Stock and Bond Markets’ Wild Ride in 2022

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. Today’s discussion is going to take a closer look at some of the biggest market headlines of the year. 2022 started with the markets riding high before a month’s long roller-coaster ride kicked off, and it’s still going. Morningstar Inc.’s chief markets editor and Smart Investor newsletter editor Tom Lauricella is joining Investing Insights to talk about the highs and the lows.

Tom, what a year it’s been. Inflation has dominated the headlines. What’s Morningstar’s take on what’s been driving inflation this year?

Tom Lauricella: Yes, there’s no question that inflation has been the big story for the markets in 2022. Much, much stronger pace of inflation than pretty much anyone could possibly have expected, I think. The Morningstar take on this is that a lot of what has been driving inflation has been related to supply chain issues. This is the stuff that happened during the pandemic when the process of getting things made and shipped and delivered just hit all kinds of snags as there were worker shortages, and it just fed on itself. This created a real bottleneck in the economy that was a big part of why we saw big price increases in things like autos, for example, and then we had knock-on effects from there. So, even though inflation has taken much longer to come down than pretty much everyone had initially expected, the view from Morningstar is that these forces are being reversed, that we’re starting to see the signs of this already, and, especially as we get into 2023, that those factors, those supply chain issues will begin to come down. Some of the other pressures that we’ve seen, such as in rents and home prices, that’s already started to come down, and we’ve already seen energy prices come down, and all these factors should finally come together next year to get inflation trending more solidly downward in the Morningstar forecast as we go through the year.

Hampton: What would it likely take to push inflation down to the Fed’s 2% target, and how long could that take?

Lauricella: That’s the big question. As I said, at Morningstar, the thought is that these forces are already in place and that it’s just going to be a matter of just month by month, a little bit of time, going through this process. The big question I think in the market’s mind and that the Fed is … The economy’s still been really strong. We’re finishing 2022 with an economy that is really cooking along. The job market is very strong, and that’s kept wages very high, and there’s the potential for wages, particularly in the service sector, to feed through to inflation. So the key variable, I think, that a lot of folks are looking at is the degree to which the economy does begin to slow down and to which in particular we can get some of those service sector wage pressures to come off the boil a little bit, and that over time, will hopefully get inflation down to the Fed’s 2% target.

Hampton: And the Fed for a while described inflation as transitory. Then it began raising its benchmark borrowing rate in March. What categories of inflation have the Fed focused on?

Lauricella: Yeah, the word transitory was the story for late 2021, and it’s a word, I think, that the Fed very much regrets using. A lot of folks regret having that been out there in their own forecasts because, yes, inflation may have been transitory, but it’s still taking a long time to come down. The big focus right now is, as I said, on that service sector: To what degree will inflation start to ease? And this is where it shows up. It shows up in things like when we go out to eat, when we’re shopping. It’s not just the underlying prices of the goods: It’s the cost of keeping the stores staffed; those are the costs that still need to come down quite a bit.

Hampton: You just mentioned keeping stores staffed. How does wage growth play into the Fed’s moves next year?

Lauricella: It’s really probably the biggest question mark at this point. We’ll have to see. I mean at this point, the most recent reading on wages in the monthly employment report was it went the wrong direction. It’s still high and rising. So for 2023, that’s going to be one of the most important data points to watch as we get those monthly employment reports. It’s not going to be just the overall pace of hiring and the unemployment rate, but it’s going to be those wage pressures. Now, if the unemployment rate does begin to rise, as the Fed and other economists begin to expect, that should take some of that upward pressure off wages, off a little bit, and that should help the inflation outlook.

Hampton: Let’s get into another big headline this year. A column titled “The Worst Bond Market Ever” recently appeared in Smart Investor. What happened this year with bonds?

Lauricella: This was unfortunately one for the record books. There literally has not been a worse bond market ever for investors. When you look back at history, a bad bond market would be something like down 2%, down 3%, that would’ve been considered a real bear market in bonds. We’re down 11% so far, according to the Morningstar Core Bond Index. That’s an unbelievably large number for the bond market. A couple of months ago, those numbers were even worse. We were down 16%, 17% for the year, and the story is just simply inflation and the Fed’s rate hikes. When inflation is high and the Fed is raising interest rates as aggressively as they were from such a low starting point, you’re going to have these kinds of massive losses in the bond market. It really, I think, in talking to people in the bond market, and I’ve covered the bond market for a long time, this is something a lot of folks never thought we’d see.

Hampton: Now with stocks also down big this year, what has the plunge in bonds meant for investors’ portfolios?

Lauricella: From an investor’s standpoint, probably the biggest story isn’t just one aspect of the markets or the other, it’s how it all came together. So we’ve got bonds down some 11%, and we’ve got stocks down 20%. Now, normally we hold bonds in our portfolios to act as some ballast against what happens in the stock market. The assumption is that if stocks are down, perhaps the economy’s sliding into a recession and weakening, and that ought to be a good market for bonds. So even if stocks are down, bonds are doing well, and you get that offset. That’s diversification in a nutshell. That has not been the case this year. It’s been the opposite. We’ve had this very unusual set of circumstances where because of that dynamic with inflation, because interest rates were so low to start off, we’ve had both stocks and bonds down this year. So that means investors have really had almost no place to hide in the markets this year. It’s been a really, really tough year from that standpoint. One of the worst for diversified portfolios that we’ve ever seen.

Hampton: How should investors think about bonds in 2023?

