Interest rates, recession risks and earnings downgrades weighed down on investor sentiment in December. The much-anticipated Christmas rally did not materialize and equities fell during the month, closing out 2022 as the worst year since the global financial crisis of 2008. As had been the case for most of the year, the drawdown was once again led by the US technology sector, and the Nasdaq significantly underperformed all other stock markets. The world’s most heavily traded stock, Tesla, fell by an unprecedented 35 percent during the month and thus lost almost two-thirds of its market capitalization in 2022. In fact, most of the US mega caps including Amazon and Alphabet posted their worst years in a decade.

“Higher for longer” fears

The major central banks continued to communicate a vigilant stance on inflation. Comments from the Federal Reserve, the ECB and even the Japanese central bank were more hawkish than expected. This led to increased fears of “higher for longer” rates and the associated risks of a recession and pressure on corporate earnings. This, in turn, led to an increased anxiety that 2023 would be marked by a profound decline in earnings. The ensuing debate was intense.

Zelensky visited Biden in Washington

The war in Ukraine seemed to have gotten bogged down, with few advances on either side. The Russian bombardment of civilian targets continued with the aim of crippling the Ukrainian infrastructure and thus weakening and demoralizing the population. President Zelensky made a short visit to the US where he met with President Biden and addressed Congress. The US pledged additional support for the war effort including deliveries of the Patriot anti-missile system. By some, this was interpreted as an escalation of the conflict.

Oil prices were up in December

Even though natural gas prices in Europe fell in December, the tit-for-tat energy war went one step further with the introduction of a price cap on Russian oil, set at USD 60 per barrel. This was in turn met by a Russian decree that countries which adhered to the price cap would no longer get any deliveries. Following a couple of weak months, oil prices increased in December.

Reopening and removal of restrictions in China

After a lengthy period of Covid-related lockdowns, the Chinese government abolished most restrictions, thereby opening up the country. Whether or not this would impact inflation and supply chain issues was not immediately clear. Following the un-locking, a rapid spread of transmission of the virus in China was recorded, prompting a number of countries, including the US, Italy and Japan to impose renewed testing requirements for travelers coming from China.

Tough month for world markets

Following two positive months, the world index retreated in December. All global sectors fell, again led by consumer discretionary and information technology. Utilities and healthcare fared somewhat better but still recorded losses. Geographically, Hong Kong was the sole major market to post a gain, followed by a relatively mild decrease in Europe. The two major US indices, the S&P500 and the NASDAQ fell significantly more.

OUTLOOK

Chairman Powell’s press conference following the Fed’s December meeting clearly focused on the strength of the labor market which according to the central bank was causing a continued higher than wanted level of inflation in the service sector. The central bank also communicated that interest rates would likely have to be higher for longer in order to rein in inflation to the 2% target which is a key l long-term goal of monetary policy. The market had hoped for a more optimistic outlook from the central bank and the year ended with very weak equity markets. One could describe it as a melt-down but not necessarily a true capitulation, as volatility was not on an extreme level.

An outlook with a great deal of uncertainty

The uncertainty surrounding corporate earnings following the more restrictive monetary policy is complicating the outlook. A recession is likely but how deep might it be? Will margins compress? Will companies see significant lower consumer demand when the monetary tightening weakens households’ purchasing power? Are investments going to be curtailed or postponed and cause further economic weakness? There is a great deal of uncertainty which makes a strong equity market start to the new year somewhat unlikely. Yes, a lot of the negatives have probably been discounted by the market but from past cycles we can conclude that a more drastic negative sentiment might be needed before the bottom of the stock market can be called.

Economists anticipating the Fed to pause

An optimistic viewpoint, also quite possible, is that the service sector’s contribution to inflation will steadily diminish as many statistical series are backward looking and do not reflect real world cooling of prices. The Fed will therefore likely pause in the first half of 2023 in order to evaluate what the higher interest rate levels mean to the inflation outlook. This anticipated pause, taken as almost a certainty by some economists, is likely to support financial markets.

A key question is whether or not we need to have a rather steep earnings revision cycle before that happens. Several scenarios are possible, and we believe that prudence and patience are warranted. Better to be safe than sorry as the saying goes. The healthcare sector with its key sub-sectors pharmaceuticals, biotechnology, medical technology, and healthcare services should, in all probability, do fundamentally well in 2023, and we stay focused on what we believe will create value for the fund in the longer term.