Economic Flash: Market Regime Change Becomes Clearer

This article is brought to you in collaboration with our colleagues at Laird Norton Wealth Management from their post, Economic Flash: New Market Regime Takes Shape.

U.S. Economy: Conflicting Signals

Data continues to present conflicting signals, with year-over-year core inflation cooling to 4.7% off a 5.5% peak in February, surprisingly high consumer confidence and unemployment at a low of 3.7% each to the positive, with negatives in advance retail sales, down-0.6%, industrial production, down-0.2%, and annual existing home sales of 4.09 million matching pandemic lows.

U.S. Stocks: Out With a Whimper

After a strong start to Q4, December was marked by ongoing uncertainty and increased investor pessimism that the Fed wouldn’t have the flexibility to slow its pace of raising interest rates. Mega-cap stocks such as Apple (-12.2%), Microsoft (-6.0%) and Tesla (-36.7%) struggled while each contributed roughly equally to the decline in the S&P 500 for the full year.

Foreign Stocks: The U.S. Dollar Giveth

A continued drop in the U.S. dollar aided most non-US equities, giving a 3% boost to developed markets in particular. Other factors that helped: tech stocks, which tend to be more interest-rate sensitive, are a smaller component of emerging market indexes, at 8% vs. 26% for the S&P 500, and some optimism about China’s economic reopening after Zero-COVID lockdowns.

Fixed Income: Munis Strong But Pricey

After a November respite, U.S. interest rates rose broadly, with some notable exceptions. Debt issued in local currencies (not U.S. dollars) performed well on the back of the falling U.S. dollar, while municipal bonds continued to benefit from lower new issuance. Entering 2023, munis are expensive, yielding only 65% of 5-year Treasuries vs. more than 80% historically.

Real Assets: Natural Gas Plummets

In a year marked by accelerated inflation expectations, real assets performed well but fell in December on indications that high inflation might be slowly winding down and amid a gathering of recessionary forces globally. Natural gas dragged down commodity indexes by dropping 33% in December, while oil was flat at around $85, down from a high of $128 in March.

Alternatives: Winning Ugly

Hedge fund strategies were generally flat for the month, which still meant they outperformed most traditional assets. For the full year 2022, hedge fund strategies did an excellent job diversifying portfolios: While the absolute results weren’t anything to write home about, many strategies outperformed the S&P 500 by double digits.

Source of data: Bloomberg

Equities Total Returns

Fixed Income Total Returns

Economic Indicators

Our Take

The new year often brings with it a sense of renewal or a fresh start. As investment professionals, it also provides us with a natural inflection point to metaphorically flip through the pages of the old calendar, the hits and misses, and then plot out our expectations for the year ahead, including portfolio adjustments.

In that spirit, one of the things we got right in 2022 was that we were entering a period of market regime change. We didn’t know exactly how that would play out, but we were keenly aware that many of the drivers behind the remarkable results of 2020 and 2021 were fading away while new catalysts were on the horizon. Among them, we noted the unusual dispersion of analyst market expectations, that much of the post-COVID recovery had likely been already priced into markets, that equity returns had been dominated by a handful of mega-cap tech stocks, rising geopolitical risk vis-a-vis China and Eastern Europe, that it would take longer than anticipated to repair fractured supply chains, and that the greatest risk to financial markets and the economy was the Federal Reserve and its response to sustained levels of higher inflation.

With all of that in mind, our highest conviction expectation for 2022 was that volatility would be a constant companion and not an occasional visitor as the pandemic “fog” lifted. Markets delivered on that expectation as the CBOE VIX measure of equity volatility jumped to an average of 25.6 over the course of 2022, about 20% higher than 2021 and the long-term average. That said, what didn’t play out as well as expected was our diversification across asset classes to lower risk since virtually all asset classes lost value in 2022, a historical anomaly. To be clear, our real asset, including commodities and infrastructure, hedge funds and even fixed-income exposures each generally outperformed global equities, but the diversification from equities that those asset classes have provided historically didn’t show up as strongly in 2022.

Looking Forward

It seems that discussion of market regime change is now much more prevalent, with the characteristics of that new regime having become a little clearer. The endemic nature of Covid-19 appears to be solidifying as China emerges from onerous Zero-COVID protocols, opening up the possibility of further repair of supply chains and calming inflation. Inflation, both headline and core, appears to be easing, albeit slowly. And the Fed has so far been able to raise interest rates without destroying the labor market or sending the economy into a deep recession. Still, interest rates may remain at current levels or higher for a significant time, indicating slower economic growth and corporate profits. This would suggest financial assets could very well continue to struggle.

