We are nearly a third of the way through the 2020s. And the start of this decade has been anything but ordinary. Pandemic. Economic shutdown. Work from home. Inflation. I could go on (and do below!).

This is certainly an interesting backdrop for our first annual letter. In it, we try to review some of the key events from 2022 and provide a little context around investment performance, share a few observations for the year ahead, and introduce some timely planning concepts. And yes, in my typical fashion, I often use 10 words when 3 would have done just fine!

In all seriousness, we thank you for the trust you’ve placed in us and hope you find this helpful. Please don’t hesitate to reach out if we can help.

Your Divvi Team.

Summary

• Inflation hurt most asset classes in 2022. Stocks, bonds, and real estate all had negative returns, leading to one of the most challenging calendar years on record for balanced portfolios. Energy stocks were one of the few bright spots after lagging for most of the last 15 years.

• The outlook for the next decade is a bit rosier than at this time last year, with higher expected returns across stocks and bonds. Keep in mind, these are long-term forecasts and volatility could certainly persist in 2023.

• New planning opportunities are available to many savers and investors. Congress passed the SECURE Act 2.0 in December, which has implications for Required Minimum Distributions (RMDs), Roth investment accounts, and much more. Higher rates also give short-term and conservative investors opportunities to earn considerably better returns than in the 2010s.

2022 Review

Inflation. If there is one word to characterize 2022, I think inflation has to be the odds-on favorite.

Consumer prices rose at the fastest pace in 40 years. The Federal Reserve (Fed) initially described inflation as “transitory,” suggesting supply-chain and COVID shocks would be short lived. As we now know, inflation was stickier than many predicted.

The Fed’s response was to raise slowly at first, then more aggressively. On seven occasions this year, the Fed bumped rates, raising the upper limit for the Fed Funds rate from 0.25% to 4.50%.

Unexpected inflation typically puts pressure on stocks, bonds, and real estate alike. And that was certainly the case this year. The chart below shows year-to-date returns, through December 31.

Interest rates don’t impact all stocks in the same way. Look at the chart below. This shows price-to-earnings (P/E) multiples for S&P 500 sectors, using Sector SPDR ETFs as proxies. When these multiples expand or move higher, investors have an optimistic view for that sector and are willing to pay more for a dollar of earnings. This is good news because it often helps push stock prices higher. Conversely, when these multiples move lower, expectations for the future are falling and investors are willing to pay less for that dollar of earnings, which puts downward pressure on stock prices.

It's no surprise to see real estate impacted most from rising rates. Higher borrowing costs and continuation of work-from-home trends were a double whammy. Other growth-oriented sectors like technology, consumer discretionary, and communications services – many of which benefited from ultra-low rates for most of the last decade – also saw their P/E multiples fall during the year as investors reassessed inflation impacts. It has not been uncommon for the most speculative (and least profitable) subset of this growth cohort to be down 80% or more from previous highs. More defensive sectors like consumer staples, health care and utilities were…well, much more defensive!

Bonds performed poorly, too. Many investors expect bonds to provide protections when stocks struggle. And, they often have. Just not last year.

Why? Again, inflation is the likely scapegoat. As a refresher, prices of high-quality bonds and interest rates have an inverse relationship. Rates go up, prices generally go down, and vice versa. For more credit-sensitive bonds like corporate bonds, prices are frequently linked to the health of the issuing company and the economy in general. Recessions often coincide with higher default rates on bonds, and recessionary pressures grew over the course of 2022.

Alternative investments like commodities and trend-following or momentum-based strategies had better results. Commodities have often been a good hedge against inflation, historically, as have trend strategies. 

2022 presented a unique set of challenges and frustrations. Balanced portfolios between stocks and bonds had one of their most lackluster years on record.

Looking Ahead

As with any new year, there are reasons to be both optimistic and cautious.

While you won’t find us making many predictions for the year ahead (forecasting is hard), here are some observations through the lens of planning and long-term investing.

