It has been a tough year for stock and bond portfolios. I believe we are seeing the impacts that a hawkish Fed is having on both bond and stock markets alike. Throughout the year, we made a few tactical changes to portfolios that included adding a position into ACWI in May and selling in late July for a 1% gain on that trade. We bumped up our large cap position to a neutral stance back in early July while also adding a small position into a high yield ETF. As of this writing, the S&P 500, our small cap ETF, and our exposure to global equities have fallen about 17% year-to-date while mid-cap has fell around 11%. Real estate investment trusts are down about 25%. Bonds have fallen about 14% with data based off the AGG. Commodities have performed well being up around 20%. These returns have resulted in negative portfolio performances anywhere between 9-14% depending on risk profiles.
Heading into 2022, we knew that this year it was going to be difficult to capture gains as inflation had started to rise. We did not see the Fed come to the conclusion that inflation was not going to be transitory until about mid-way through 2022. Since January, the Fed has hiked the Federal Funds rate by 3.75% to combat rising inflation. The four biggest rate increases happened in June, July, September, and November. All with a 75-basis point hike each. Peak inflation happened in June with a reading of 9.1% and has been tapering off since then. However, core inflation has been sticky, hovering around 6.3% on average. These hikes have had impacts on our bond positions, but we are under benchmark duration as this was somewhat expected. To summarize 2022, stocks and bonds have performed poorly given the Fed’s stance on raising rates. These rising rates have been the primary factor in the poor performance of the stock and bond markets, plus high valuations which we have talked about repeatedly.
The most talked about issue going into 2023 is the risk of a recession. My point of view is that we reached a recession in the summer because of consecutive quarters of negative GDP growth. Likewise, we reached bear market territory in the S&P 500. However, there are economic factors that still need to be addressed before we can begin seeing some real growth in portfolios again. By the time unemployment begins to rise and corporate earnings begin to decline, an agreement will be reached between academics, economic policy makers, and financial institutions that we have entered a recession. We have already seen an inverted yield curve, which at times precedes a recession. We are continuing to see corporate layoffs make headlines. All signs point to a recession in 2023. To give you a clear view, I think 2023 is going to be another difficult year for equities and bonds and this recession will continue into 2023 but with some potential bright sides. The biggest and most impactful, I believe, will be the Fed.
It looks like the Fed will continue its rates increases during 2023 because of the current trends of inflation. It’s unlikely they will continue to be as aggressive as they have been with their past four decisions on hikes, but we will still see increases of 25 and 50 basis points in 2023. What we are looking for is the Fed to begin maintaining their rates, i.e. not increasing rates, or even pivoting and begin cutting rates.
If the Fed begins to pivot, we will have seen inflation begin to fall further to a much more acceptable level or at least a level acceptable to the Fed. As inflation continues its downward trajectory from its current state, we could see levels of inflation around 4-5% during the second half of 2023. This would likely be in conjunction with a rise in unemployment, another important indicator. The Fed would never come out and say this but, they are looking to see unemployment rise in order to slow the spending of consumers to combat inflation. This is the easiest way to bring inflation down and most likely scenario they want to achieve.
How does this impact equities and bonds? It is likely equities will continue to be impacted by rate increases for the first half of 2023. I don’t expect major gains in equities and in fact if we enter a recession, again, in 2023 it is likely equities will fall further from where we are now. The S&P 500 has potential to reach the low 3000s during the year if a recession occurs. That is another 20-25% drawdown from where we are now at around 4000. If a recession does not occur and economic indicators are looking favorable, then a neutral or even overweight stance on equities is on the table.
Bonds are a different story. We have been quite negative for the past year on bond prices in a rising interest rate environment. Portfolio bond durations have been kept below our benchmark for quite some time now and in 2023 it looks like that could change. The change would likely happen once we see the Fed begin to stop increasing rates or even begin to cut rates. In that case, we would go neutral on bond durations to begin capturing a higher yield. With inflation between 4-5% and bond yields much higher than where they are now, we will finally be able to capture some positive returns in our bond portfolio. As to a specific point in time when this change could happen, the Summary of Economic Projections expect the Fed to begin tapering the rate increases mid-2023. The Fed Funds rate is expected to reach anywhere between 4.75-5.75% by mid-2023. That is the point in time where we think extending bond durations would be suitable for portfolios.
So far, the only quarter of GDP growth was Q3 and the projection for Q4 is a remarkably uninspiring increase of 0.4%. That number could miss, and we would still be technically in a recession. Recessions last anywhere from 2 to 18 months with an average of 10 months. This recession looks to be like a longer one than the average. Interest rates will continue to rise until inflation declines to a level the Fed is comfortable with so they can reach their 2% goal. The Fed would like to see an overheated labor market begin to cool before pivoting. At this point, we should see unemployment begin to rise. Our focus over the next year and will be to determine when to increase bond durations and be careful of when to add to equities. It is reasonable to say that the stock and bond markets recover faster than economic data and these tactical decisions are highly likely to happen in 2023.