CIO Roundtable: A Review of 2022 and Outlook for 2023

A message from our Chief Investment Officer - Ryan C. Kelley:

After almost 13 years of resilience following the Financial Crisis of 2008, the 2022 equity markets were shaken by stinging inflation, rapidly rising interest rates, soaring energy costs, and slowing economic growth teetering on recession. 

While many investors would like to forget this year, we prefer to maintain perspective in this market downturn. Experiencing negative market movements on any given day can seem disappointing—almost a full year of negative returns with little respite along the way feels painful. Yet while over shorter periods, market returns can be “choppy,” over the long term, stocks generally trend up. In fact, over the past 100 calendar years, the Dow had an average annual total return of 10.25%. 

Looking ahead, we believe the outlook for U.S. stocks remains positive. 

•    Equities appear attractive from a valuation standpoint, even as rates rise.
•    The prospect of slower economic growth may dampen inflationary pressures.
•    While the Fed has raised rates several times in calendar 2022, we believe tempered inflation will allow the potential for a more neutral stance toward future rate hikes.
•    The unemployment rate is near record lows.
•    There are elevated levels of cash on U.S. companies’ balance
sheets and in consumer bank accounts.

While volatility and uncertainty may continue in the short term, we encourage investors to stay the course, maintain a diversified portfolio, and keep a long-term view.

Please enjoy the following perspective from our team of talented and seasoned Portfolio Managers.

-Ryan C. Kelley, Chief Investment Officer

2022 in Review

Through November 30, 2022, the S&P 500® has declined 13.1%. In general, growth stocks have fallen more than value companies: The Russell 1000 Growth® Index of large growth stocks decreased 23.3% and the Russell 1000 Value® Index of large value stocks declined only 3.7%. 

After hitting an all-time high in January 2022, the S&P 500 began its turbulent downdraft, and by June 2022, stocks fell into a bear market of a 20% decline. 

The losses in the equity market were widespread. Eight of the 11 S&P 500 sectors were in negative territory in the first 11 months of the year. Energy companies’ performance far outpaced its sector peers, climbing over 70% as of 11/30/22. The Consumer Services sector was the bottom YTD performer, falling nearly 35% over the same period. 

Multiple macroeconomic factors including global conflicts, adjustments to post-pandemic life, inflation levels not seen in decades, and quickly rising interest rates negatively affected investor sentiment and increased market volatility.

In 2022, the Fed raised rates seven times in an attempt to ease the persistently high inflation. Between March and December, the Fed increased rates between 25 and 75 basis points each time, with the fed funds target rate rising from 0.25% to 4.5%.

Following these rate hikes, inflation data has softened. After hitting a monthly high of 9.1% in June 2022, one measure of inflation, the Consumer Price Index (CPI), has slowly declined each month falling to 7.1% in November. While still elevated, we believe inflation is starting to weaken. As a result, Fed Chair Jerome Powell has signaled that the Fed could slow the pace of interest rate increases in 2023.

Catalysts for 2023

Many of our Portfolio Managers remarked how interest rate stabilization along with a continued decline in the inflation rate could be strong catalysts for equity markets in 2023.

One of our most seasoned Portfolio Managers who has invested through multiple market cycles pointed out that the next market phase may come when companies announce quarterly earnings in early 2023. Based on the slowing economy in 2022, some companies may show a decline in earnings, prompting layoffs and spending cutbacks. Although these reports may introduce additional volatility in equities, once these earnings declines are behind us, we will likely see companies’ earnings rebound from lower levels. 

Another factor that may drive the market higher is a Congress split between a Republican-controlled House and a Democratic-run Senate as a result of the 2022 fall election. This split may perpetuate a notion of gridlock in Washington, DC, and gridlock has historically been positive for the markets. 

Looking ahead, the U.S. may see a recession in 2023. However, many of our Portfolio Managers believe that the market has already factored in this economic downturn as many cyclical and interest-rate sensitive areas of the market have already been negatively affected. In 2023, the effects from the recession will likely be muted. 