1. Stocks and bonds both have higher expected long-term returns when compared to last year. Depending on the category, returns are generally expected to be 1-2.5% higher than last year’s projections.

   If a 2% difference doesn’t sound like much, try thinking of it in terms of dollars. The chart below may help.

   It assumes $100,000 is invested at different rates of return for 10 years. The dark green bar is the lower return (2%, 4% and 6%), and the brown bar assumes the return is increased by 2% per year (4%, 6%, and 8%).

   Compounding $100,000 at 2% per year for a decade leaves an investor with $121,899. And if we instead assume they earn 4%, they earn an additional $26,000 over the 10 years. This is shown in the far-left bar.

   Moving from a 6% return to an 8% return results in $35,000 in additional growth. This is shown in the far-right bar.

2. The Fed will either pivot or it won’t. I know – really going out on a limb here. But whether they do or they don’t could have a big impact on this year’s returns. Coming into 2023, The Fed has been steadfast that inflationary pressures have not subsided and interest rates need to move higher. On the flip side, many market watchers are seeing signs of recession form on the horizon. Wage growth seems to be slowing, and headlines announcing major layoffs seem to appear daily. If the economy weakens, the typical response from the Fed is to cut rates to stimulate growth. Most believe lower rates would be a positive tailwind for stock prices, whereas higher rates for longer would be a challenging headwind. Rather than trying to predict the outcome and invest accordingly, we would aim to take a longer-term approach and own investments that are not entirely dependent on any specific Fed policy outcome.

3. Income may be more important to future total returns. Bond yields are considerably higher now than in recent memory. And while stocks are expected to return more (see point 1), forecasts still call for returns well below long-term averages. The chart below illustrates several historical long-term periods characterized either by high returns (left side of the chart) or low returns (right side of the chart). Dividends have historically been an important contributor to total returns for stock investors, and that seems particularly true in those low-return environments. In the chart, both bars show returns for the S&P 500. The green bars represent total returns, inclusive of dividends, whereas the light green bars just show price appreciation.

4. The same goes for international diversification. U.S. stocks have trounced international stocks – including developed markets like western Europe and Japan and emerging markets like China and India – since the mid-2000s. 10-year forecasts from most firms we monitor now call for better returns outside the U.S. To be fair, optimistic predictions for international stocks are not new – this has been the case for at least a few years now. Regardless, it may be an opportune time to revisit how stock investments are diversified around the world.

5. Inflation, price-to-earnings multiples, fallout from Russia’s invasion of Ukraine – each of these impacts stock prices in the short run. Over the long run, though, we believe the value of a business is driven by its ability to deliver cash flows.

Planning Opportunities

Between the SECURE Act 2.0 and higher interest rates, planning could be more interesting in 2023.

Roth conversions: Markets are still meaningfully off all-time highs and tax rates will remain low for at least another couple years, through 2025. A full or partial conversion might make sense for those wanting to minimize taxes paid and/or create great tax flexibility during the distribution phase of retirement.

New Roth opportunities: For the first time, business owners will have the opportunity to save for retirement via Roth SEP and SIMPLE IRAs 2023. Like other Roth options, contributions will be made after tax, but it could provide a meaningful opportunity to grow assets in a tax-free income bucket for retirement years.

529-to-Roth IRA rollover: Clients have long wondered what happens to 529 dollars if beneficiaries don’t need the money for qualified education expenses. Well, the SECURE Act 2.0 gives parents and grandparents another option in the form of a Roth IRA rollover. There are plenty of strings attached, however. For example, rollovers are limited to $35,000 per beneficiary and the plan must have been in existence for at least 15 years. Still, this new option could start quite a tax-free retirement snowball for the right individuals.

Cash is back: After hovering near record lows for most of the last decade, interest rates are offering savers a considerable boost in short-term yields. Money markets, certificates of deposit, and other short-term investment options are all presenting opportunities to revisit short-term holdings to potentially earn higher returns on low-risk, liquid savings.

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