The fourth quarter provided some encouragement in an otherwise grim year for equity and fixed income investors. Central banks around the world continue to tighten monetary policy aggressively through the end of 2022. However, investors expect rate hikes to slow in 2023. Inflation retreated from recent highs as the US Consumer Price Index reported a 6.5% annual increase. of the end of the year. This compared to 9.1% at its last peak in June.

The U.S. dollar depreciated after rising for much of 2022, as interest-rate differentials between the United States and other countries narrowed. A devaluation of the dollar eased the struggle for foreign currency-denominated investments.

Despite gains across all major asset classes in the fourth quarter, only commodities – driven by record energy prices – ended the year with net positive returns. We should enter 2023 as investors grapple with slower global growth projections, pending rate hikes by central banks, and the reopening of China.

Each quarter, Morningstar’s quantitative research team reviews recent US market trends and evaluates the performance of individual asset classes. We then share our findings in the Morningstar Markets Observer, a publication that draws on meticulous research and market insights.

Here are some findings from our latest quarterly market review.

Markets peg higher rates until mid-2023, followed by rate cuts

As of mid-January, futures markets were pricing in the federal-funds rate (solid green line) peaking at around 5.0% in summer 2023 — with 4.5% expected at the end of September 2022 (dashed green line) — after the rate. deduction. Markets expect higher European Central Bank terminal rates than in September, following aggressive easing in the second half of the year. Bank of England expectations fell dramatically as UK financial markets stabilized in the fourth quarter.

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Asset-class winners and losers

The colorful pattern in this “quilt chart” illustrates how unpredictable market fluctuations can be. Despite recording the worst return in the past 15 years, commodities led the way among asset classes in 2022. Rising rates, high inflation, and reduced growth expectations created a difficult environment for both equity and fixed-income markets globally. Large-cap stocks topped all asset classes in 2019, 2020, and 2021, followed by last in 2022.

Quilt chart showing the highest and lowest returns of various asset classes between 2008 and 2022.

Who stands to benefit from China’s reopening?

Using the Morningstar Country Indexes, we can see which country’s constituents are most exposed to China, and which regions stand to benefit most from a reversal of China’s “zero-COVID” policies. Several Asia-Pacific neighbors have the highest revenue risk, although the degree of that risk has changed over the past three years. Brazil and Chile have seen a clear increase in the revenue share of components attributed to China, albeit to a lesser extent, as have some European countries.

Bar chart of how the share of revenue of different country components falling in China has evolved between 2019 and 2022.

Volatility was a key feature of global rate markets in 2022

After a lull in 2021, global rates saw an explosion of volatility in 2022. Most benchmark sovereign 10-year yields rose 200-300 basis points or more in the third and fourth quarters, with swings of 50-100 basis points. Japan joined the party late in the year as the Bank of Japan surprised markets by loosening its yield-curve control policy. As central banks continue to pull away from bond markets, 2023 could be another tough year for rates around the world.

Line chart showing volatility of yield rates of various countries between January 2020 and November 2022.

Stocks lost less than bonds for the first time … ever

Rarely do both stocks and bonds post negative returns in a given year, but when they do, stocks always sink deeper than bonds. That is until now. US long-term government bonds recorded their worst calendar year on record in 2022, posting a negative 26% return. Large-cap stocks lost “only” 18%. Bonds have not survived the double whammy of unexpectedly fast inflation and aggressive central-bank tightening, which are particularly challenging conditions for fixed income.

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A bar chart shows that 2022 was the first year in which both stocks and bonds posted negative returns, with bonds experiencing worse returns.

US margins squeeze in high-labor-cost sectors

Strong U.S. wage inflation will eat into corporate income margins in 2022, especially for service sectors where labor is a major cost. Major corporations in technology, communications services and financial services announced a wave of layoffs in 2022 after a roaring year of hiring in 2021. In contrast, energy and, to a lesser extent, basic materials and industries are exposed to relatively low high labor costs. , helping to insulate the margins in those areas.

Bar chart showing year-over-year net change in margins for various regions.

Factor profiles revert to first-half trends after deviating in the third quarter

Looking at the factor profile chart below, it appears that the third quarter was something of an anomaly. Value, high-yield, and low-volatility funds were among the best performers in the fourth quarter, similar to the first half of the year, but significantly at odds with the third quarter. That said, the best performers were consistently biased toward small-cap and low-quality stocks through most of the year. However, there was a slight tilt towards momentum in the fourth quarter.

Chart showing the factor profile exposure of the top 10% of US equity fund returns each quarter.

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