Lauricella: The good news, the silver lining here as we look at these losses in our portfolios, is that yields are much higher. Yields are at historically attractive levels in the bond market. What that means is that you can earn 5%, 6% on a safe investment. You don’t have to stretch into something that has a risk of losing a lot of money to earn some real return. And we’re talking government bonds here. So you’re going to get your money back. If you want to stretch into something a little riskier, like corporate bonds, you make even more. High-yield bonds are yielding at around 8%, 9%. Those come with a little more risk, but the bond market is now offering yield levels that, depending on what happens in the stock market, are very competitive with equities. A lot of folks out there, and we’ve written about this, who are saying that right now bonds are probably a better bet than stocks, and that’s a very different landscape than we’ve seen in quite a long time.

Hampton: Wow. Well, Big Tech names like Amazon, Microsoft, and Apple, they led the market at the start of the year. The current economic environment has pressured this sector. Can you describe why tech was hit so hard?

Lauricella: Talk about some more eye-popping numbers here. We’ve got Microsoft down 26% this year. Amazon down 47% this year. Even Apple, such a stable company, down some 20% worse than the overall market. These were the stocks that investors would come to rely on as being almost like a sure thing. Their products were ubiquitous. I mean, think Amazon is everywhere in our lives, and those stocks had done very well for quite some time. But when the dynamic changed in the economy with interest rates rising and the outlook for potential recession, these stocks were pretty expensive. All the investors, a lot of investors had the same idea, let’s move into these stocks, they’re such great companies, but they were expensive. So you had a combination of rising interest rates, which is a negative for growthier stocks where a lot of the expected earnings are off in the future. So you had rising interest rates, negative, you had valuations, a big negative. Those stocks were very expensive. That combined to just lead to be a terrible year for Big Tech.

Hampton: What is it going to take for tech to rebound?

Lauricella: That’s a good question, and it’s very much an open question, and almost unanimously, in talking to people in the markets, what they’re saying is people have to think about technology differently. Prior to this year, you had what some people referred to as sort of “hope and dream” stocks that their expectations for business growth were so high that these companies really had to grow a lot to just keep up with their expected valuations. There’s a lot of great tech companies that are making a lot of money as... I mean, again, Apple, churning out cash. Amazon, very dominant, even if they have a tough year. Google, I mean these are very, very solid, stable companies for the most part. But investors need to think about them a little bit differently. Look for technology companies that are profitable, that are churning out cash in a way, looking at technology stocks, perhaps more like you would look at a value or dividend stock.

Hampton: Another area that was riding high at the beginning of the year was crypto. Tom, do you remember the Super Bowl ads?

Lauricella: Yes. That’s always a negative sign. That’s one of those warning signs when you start to see Super Bowl ads about financial investments. It’s hard to describe the carnage in the crypto space this year, and I think it’s disappointed a lot of people. But then there were also a lot of folks who were out there saying, “We told you so.” This was always going to be a speculative investment, the way it was being structured and touted. Essentially, you were buying cryptocurrencies with the belief that you’re buying it because somebody else will pay more for it. It’s the greater fool theory, in a way; I’m buying this because other people will pay more for it. Doesn’t always work that way. And we’re seeing what happens in the reverse.

Hampton: Another article that appeared in Smart Investor laid out some lessons from crypto’s implosion. What are they?

Lauricella: John Rekenthaler had a great piece on this. The first point of his was that we got a reminder of the high volatility inherent in crypto. Volatility works both ways, people forget. So we had volatility for years on the way up. There were huge gains, and now we’re seeing what happens when you have volatility on the way down, which is the way people usually think of volatility. First and foremost: Crypto is volatile. Second, it hasn’t really turned out to be a diversifier in portfolios. That was something that folks had touted about crypto, that it wouldn’t necessarily be correlated to anything else in the markets. That may well be true, but it certainly hasn’t helped anyone’s portfolios from a diversification standpoint in a year when stocks and bonds are down. Event risks, we’ve seen this left and right with the collapse of exchanges. Now we’ve seen allegations of criminal activity. We’ve had so-called stablecoins proving not to be so stable. Another word for this is headline risk. There is a lot of risk out there in terms of potential negative developments, and they all were just popping up left and right this year. And then last one is it’s similar in that you just can’t avoid the dangers, that there are some real risks in cryptocurrencies, and there’s not a lot of places to hide in the crypto market when things go wrong.

Hampton: As we wrap up our conversation, what should investors watch for in 2023? Because I know your team’s going to be tracking the big stories.

Lauricella: The big story is really just going to be what happens with inflation. If you can tell me now what will happen to inflation next year, I can tell you what’s … well, maybe not exactly, but give you a pretty good outline what will happen in the markets. First and foremost, it’s going to be watching the variables that go into inflation. Second, the degree to which we have a recession. The bond market is predicting that it’s very likely that we’re going to see an economic downturn. Morningstar calls it will have a very shallow recession. If it turns out that the Fed’s rate hikes have to stay in place longer or they have to go higher—and we end up with a deeper recession that the market’s not really prepared for on the equity side—and so that could have a big effect. So really it looks like another year where these big macroeconomic forces are going to drive a lot. It’s not always that way, but we’re very much in that zone right now.

Hampton: Tom, we have a lot to watch for next year. Thanks for reviewing this year with me. Happy New Year.

Lauricella: Thanks for having me.

Hampton: That was a great conversation with chief markets editor Tom Lauricella. Subscribe to Smart Investor Newsletter to read his insights each week. Also subscribe to Morningstar’s YouTube channel to stay up to date on new videos. Investing Insights is going on a holiday break. We will return in January with a two-part episode focused on creating a financial plan for the new year. And you don’t want to miss my conversation with Morningstar Inc.’s director of financial psychology, Sarah Newcomb. Thanks to podcast producer Jake VanKerson. And thanks to all of you for tuning into Investing Insights. I’m your host, Ivanna Hampton. I’m a senior multimedia editor at Morningstar. Happy holidays.