2022 Market Review: The Year of Inflation

In aggregate, the US financial markets in 2022 had one of its five worst performances in over a hundred years. To make it even more remarkable, it wasn’t just the poor performance of the equity markets (a 19.4% drop in equities, while bad,¹ isn’t historically bad). What made the year so bad was the simultaneous and historically bad drop (the worst in over a hundred years) in the bond markets. Almost always when equities go down bonds go up. But that didn’t happen last year as the S&P Treasury Index, a broad measure of US Treasuries, lost 10.7% in 2022. There have only been three other years in the last hundred when both bonds and equities went down. They include 1931 (a global currency crisis that forced many countries to permanently abandon the gold standard), 1941 (the US entered World War II), and 1969 (high and accelerating inflation). The bond markets’ performance in 2022 was more than twice as bad as the bond returns of 1931, 1941, and 1969.

The primary reason for the across-the-board poor performance of the bond markets was the Federal Reserve’s end to its bond-buying program, Quantitative Easing (QE). It had been a buyer of trillions of dollars of US Treasuries prior to 2022. (as well as for several years after the Great Financial Crisis of 2008). However, after the Fed announced it was shrinking its balance sheet (thus ending QE), it stopped buying bonds in early 2022. By the end of 2022, the Fed’s balance sheet was shrinking by about $100 billion per month. As a result, bond prices dropped, causing interest rates at all maturities to go up. The 2-year yield went up from 0.78% at the start of 2022 to 4.41% by the end, while the 10-year yield went up from 1.63% to 3.88%. And the performance of the US Treasury market contributed to the performance of all bonds. Corporate bonds issued by S&P 500 companies dropped 14.2% in 2022. Bloomberg’s Multiverse index, which tracks global government and corporate debt, lost 16.0%.

Investors didn’t do much better by moving to other markets. Investing in foreign equities by US investors for the most part resulted in similar or worse performance due to the strength of the dollar against most currencies in 2022. By investing in non-dollar investments, US investors were also long on foreign currencies, which means they not only lost on the underlying investment in local currency but then also lost on the local currency depreciation against the dollar. For example, European stocks were down 11.9% in euros, but US investors also lost on the euro as it dropped 6.2% against the dollar. So overall, US investors lost 17.4% on European stocks after liquidating and repatriating their funds back to dollars. Similarly, Japanese stocks dropped 9.7% in yen, but the yen dropped 13.9% against the dollar. So, US investors lost 22.2% overall on Japanese equities.

It wasn’t entirely doom and gloom. Commodities were up 23%. Specifically, energy commodities such as oil and natural gas did very well. As a result, the energy sector performed very well, with energy stocks up 57%.

However, outside of commodities, there were few places for investors to hide in 2022. Inflation is the obvious macro-explanation for the poor market performance but diving into the details of how inflation affected markets, particularly the equity markets, is revealing.

Earnings vs Multiples

Using a simple earnings discount model, a stock price is composed of the product of two components: earnings and a price-to-earnings (PE) multiple, i.e., price equals earnings x PE multiple. So, earnings per share of $3 for a company and a PE multiple of 10 for that firm results in stock price of $3/share x 10 = $30 per share for the firm. Therefore, a stock price increase comes from the growth of one or both of these two components, i.e. earnings growth and/or PE multiple growth, and vice versa for a stock price decrease.

Usually, equity market drops coincide with earnings drops. Earnings for S&P 500 companies had increased about 8.5% per year over the ten years prior to 2022, while stock returns were 15% per year. From an earnings/PE multiple breakdown of stock returns, the fact that earnings advanced at only about half the rate of stock returns indicates that a significant part of the stock market’s returns during the previous ten years were due to a PE multiple expansion.² Indeed, the PE multiple increased from 14.8 to 23.1 during the ten years prior to 2022.

During 2022, however, while US stocks retreated about 19%, earnings for US companies increased: they increased about 5% for the year.³ So, the entire drop in the US equities (and more) last year was due to a PE multiple contraction rather than an earnings contraction — the PE multiple decreased from 23.1 at the start of 2022 to 19.9 by the end of 2022.

