Carl Terzer, CapVisor
20 December 2022ArticleAnalysis

2022 – an unusual year

In the majority of market cycles, when stocks fall, bonds either hold their value or rise. In investment terminology, they are usually slightly “inversely correlated” and therefore, typically provide a diversification benefit when combined in a captive’s investment programme.

This year, we have experienced negative bond returns at levels unprecedented in recent history. Since 1976, we have seen the Bloomberg Aggregate, the commonly used benchmark index representing the US investment-grade bond universe, produce negative annualised returns only five times, including this year.

Figure 1 below shows that even negative intra-year returns (in red) from 1976 to 2021 have been nowhere near the losses experienced in 2022. The annual average return was 7.1 percent. Despite average intra-year drops of 3.1 percent, annual returns were positive in 42 of 46 years.

Figure 1: Bloomberg US Aggregate intra-year declines vs calendar year returns

Source: Bloomberg; FactSet; JP Morgan Asset Management

Equity markets have been on a rollercoaster but unfortunately mainly headed downward. Figure 2 shows monthly returns for the S&P 500 for 2022 through December 9. The year-to-date return is -16.17 percent.

Figure 2: 2022 monthly returns for the S&P 500*

* To December 9, 2022

Source: StatMuse

2022 was truly an anomalous year in which stocks and bonds both produced significantly negative returns. This has only happened three times since 1927. 2022 will go down in the record books as one of the worst years since records have been kept.

Why? We have recently come out of the longest bull market in the history of the US stock market, as well as an unprecedented 14 years of near-zero interest rates. We have had an “easy money” monetary policy, coupled with a fiscal policy that flushed the economy with additional liquidity during the COVID-19 pandemic.

For good measure, throw in a bit of current geopolitical turmoil: a war, supply chain kinks exacerbated by the pandemic and the start of a deglobalisation cycle. The result: conditions that have combined to produce the worst inflation since the early 1980s. We believe that it is these market distortions, many of which have been baked in the last decade, that are primarily why markets are not currently behaving as they would under normal economic and other sociopolitical influences.

While there are many contributors, the crux of the problem is inflation. At 40-year highs, the Federal Open Market Committee is in process of steep interest rate increases in an effort to slow inflation. Figuring out the level of interest rate hikes that will bring it within a reasonable range is the tricky part. Inflation itself will help drain excess dollars/liquidity from the marketplace. High rates should depress demand, also bringing inflation down. These influences will likely take some more time, as there is typically a lag during which time behaviours are adapting to the new prices and cost of capital. That’s the tricky part for the Fed.

Economists are uncertain of where rates may top out since inflation appears to be more stubborn than anticipated. Notwithstanding the fact that the underlying US economy is still in pretty good shape, forecasters are presently factoring in a 65 percent probability for a recession in 2023. They think that the Fed is likely to oversteer, and its past track record is not reassuring. Fortunately, most think that the severity and duration of a recession would be mild and short although at this point, that outcome remains far from certain. The Fed is committed to raising rates until inflation is under control, meaning making tangible progress toward the Fed’s 2 percent target rate.

At that point, we will expect to see rate hikes cease and even perhaps witness rate declines if the economy risks a deep recession, if unemployment becomes too elevated, or if risks of stagflation increase. Bonds will be expected to make adjustments almost in lockstep with the Fed’s actions. Equity markets may take longer to normalise as the stock market reacts more so to things such as future earnings growth, sociopolitical global events, employment, sentiment/momentum, etc.

Final thoughts

While the last several quarterly investment performance reports are disappointing to view, please keep in mind that all insurers must rely on their sound long-term strategy and an optimised strategic asset allocation. Presently, all insurers are in the same or a very similar unfortunate situation.

Under the more normalised market conditions that lie ahead, this will provide the expected diversification benefits and improve risk-adjusted returns for captive portfolios. Most, if not all, of the bond market’s value “losses” are unrealised and will likely be recouped as the bonds move through time to mature at face value.

As the markets continue their adjustment from the easy money policies that have distorted many natural market forces since 2008, we hope to see more normal and predictable market forces take over. We expect that by the second or third quarter of 2023, there will signs of such normalisation.

For insurers, it is important to “stay the course” through these volatile periods as they need to be disciplined, long-term investors. Once asset classes experience the inevitable “reversion to mean”, asset classes in captive portfolios should regain historical relationships, returns and correlations.

In the meantime, and looking at the bright side, current conditions present some tactical opportunities: that is, before the beginning of the new economic cycle or interest rate regime. New incoming premiums can be put to work at bond yield levels that have not been seen in a decade. Stock prices have substantially moderated from their record highs, with many strong companies being oversold, presenting seasoned stock-pickers with potentially fantastic opportunities over the next several quarters.

Here’s to a happier New Year for investing.

Carl E Terzer is principal and chief insurance strategist at CapVisor Associates. He can be contacted at: