2022 Second Quarter Investment Update
Bear Market Officially Arrives. Recession Next?
The second quarter culminated with the most difficult start to a calendar year for U.S. stocks since 1970. The S&P 500 officially entered bear market territory on June 13 as it exceeded a 20% decline from the all- time high reached on January 4. While inflation remains a persistent theme of market observers, a closer focus on the economy’s health and business cycle took hold as well. Leading indicators are presenting clear trends of a slowing economy, while other measures like employment are not yet registering classic signs of a recession. The Federal Reserve Bank of Atlanta’s GDPNow estimate is currently forecasting a negative GDP output for the second quarter, which fits the technical definition of a recession following the 1.6% decline in the first quarter. However, the Consumer Price Index stubbornly sits at a 9.1% annual rate, and despite flattening commodity prices and a strong dollar, inflation is still well above levels at which the Federal Reserve is likely to pivot course on higher interest rates. The debate over the economy, corporate profits and how those elements will influence Fed policy should dominate market sentiment in the coming quarter.
We’ve Seen This Movie Before
The risk-off sentiment in markets accelerated in the second quarter, as disappointing inflation data and hawkish central bank rhetoric weighed on global markets.
Large-cap US stocks (as measured by the Russell 1000 Index) were down 16.7%, small-cap US stocks (Russell 2000) were down 17.2%, international stocks (MSCI EAFE) were down 14.5% and emerging markets (MSCI EM) were down 11.5%.
Again, it was a positive relative quarter for lower valuation stocks. In the US, large-cap value stocks outperformed their growth peers by over 8%. Lower volatility strategies outperformed their respective index in the US, international and emerging markets.
Among fixed income, US taxable bonds (Bloomberg US Aggregate Bond Index) were down 4.7% and municipal bonds (Bloomberg Municipal Bond Index) were down 2.9%. High yield and international bond indices were down between 8-10%, as concerns about credit and a strong dollar were headwinds for these sectors.
Alternative Investments Add Meaningful Diversification Benefits
Alternative strategies continued to offer compelling results in an environment where both stocks and bonds had deeply negative returns. Our managed futures position was up 7.9% in the quarter and is now up 17.7% for the year. Our merger and event-driven strategies were down collectively about 2% in the second quarter.
In the second quarter, markets effectively continued to take back excessive gains pulled forward from the pandemic lows in March 2020. We use the word “excessive” because many valuations and growth rates were built on the premise of exceptionally low-interest rates and inflation for a long time. Unfortunately, the Federal Reserve is now faced with some of the highest inflationary pressures in 40 years. It’s become a consensus view the Fed kept interest rates too low for too long, especially in 2021, and the market distortions from those decisions are painfully being wrung out of stock and bond prices.
Our diversified stock portfolios again declined considerably less than their benchmark in the second quarter by avoiding some of the highest valuation and most unprofitable companies. These have generally been the companies in the bear market’s crosshairs.
Our taxable bond portfolio was slightly behind its benchmark in the second quarter due primarily to the more volatile components of high yield and emerging market debt. In particular, foreign debt has been subject to headwinds of a very strong dollar, which is hitting multi-decade highs against even established currencies such as the euro and yen. Our municipal bond-focused strategy slightly outperformed in the quarter; our manager emphasis on higher quality and lower duration helped in a period where investors were eschewing credit and interest rate risk.
In our annual outlook and first quarter update, we warned of the challenges and potential storm clouds ahead in 2022. Unlike many large Wall Street firms, we have not had to dramatically revise our forecasts and tactics to address the slowing economy and difficult markets. While we are not satisfied in reporting losses, any manager will eventually face a down cycle; the stock market historically drops about 30% of the time. Many of the best managers succeed by avoiding large losses in these down cycles, and generally we are pleased with our navigation so far. The market has almost methodically punished stocks AND bonds throughout 2022. However, by anticipating some of these events, we have avoided many of the worst offenders.