There are two primary components to a PE multiple: a riskfree rate (a US Treasury yield) and a risk premium.⁴ A PE multiple is inversely related to these components. The higher that interest rates are, or the higher the risk premium demanded by investors is, the lower the PE multiple and vice versa. Therefore, for a PE multiple contraction to take place, either US Treasury yields must go up, the market-wide risk premium demanded by investors has to go up, or both. In 2022, certainly interest rates went up as discussed earlier and, in turn, were one big reason that the PE multiple on equities decreased.

The other reason for the PE multiple contraction is that volatility, or risk, went up in 2022, which in turn caused the risk premium demanded by investors to increase. The VIX, a good indicator of volatility, averaged 18% during 2021, while it averaged 28% during 2022. As volatility in the markets increased, investors started demanding a higher risk premium for bearing that higher risk. Consequently, the risk premium increased by 56%.⁵ This increase in risk premium compounded the increase in interest rates in 2022, causing the yearlong drop in PE multiple.

Looking Ahead to 2023

One interpretation of the PE multiple contraction in 2022 is that only “one shoe” of the price = multiple x earnings relationship has dropped. We have not yet had a an earnings drop (the “other shoe”), which typically happens only during recessions. This is why the major discussion among investment professionals is whether the US economy is due for a recession in 2023.

The latest data from the end of 2022 and the start of 2023 does indeed indicate that the US economy is slowing down. Consumer spending constitutes roughly two-thirds of the economy, and consumer spending appears to be slowing. In November and December of 2022, retail sales decreased by 1.0% and 1.1%, respectively, from the prior month. Overall consumer spending fell 0.1% in November from the prior month and accelerated to fall 0.2% in December.⁶ Business spending makes up the remaining one-thirds of the economy, and S&P reported that business activity was contracting in both December, 2022 and January, 2023.⁷

If there is a recession, and corporate earnings decrease while the PE multiple stays relatively constant, equities would decrease proportionally with earnings. This is precisely the prediction being made by many institutional investors. Specifically, they are predicting that earnings in Q1, 2023 and possibly Q2 will decrease, while the PE multiple stays relatively constant. The earnings decrease would cause a further drop in the equity markets. However, if the recession is mild, as most institutional investors are also predicting, then earnings should rebound in Q3 and Q4, 2023, and equity markets should also rebound. The major assumption in this consensus is that the PE multiple stays relatively constant.

As mentioned earlier, there were only three periods in the last 100 years when equity and bond markets both dropped. Of these three, only in 1969 were the joint market drops due primarily to inflation, just like 2022.

When we look at 1969 and afterwards a bit more closely, we can see a pattern very similar to 2022. Inflation reached 6.2% by November of 1969, and gradually dropped as the Federal Reserve rapidly raised the fed funds rate from 4.0% to 10.5% during the year in order to bring inflation under control. The increase in interest rates caused a decrease in the PE multiple of 11% from the start of the year. The resulting equity market drop of 8.2% in 1969 was due primarily to this PE multiple contraction because corporate earnings during 1969 increased by 3% from the previous year.

In the subsequent year, 1970, the US experienced a significant recession, with corporate earnings dropping 9%. However, equity markets rallied and increased by 3.6% for the year because the PE multiple increased by 14% as the Fed Funds rate dropped to 3.0% by the end of 1970.

While the one guarantee we have is that history never repeats exactly, this one year in history provides hope that the gloom surrounding the markets at the end of 2022 may not translate into another poor market performance in 2023.

Footnotes

[1] In the ten years prior to 2022, the US equity markets returned about 15% per year — exceptional performance over a ten-year period. However, once 2022’s 19% loss is added to those ten years, the return drops to a relatively average 11% per year — a performance drop that reflects the intensity of losses in 2022.

[2] The earnings discount model has in its denominator the total expected return on equities less expected earnings growth. This is essentially the expected capital gain portion of the total return on equities, while earnings growth provides the dividend portion of that total return.

[3] This is using actual earnings for the first three quarters and an estimate by equity analysts of corporate earnings for the 4th quarter as those haven’t yet been reported.

[4] For example, the simple Capital Asset Pricing Model states that the cost of equity, i.e., the required rate of return by stockholders, equals the riskfree rate plus “beta” times the risk premium.

[5] Using a conservative assumption that the market price per unit of risk stayed constant. If this increased, as many analysts estimate, the increase in the risk premium would have been even greater.

[6] As measured by personal-consumption expenditures.

[7] S&P Global’s survey of business activity came in at 45 for December and 46.2 in January. Any value below 50 indicates business contraction, while above 50 indicates business growth.