As we assess the aftershocks of 2022, we are encouraged by the opportunities that 2023 provides. Despite the rampant negativity from financial media, there are essential pillars of strength in the U.S. economy, such as positive GDP growth and low unemployment. While the Federal Reserve attempts to slow growth just enough to keep inflation on a downward trajectory, a severe recession seems less likely absent some unforeseen shock, which is always a possibility. Our portfolios of high-quality companies outperformed by a wide margin last year. We believe that focusing on quality is the key to long-term investing success.
High inflation, interest rate hikes, and slowing corporate profit outlooks roiled markets last year. Quality companies with solid balance sheets tend to outperform in periods of heightened volatility, as we saw in 2022. Companies with resilient revenues and profits avoided much of the market’s downdraft compared to highly cyclical or growth companies.
Looking ahead, a controlled slowdown alongside declining inflation suggests that the Fed is close to completing its hiking cycle. This should allow bonds and stocks to post positive returns as volatility subsides. We maintain a balanced and diversified position with continued emphasis on quality. Our continued focus on high-quality names should bode well for future relative returns, if a severe recession is avoided or not. Any moderation in inflation and stabilization of interest rates can disproportionately benefit equity returns.
In the long-term, companies that grow their earnings faster than the market average prove to be the outperformers. Within our portfolios, we aim to invest in a range of companies diversified by market capitalization, industry, and geography. However, our companies tend to have similar characteristics. We believe that companies that reliably compound their earnings and produce strong cash flows represent the best investment opportunities in changing market conditions.
Europe continues to face a challenging macroeconomic backdrop given the ongoing energy crisis and tightening monetary policy in response to elevated inflation. Since Russia’s invasion of Ukraine, disrupted energy markets and the resulting spike in commodity prices have remained the focal point for Europe. Valuations appear cheap relative to the U.S., and there is a greater opportunity set of high-quality companies. We recently added another market-leading industrial name to the non-U.S. portfolio. Expect us to take advantage of the likely volatile conditions ahead.
The uptick in bond yields has made the return potential of high-quality bonds the most attractive we have seen in years. While we generally take a conservative approach to duration and interest rate sensitivity, we see attractive yields in shorter maturities. If the Fed’s interest rate hiking cycle winds down, the volatility in bond prices should subside. Higher yields and lower volatility make bonds an attractive prospect in 2023.
A month into 2023, we are cautiously optimistic. Much of what has happened over the past three years has been without precedent. We know that more unexpected developments are likely to occur in the future. However, owning a portfolio of high-quality companies is the best approach to ever-changing market conditions. We look forward to working with you in the months and years ahead. Thank you for your continued trust and confidence in Cardinal Capital.