That last bit may sound ominous, but the current investment environment is arguably compelling from multiple perspectives. This year was unique in that so many financial assets sold off in tandem. The consequence is that many assets offer valuations and/or yields that are more attractive than we have seen in many years. For example, despite having held up well during a difficult year, international equities remain at lower valuations relative to U.S. stocks, are cheaper relative to their own history and appear to face less pressure from a strong U.S. dollar. That said, because we build portfolios through a long-term lens for most of our clients, the changes that we make from year-to-year to our top-down asset allocations are typically modest and will primarily espouse the long-term principle of rebalancing. We also anticipate adding value to portfolios by identifying new strategies, including possible opportunities within higher-yielding corporate credit and the reinvigoration of the U.S. supply chain. Overall, we think it will be a challenging year ahead with more potential to invest at attractive valuations.

Glossary of Indices


U.S. Large Capitalization = S&P 500 Index

Tracks the performance of a representative sample of 500 leading companies in the major industries of the U.S. economy.

U.S. Small Capitalization = Russell 2000 Index

Tracks performance of the 2,000 smallest companies in the Russell 3000 Index, representative of the U.S. small capitalization equity market.

U.S. Growth Equities = Russell 3000 Growth Index

Tracks the performance of those Russell 3000 companies that have higher price-to-book ratios and higher forecasted growth values.

U.S. Value Equities = Russell 3000 Value Index

Tracks performance of those Russell 3000 companies that have lower price-to-book ratios and lower forecasted growth values.


International Equities (Developed Countries) = MSCI EAFE Index

A float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. Consists of the stock market indices of these 20 developed countries: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

Emerging Market Equities = MSCI Emerging Markets Index

A float-adjusted market capitalization index designed to measure equity performance in the major emerging markets. Consists of the following 25 emerging-market -country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.


U.S. Aggregate Bond = Barclays Capital U.S. Aggregate Bond Index

Covers U.S. dollar-denominated, investment-grade, fixed-rate, taxable bond market consisting of SEC-registered securities. Includes U.S. Treasuries, U.S. agency bonds, U.S. corporates, mortgage-based securities (MBS, CMBS) and asset-backed securities (ABS).

TIPS (Treasury Inflation-Protected Securities) = Barclays U.S. Treasury Tips Index

Measures the performance of TIPS of various maturities issued by U.S. Treasury.


International Developed Bonds = BofA Merrill Lynch Global Government Bond II ex U.S.

Measures the performance of non-U.S. developed-market government bonds on an unhedged currency basis.

Emerging Market Bonds = BofA Merrill Lynch Emerging Markets Sovereign

Bond Index Measures the performance of emerging markets government bonds on an unhedged currency basis.


Intermediate Municipal Bonds = Merrill Lynch Municipals, 3-7 Yrs Index

A subset of The Merrill Lynch U.S. Municipal Securities Index, including all securities with a remaining term to final maturity of between 3 and 7 years.

Municipals, Broad Market = Merrill Lynch Municipal Master Index

Tracks the performance of U.S. dollar denominated investment-grade tax-exempt debt publicly issued by U.S. states and territories, and their political subdivisions.


Absolute Return Funds = HFRX Absolute Return Index

Tracks the performance of hedge funds aiming to provide stable performance regardless of market conditions. Such funds tend to be less volatile and less correlated to market benchmarks. Data is based on estimates for the most recent months, may not include performance for the last business day of the indicated month and is subject to revision.

Market Directional Funds = HFRX Market Directional Index

Tracks the performance of hedge funds that add value by participating in the direction of various financial markets. Such funds characteristically have higher expected volatility than Absolute Return strategies (see above). Performance data is based on estimates for the most recent months, may not include performance for the last business day of the indicated month, and is subject to revision.


Equity Volatility = CBOE VIX Index

Aims to measure investor expectations for near-term stock-market volatility as conveyed by the pricing of stock options on the S&P 500 index that mature within 30 days.

Implied Inflation = 10-Yr TIPS Implied Inflation

Gauges investor expectations for future U.S. inflation based on the difference between the yield on a 10-year TIPS (Treasury Inflation Protected Security) and the yield on a nominal 10-year Treasury.

Gold Spot $/oz.

An index intended to measure the current price of gold, based on futures contracts deliverable in the following month priced in U.S. dollars per Troy ounce.

Oil = Brent Crude Oil Spot Price $/bbl

Brent Crude Oil refers to a particular grade of crude oil often quoted in financial reports as the global benchmark for the price of oil. It typically trades at a premium to the West Texas Intermediate price.

U.S. Dollar = Trade-Weighted U.S. Dollar Index

Value of the U.S. dollar relative to a composite of 26 currencies of major U.S. trade partners, weighted based on trade data.


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