In June, almost all sectors and styles sold off indiscriminately; this type of action and behavior is usually seen near a market low. We expect as we enter the third quarter and there is more clarity around corporate earnings for the rest of 2022 and some of 2023, the market will begin to grade winners and losers in a more discerning fashion. We continue to expect that there is damage ahead in some of the highest valuation stocks, which have a lofty hurdle for sales and earnings growth ahead. If we are near a bottom for the overall US market, the valuations are at some the highest levels ever seen for such a “low”. The market is attempting to look ahead to an inflation peak and possible cooling of interest rates to justify a recovery for these stocks. The weight of the evidence leads us to believe these rallies will be short-lived, not due primarily to interest rates but more likely unrealistic earnings expectations and shrinking profit margins from inflation and the end of stimulus programs.
That said, we are in the camp of believing inflation is *nearing* a peak and will not justify dramatically higher interest rates from this point. We’ve posited that the U.S. economy and credit markets are so calibrated to low or near-zero interest rates, that the rate of change, even to 3-3.5% levels, has caused considerable tightening and negative effects to the economy. Since we do not expect bond yields to move much higher, we anticipate fixed income will provide more traditional diversification benefits. If the economy deteriorates and recession fears are realized, bond yields should go lower and prices higher, offsetting a likely negative outcome for stocks.
We continue to favor value-oriented strategies but are beginning to lift some of our defensive characteristics in certain sectors. Particularly in small-cap and international markets, stocks are priced historically cheaply, and we want to take advantage of a bounce or cyclical rotation if the Federal Reserve changes course later this year. We are adding small-cap exposure across both U.S. & foreign markets.
In the bond market, we are reducing our exposure to inflation-protected securities and adding exposure to traditional Treasuries and other global sovereign debt. With the economy slowing, we want to position for the continued yield curve inversion where longer-dated bonds increase in value thus decline in yield, and an unwinding of interest rate and expectations in the long term. It has been a difficult year for non-dollar denominated bonds, but we think this presents an opportunity to add currency diversification at historically cheap valuations. Dollar rallies have tended to peak near a pivot in a Federal Reserve tightening cycle, and we expect that pivot (or “rhetoric”, not actual rate cuts) is likely to happen in the second half of the year.
We plan to maintain our alternative investment posture unless there is a clear drop in volatility and shift in negative fundamental and technical trends. We are monitoring our managed futures position in navigating the rapid shifts in commodity and currency markets; so far, we continue to see it as well suited to an inflationary pattern, even a moderating one.
We want to keep you apprised of our current outlook because we are occasionally flabbergasted by some of the “research” that is distributed from national and global wealth managers. At the beginning of the year, many analysts seemed to be in denial about (pick your topic) interest rate increases, stock market corrections, bear markets and recessions. Only when we are on the cusp of the event have many admitted it was possible or likely to persist. Now some of the Street’s conventional wisdom includes comments like “any recession will be technical and short-lived” and “earnings still look strong and negative revisions will be minor”. A lot of these platitudes echo ideas like “inflation will be transitory”. We saw how that movie ended, to borrow from our earlier headline.
We mention this not because we are perpetually bearish or think this is a terrible time to invest. We believe there is often an inherent conflict between large firm’s advice and your best interests. Most large firms need investors to support the companies and products they do business with. Not surprisingly, their strategists can twist themselves into pretzels offering you reasons to buy an investment that worked well yesterday but may not tomorrow. Our only interest is in finding the best investment for tomorrow, and when tomorrow comes, the best one for the day after that, and so on. When the facts and circumstances change, we change. We will not wait until you are uncomfortable to give you our concerns about the stock market and outlook. Likewise, we will not sit on cash until our clients “feel good” about putting money to work. Many of the best long-term returns are made in the worst market environments.
Thank you for your confidence in our team and advice, and for entrusting us to steward your wealth through these challenging times. We have and will continue to take that responsibility seriously.