This year tested investors’ nerves. We reflect on why it was a banner year for tax-loss harvesting, if Fed tightening is working, and the silver linings going into 2023.
This year tested investors’ nerves by all measures. Most equity benchmarks have produced double-digit losses year-to-date, with several tipping into formal bear-market territory—a decline equal to or greater than 20%—before exhibiting a partial recovery in the fourth quarter. At the end of November the S&P 500® was off 13.1%, while the MSCI EAFE and Emerging Markets (EM) indexes were down 14.5% and 19.0% respectively, as measured in USD. Only energy had produced a positive year-to-date return across the 11 commonly referenced sectors.
What’s made the year particularly challenging is that there have been few places for investors to hide from falling prices. Fixed income is frequently positioned as a portfolio’s anchor in a storm, but it experienced a similar bear market to equities, with most benchmarks down between 8% and 12% year to date. Commodities were the lone bright spot among asset classes, generating a year-to-date return of 16.4%.
With all that bad news, can we hope for better in 2023? Let’s take a look at the current environment and how investors can shield themselves from the elements.
2022 recap
Director of investment strategy Natalie Miller noted in November that tax-loss harvesting had a banner year in 2022. Tax-loss harvesting involves selling positions that are down in price to realize losses for taxable investors, which they can then use to offset capital gains elsewhere in their portfolios or carry losses forward to future years. The bear market of 2022 was an ideal environment for tax-loss harvesting, with many portfolios achieving twice their annual targets.
Although the Russo-Ukrainian War and COVID-19 lockdowns in China all contributed to the negative market environment in 2022, the Fed’s aggressive monetary tightening has been the primary driver of returns. It’s easy to forget that as recently as the first quarter of 2022, the Fed was targeting a funds rate near zero and purchasing bonds to provide further economic stimulus. The Fed aggressively reversed course starting in March with a 0.25% rate increase. To combat inflationary pressures, the Fed subsequently hiked its interest rate target by an additional 3.5%, and markets are expecting another 0.50% increase at December’s FOMC meeting. This means the Fed will have increased interest rates by 4.25% in less than 12 months. At the same time, the Fed has transitioned from quantitative easing (buying bonds) to quantitative tightening (selling bonds). The US economy hasn’t experienced a tightening of monetary conditions like this since former Fed chair Paul Volcker’s battle to defeat inflation in October 1979. The impact on interest rates across the curve has been stunning, particularly on the front end of the curve.
US Treasury Curve
Source: Bloomberg, 11/25/2022. For illustrative purposes only. Not a recommendation to buy or sell any security.
The sharp rise in interest rates is having the desired effect. Asset prices, including stocks and bonds as well as real estate, have declined. The year-over-year growth of M2, a broad monetary aggregate, has dropped precipitously to near zero. This outcome should lead to slower economic growth and less inflationary pressure. With five- and 10-year breakeven rates trading near 2.3%, the market is signaling its belief that the Fed will ultimately gain the upper hand and reduce inflation closer to its 2% target.
Year-over-year M2 growth
Source: Federal Reserve Economic Data, 11/25/2022. For illustrative purposes only.
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What’s ahead for investors in 2023?
The full impact of the Fed’s restrictive monetary stance will become more transparent in 2023. The unemployment rate is expected to tick up as the economy slows down and companies seek to reduce costs. This process has already begun, with a rash of head count reduction announcements in the once-hot tech sector. A negative wealth effect from declining asset prices will begin to filter through the economy and slow demand.
The inverted yield curve is an indicator of economic weakness in the future. The market is currently predicting that the terminal rate for Fed increases will be around 5%-0.75% above where observers expect rates to be after the December FOMC meeting. It’s always possible that inflation could prove to be more resilient than expected and rates could rise higher. The level of volatility in both equity and fixed income markets will remain elevated, regardless of the outcome, until it’s clearer that the Fed is winning its battle with inflation.
It can be painful for investors enduring this volatility—but there’s a silver lining to consider. The sell-off in financial assets has created an improved risk–return profile for many asset classes going forward. Consider municipal bonds as one example. At the beginning of 2022, a taxable investor based in California could purchase a laddered municipal portfolio with a tax-equivalent yield of slightly less than 3%. That portfolio now trades at a tax-equivalent yield of above 7%, or 4% higher than in January, thanks to the sell-off in rates. Yields in fixed income haven’t been this high since before the 2008 global financial crisis.
A similar situation exists in equity markets. When investors purchase equity shares in a company, they’re paying for that company’s future earnings. The key metric is the forward price/earnings (P/E) ratio, which is price the investor pays for a dollar of earnings in the future. Using an estimate of forward earnings, the sell-off in equities has made them cheaper with foreign developed-market and EM equities trading at a significant discount to domestic equities.
P/E ratio of global equity indexes
Source: FactSet, 11/20/2022. For illustrative purposes only. Not a recommendation to buy or sell any security. It is not possible to invest directly in an index.
Could stocks decline further in price? Of course. Earnings could underperform expectations, P/E ratios could decline further, or both could happen in a recession. Buying a broad basket of equities at a lower P/E ratio simply means that an investor pays less for those companies’ expected earnings. It reduces the likelihood that they overpaid for earnings, but it doesn't eliminate it.
The bottom line
The Fed took aggressive actions to reverse the course of inflation and created a headwind for investors. However, the pain of 2022 has led to opportunities for investors heading into 2023. Parametric stands ready to assist investors as they navigate what we expect will continue to be a volatile market environment.
Experts expect tax-loss harvesting to add 1% to 2% of additional after-tax performance per year to a diversified equity portfolio and 0.3% for a fixed income portfolio. For more information, see Shomesh E. Chaudhuri, Terence C. Burnham, and Andrew W. Lo, “An Empirical Evaluation of TaxLoss-Harvesting Alpha.” Financial Analysts Journal 76:3 (2020): 99–108; and Andrew Kalotay, “Tax-Efficient Trading of Municipal Bonds,” Financial Analysts Journal 72:1 (2016) 48–57. These studies did not involve Parametric or its clients. There is no guarantee that a tax-management strategy will result in increased after-tax returns. Results will differ based on an individual investor’s circumstances.