Disciplined Capital Allocation in the Energy Sector Appears Here to Stay

While the Energy sector performance has been strong in 2022, we believe this move is more sustainable than it ever has been. Investors may have been underappreciating the degree to which management teams have maintained disciplined and shareholder friendly, capital allocation practices over the past several years in the U.S. upstream sector. Historically, as commodity prices rose, many exploration and development companies increased their debt and ramped up drilling and development activity to drive production growth. Yet when the commodity price fell, balance sheets became stressed. 

Now these companies are producing oil and natural gas while attempting to reduce debt, and as a result, generating significant levels of excess cash. In fact, as of November 2022, the sector’s free cash flow yield was approximately 15%. With this cash surplus, many companies are returning capital to shareholders and buying back shares. Yet the Energy sector’s enterprise value to EBITDA on a forward basis is the lowest of all the S&P 500 sectors. 

Finally, the weighting of the Energy sector has historically been about 10% in the S&P 500, and it’s currently about half of that. 

We believe these multiple factors could continue to drive the performance of Energy companies in the new year.

An Overall Healthy Banking Sector 

Over 2022, the Financials Sector has had to quickly transition its strategy to account for rapidly rising rates. While many banks’ net interest margins (the difference between their income generated from loans and the cost of funds) have been slowly improving, it takes time to significantly increase margins and positively impact book value. 

As it relates to investors’ recession fears, over the past 40 years, many historical downturns have been triggered by the financial services industry, such as the 2008 Financial Crisis. 

Lax lending standards fueled a housing bubble, and when the bubble popped, banks experienced a credit liquidity crunch which resulted in a collapse of the housing market and eventual economic recession. 

Currently, the overall banking sector is healthy. Banks have sufficient capital to withstand an economic shock. Banks continue to lend and non-performing loans are at historically low levels.

Japan in 2023

A key investment theme in Japan is to look for companies that can benefit from an accelerated growth in overseas business resulting from a weak Japanese yen, as well as growth in their domestic business, boosted by the reopening of the Japanese economy to tourists.

There is an increasing inflationary trend in Japan but it may be transitory. The main driver has been higher energy costs accentuated by Japanese yen depreciation.  

Once global commodity prices start to ease and the weakening of the Japanese yen loses intensity in 2023, the economy could slip back into deflation again. Accordingly, the Bank of Japan has kept its ultra-easy monetary policy while other countries have raised rates. The government wants to see positive real wage growth so domestic consumption can grow more consistently, leading to a sustainable inflationary trend. 

Japan’s reopening of borders to foreign tourists should increase consumer spending within the country. For perspective, in 2019 tourism contributed about 1% of GDP. With the yen sharply lower, the actual impact could be 20% to 30% greater in yen terms than in 2019, assuming the same average spend. 

Domestic consumption should be a driver of GDP in 2023 with pent-up demand from the pandemic. In addition, an increase of inbound tourists may cause wage inflation in the hospitality industry, leading to an upward pressure on salaries during the wage negotiation season in the spring of 2023. Combined with price hikes due to rising import prices, wage inflation could cause Japan’s inflation rate to rise to approximately 3% year-over-year for the first time in many decades.

As we head into 2023, we believe Japan offers some of the most globally competitive businesses, and through Japanese companies, investors can gain exposure to global economies, especially emerging Asia countries. In addition, Japan offers better transparency, market liquidity, and reasonable valuations compared to other Asian equity markets, including India.

ESG-Driven Investing

In December, Hennessy Funds added the Hennessy Stance ESG Large Cap ETF, the first ETF in its fund line-up. With the ETF under the management of sub-advisor Stance Capital, Portfolio Managers Bill Davis and Kyle Balkissoon seek to align investors’ capital with their values while outperforming the overall market, and to do so with less volatility.

We believe an increasing numbers of investors, particularly large institutional investors, have an interest in ESG products and this trend appears to be strengthening. For example, with the Climate Action 100+, 700 global investors representing $68 trillion of global investible assets are focused on companies that are key to driving the global net zero emissions transition. These investors have engaged nearly 170 companies that account for up to 80% of global corporate industrial greenhouse gas emissions to decarbonize their business models. With this initiative along with many others around the world, we believe ESG will remain an important consideration for many investors.