This year has proven to be a tough one for financial markets, thanks to soaring interest rates, raging inflation, sluggish economic growth and effects from the war in Ukraine.
The S&P 500 stock index has lost 17% so far in 2022, and the Bloomberg Aggregate bond index has shed 12%. Real estate hasn’t fared well either, with the FTSE Nareit All Equity REIT index falling 23% .
As for stocks, the growth sector particularly got hit by rising interest rates. That’s because growth stocks are valuable for their high earnings in future years, while rate increases make safe investments such as bonds more valuable now.
Big technology stocks, including Alphabet, Amazon, Apple, Meta Platforms and Microsoft, fell especially hard. Most of them soared amid rampant demand for technology products during the pandemic, but fell down to earth afterward.
Meta (META) also had issues related to its own business that pulled it down, such as making a huge bet on the metaverse. Meta has dropped 66.3% year to date.
Value stocks generally outperform growth in times of economic weakness, because they aren’t as dependent on strongly growing earnings. The Russell 1000 Value index has slipped 8% so far this year, compared to a 26% descent by the Russell 1000 Growth index.
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Stock Outlook
So what’s the outlook for next year? The consensus is that the Federal Reserve will stop lifting interest rates around mid-year. That would be a positive signal for the economy and earnings, which could boost stocks. But nobody really knows what will happen.
Vanguard analysts are cautious. “High inflation and rising real interest rates have caused … our estimate of fair value to decline,” they wrote in a commentary. “Although equity valuations have improved, they are still overvalued.”
More improvement on inflation and declines in interest rates are needed to push fair value higher, the analysts said.
“In addition to stretched valuations, the risks posed to earnings by high inflation and the growing likelihood of recession underscore our cautious stance on U.S. equities,” they said.
While “favorable valuations have improved our outlook for U.S. equities compared with last year, we still caution investors against expecting returns similar to the 11.3% per year they experienced in the last decade,” the analysts said.
“In addition to our expected 5% annualized earnings growth, we expect dividend yields to average 1.9% per year [over the next decade], in line with the last decade. But we expect valuations to contract 1.2% annually.”
Putting that together Vanguard analysts predict stocks will return 4.7%–6.7% annually during the next 10 years.
Bond Outlook
Turning to bonds, with their elevated yields and the possibility that the Fed will stop raising rates around mid-year, they might be a good place to invest next year.
“After a dreadful year, return prospects for bonds in 2023 look much better as the Fed concludes its rate hiking cycle,” J.P. Morgan Asset Management analysts wrote in a commentary.
“Investors can take advantage of higher yields in short-dated bonds while adding duration [longer-term bonds] as a hedge against market volatility and maintaining a high quality bias in credit,” they wrote.
Looking at credit quality, “With investment-grade and high-yield corporate bonds yielding close to 6% and 9%, respectively, investors may be tempted to dip their toes back into lower-rated credits,” the analysts said.
“However, in our view, credit spreads have not widened enough, particularly for low-quality bonds, to compensate for the rising risk of default.”
As for real estate, it’s “looking somewhat expensive in aggregate, but beneath the surface we continue to observe significant dispersion,” the J.P. Morgan analysts said.
“Industrial assets remain expensive, whereas vacancy rates in the office and retail sectors are near all-time highs. As we look ahead, private real estate assets seem well positioned to deliver stable cash flows and public-market diversification, even if capital values decline.”
