The fourth quarter of 2022 continued some of the major trends of the year: volatility, unpredictability, and the primacy of Federal Reserve action. Following a surprisingly robust rally in October and November, the S&P 500® Index dropped -5.8% in December to finish the quarter up 7.6% and the annual period down -18.1%. The year was marked by the sharpest increases in interest rates by the Fed in history as it fought to dampen demand and repress persistent inflation. With higher rates cascading through the economy while market pundits grasped for precedence, the stock market reeled, and the bond market suffered its worst year on record. The Bloomberg Aggregate Bond Index was down -13%.
Among the laggards in 2022 were some of the most prominent mega-cap technology and communication stocks. Led by these big companies, Communication Services was down -39.9% for the year, Consumer Discretionary was down -37.0%, and Technology slid -28.2%. Higher rates were punishing to the housing market as mortgage rates soared and the Real Estate Sector sank -26.2% over the year. The fourth quarter rally missed these four sectors, instead favoring the cyclical sectors of Energy, Industrials, Materials, and Financials, all of which outperformed the broader market for the quarter and year. The outlier was the Energy Sector which was up a stunning 65.4% for the year, and 22.7% in the final quarter. The major catalyst was oil prices which were elevated for most of the year, although a fourth quarter dip brought the level back to the $80 per barrel range, close to where it began the year.
Across the broader equity market, value stocks were outperformers for the quarter and the year compared to growth. In terms of market capitalization, midcap stocks proved more resilient than large cap and small cap stocks, with the S&P Midcap 400® advancing 10.8% in the fourth quarter to bring the 2022 return to -13.1%, while the small (Russell 2000) and large cap (S&P 500) indices declined in the range of eighteen to twenty percent. The damage among the largest stocks and the relative stability of midcaps can also be seen in the unusual annual performance advantage of the S&P 500 equal weighted index, which gives each company in the index an equal weighting rather than weighting by size as in the standard index. The equal weighted index in 2022 dropped -11.5%, outpacing the market-weighted index by more than six percent.
The major backdrops for stock and bond performance in 2022 were inflation and the concomitant Fed rate increases. By the end of the year, we began to see some movement downward in demand and a bit of softening of inflation, but nothing dramatic enough to give us confidence to contradict Chairman Powell's declaration in December. "We still have some ways to go," he said, “in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to two percent over time." The housing market is an early indicator of a general slowdown, and that has certainly been achieved. Auto sales are also beginning to slacken. Just to balance Powell's rather dire forecast for future tightening, he has also said that the Federal Reserve doesn't want to go so far that they trip a deep recession, forcing dramatic cuts. In other words, we enter 2023 with dual headwinds: high rates slated to go higher and uncertainty on their peak or duration. Even when the dust settles, we are unlikely to see an interest rate environment as accommodative as the one we've grown accustomed to since the 2008 financial crisis.
Additional clouds that hung over the market this past year remain. The war in Ukraine and its impact on energy prices and supply chains are likely to put Europe into recession. China's expanding GDP, the engine of global growth over the past decade, slowed as the country faced waves of shutdowns around its zero Covid policy. Towards the end of the year the government relented to widespread discontent over this policy and opened back up; however, with Covid infections spiking, China is one area that bears watching.
In addition to the impact of rates, technical indicators such as the inversion in yield between the 1-year and 10-year Treasury make the probability of a recession in the U.S. in 2023 relatively high. The combination of sticky inflation and higher interest rates may sound like a recipe for further stock losses in 2023. We expect further volatility in the near term but are hopeful for a relatively short and shallow slowdown, with markets stabilizing in the second half and looking toward growth in 2024. There are many high-quality companies now trading at attractive valuations. If volatility continues in 2023, it could create buying opportunities for portfolios with longer time horizons. Investor sentiment remains near all-time lows, one of the best contrarian indicators supporting the bottoming of a market. We also look at historical precedence: back-to-back losing years for the stock market are rare, only occurring three times in the past fifty years. Areas of the market and our economy, such as health care, remain in secular growth trends.
What might influence the Fed to shift policy? The announcements of layoffs at major firms, particularly the mega-cap stocks that have led the market in past years, seem a harbinger of softening labor demand, one of the prerequisites prior to a Fed pause or pivot. The impact of tighter money has not yet been fully realized but will hit consumers and businesses as they look to renew expiring loans or face the need for borrowed capital. The Fed's actions are a brake on the economy -- but it takes a while between hitting the pedal and seeing the impact.
After several years of underwhelming yields, fixed income has become a more attractive asset class where yields in Treasury and corporate bonds are at their highest levels since before 2008. We believe the travails of the bond market are largely behind us with a prospective return to more normative times when a fixed income allocation can make a steady contribution to total returns. Although we may continue to see volatility in both the equity and fixed income markets, history has taught investors that timing a bottom is impossible, and the spike in interest rates has made a balanced portfolio look attractive again. The market can chug along in either direction for some time on the fumes of sentiment and the impetus of expectations.