield debt is obviously very sensitive to that, because these are companies that are leveraged up and may not have the slack to keep up with their payments in a recession. But this bigger yield leaves a little more margin for error because that yield will make up for some defaults or some interest-rate risk. So, it’s pretty attractive, though I would not be grabbing high yield with both fists.

And as Marta points out, even investment-grade corporates have really been smoked this year, and so you don’t necessarily have to take huge risks for yield. But this year has shown that any kind of income-oriented strategy is vulnerable. Now those risks are already clearly spelled out.

Lauricella: If you see one fund yielding 9%, then another yielding 11%, you’ve got to question it, right?

Kinnel: Anytime you see a fund that’s yielding a lot more than its peers or benchmark, you know it’s taking a lot of risk. And sometimes it’s a rather idiosyncratic risk that’s hard to find. Usually, it’s obvious, like more interest-rate risk or more credit risk. I would say this is a good time to curb those tendencies to go for the biggest yield, because you can be richly rewarded with a well-run fund that’s got risks in check. But there will always be people who want to stretch for a higher yield. And generally, that’s a dangerous strategy.

Lauricella: Preston, do you have a sense of how balance sheets are across corporate America?

Caldwell: In aggregate, private-sector balance sheets on both the household and the business side have improved quite a bit since the start of the pandemic. The fiscal stimulus meant that the government was a big net borrower during the pandemic. Whenever the government’s a big net borrower, holding the foreign sector equal, the domestic U.S. private sector becomes a big net lender, so they paid down a lot of net debt on both the household and the firm side. With the monetary-policy support, many entities have refinanced at lower rates, and those are still locked in, even as rates have risen quite a bit over the past year. That would all suggest reason for optimism at the macro level. But could there be micro pockets of vulnerability? That I’m less sure about.

Investing in Uncertainty

Lauricella: I want to follow up on emerging markets. China isn’t necessarily a big part of everybody’s portfolios, but it plays a big role in the emerging-market indexes. Marta, how do you evaluate the risk of investing in China, when so much of it is at the government level?

Norton: We just had a teamwide conversation on what is uninvestable and how do you determine it? I’ve seen several sell-side headlines that have come out over different stretches calling China uninvestable. If the uncertainty window seems particularly wide-open for a market, people don’t know if they’re going to get paid back. Sometimes that relates to rule of law, or geopolitical risk more broadly.

But we’re global investors. My perspective is that there’s probably greater uncertainty around most investments than people realize. You’re never going to be able to handicap the geopolitical risk in China, at least not accurately, and the zero-COVID policy can surprise in ways that caught us off guard. And there are a number of regulatory concerns as well. When we wrestle with that, we consider what could happen if this investment went to zero. What would that do to the portfolio? We do a lot of scenario analysis around that type of uncertainty.

In fact, from our expectations of returns, China looks very attractive right now. But the fundamental risk is also through the roof. So, that’s how we’re sizing it, based not on how big it is in the markets but on how much pain our portfolio could take and still deliver a good outcome for investors.

Lauricella: Russ, the Morningstar house view on liquid alts has been that they often do not deliver what they advertise. When you look across the spectrum of alternatives for fund investors, what’s the verdict for 2022?

Kinnel: It’s actually been a pretty good year for a lot of alt strategies. One big reason is that trend following worked. Trend following would have told you to, say, start buying up commodities. The average market-neutral fund has positive returns. A lot of the other alts are either positive or barely negative.

Alts have redeemed themselves as diversifiers. In other down markets, plain old short-term bond funds had done a better job than alts, for a smaller fee. But this time, a lot of the alt strategies have actually done a nice job, suggesting that they might be a good part of the portfolio to diversify beyond your traditional stocks and bonds.

Lauricella: Marta, how do you see alts in the context of portfolio strategy?

Norton: With anything that you own in a portfolio, you should have a fundamental rationale for owning it. You should know what role it’s going to play—at a most basic level, whether it’s for capital appreciation or capital preservation.

We have some advantage with alts because we’ve been using alts strategies for so long. I was with the team when we made it through the global financial crisis, and I remember being disappointed with a lot of alts managers. They had made these tremendous promises, especially long-short funds, that they could somehow have the upside but still mitigate the downside. And a lot of them disappointed. Some did OK but certainly not as well as investors hoped. The results were roughly in line with what you would get from a conservative asset-allocation portfolio.

So, we spent a few years thinking through, what are we really trying to get with alts? There’s a lot of different stripes. You have alts that are almost equitylike in terms of the volatility and risk that they take on, but are diversifiers, like some commodity and managed-futures strategies. Other alts are trying to be very defensive and diversify away from rate and equity risk.

From a portfolio-context perspective, if we want big returns, we’re going to turn to the equity market. We’re not going to play around with an unpredictable managed-futures strategy. But back to the point I made at the start of the conversation, there is some overlap between the drivers of fixed income and the drivers of equity. Is there a way for us to diversify away from that? That’s where we turn to alternatives.

We’re very purposeful. We have three managers in our alt strategy. We’ve known them for a very long time. They charge lower fees than what you typically see in alts. They have a predictability to their returns. They have a fundamental case behind what they’re trying to achieve that’s something that we can understand.

The cost to them is that we give up a lot of upside. If you’re in an environment like we were in the 2010s, when monetary policy is very accommodative and fixed income and equities are a fine place to be, then alternatives are going to be a bit of a disappointment. Just like life insurance can be kind of a drag on your overall financial picture—but when you need it, it’s there. That’s how we looked at alts, and we were really pleased with how they helped our portfolios this past year. To Russ’ point, our alts fund outperformed our defensive bond fund meaningfully over this stretch.

Durable Lessons

Lauricella: What’s one final takeaway for investors from this crazy 2022—the durable lesson?

Kinnel: One of the lessons is that these long-term investments really need to be long term. Even bond funds are not meant to be a place where you put money for your kid going to college next month. Diversification works, but there are these storms that hit. It seems like every few years, you get some downturns, and the short term is incredibly hard to predict. But the long-term economies and markets are very resilient, and you will likely be rewarded.

It’s very important to have a realistic outlook for both the upside and the downside of your investments, so that you can make it through—because the rallies can be just as violent and surprising as the selloffs.

Caldwell: At the macro level, asset price volatility is an order of magnitude larger than volatility in the underlying fundamentals across any kind of asset. Asset prices always overreact, basically.

Also, it’s remarkable to me how extreme and wrong the narrative was early on in the pandemic recovery, with talk of a new normal in terms of relative sector performance. Tech was going through the roof and energy was getting hammered because, supposedly, nobody was going to be driving to work anymore or going to shop in stores. That goes to show you that we should be skeptical of these grand new narratives that come to dominate the market. No matter how efficient the market is at a micro level, at a macro level, it can still be very inefficient.

Norton: I’m learning lessons all the time, but the most durable lesson to me relates to uncertainty and to holding convictions loosely. We investors do a lot of analysis, and when we come to a conclusion, it means something to us. We put a little bit of our heart into it, and we get married to it. This is behavioral bias 101.

I think the best way to invest is pragmatically, to be willing to take in new information as it comes without losing your moorings or your philosophy as you do it. Have a loose grip on your convictions. Work hard to come to them but be willing to change your mind.

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