January 24, 2023

Market Commentary
The second quarter of 2022 held more challenges for nearly every asset class amid high inflation and historically low consumer sentiment. U.S. stocks finished the quarter down 16.1% with smaller companies underperforming larger ones.

International stocks held up better, however they still declined 14.3%. Emerging market stocks underperformed their developed market counterparts.

Inflation continues to run significantly above long-run averages. The May Consumer Price Index increased by 8.6% compared to the previous year. This spurred continued increases in interest rates as investors grew more concerned about the specter of restrictive monetary policy and inflation itself.

Higher interest rates meant that the bond market posted significant losses for the second straight quarter with the bond market falling 4.7%. Bond markets followed up the worst 3-month period since 1980 in the first quarter with the worst 3-month period (excluding Q1 2022) since 1994 during the second quarter. Put these two brutal quarters together and the bond market is down 10.4% on a year-to-date basis. This was the worst 6-month period since the 6 months ending March 31, 1980 when the bond market fell 11.5% during the last major inflationary scare.

Economic Outlook
The U.S. Federal Reserve’s (“the Fed”) advancement towards a more aggressive monetary stance, including the largest single rate hike we’ve seen in over 25 years, has sparked “not if, but when” style concerns about recession. A robust labor market, strong industrial production, and strong retail sales in the face of falling real personal income have led us to believe that we might still have some time before a recession begins, but that has been little consolation to the stock market.

Perhaps the most concerning of the economic indicators above is real personal income. While the labor market is tight and wages are rising, they are not rising faster than inflation. Inflation-adjusted wages are falling faster than they have in 40 years. As essentials like housing, food, and energy eat into these wages, discretionary spending is likely to decrease if inflation does not decelerate while wages continue to grow.

Consumers have largely drawn down their once impressive savings which they accumulated throughout 2020. We are carefully watching revolving credit balances (think credit card debt). These are currently at all-time highs and seem to be supporting the continued strong consumer demand. With regard to the labor markets, there are still nearly two job vacancies for every unemployed person in the U.S. as of April, but we’ve started to observe more announcements of layoffs and hiring freezes from U.S. businesses.

The Fed’s guidance accelerated both the speed and magnitude of rate hikes in Q2. In May, the Fed increased the Fed Funds rate by 0.50% in a single meeting for the first time since 2000. They followed that up in June with the first 0.75% rate hike since 1994. The Fed Funds rate ended the quarter at a range of 1.5% to 1.75%, up from a range of 0.0%-0.25% at the beginning of 2022.

In addition to rate hikes, the Fed began the process of reducing their balance sheet at the beginning of June, and has announced plans to potentially accelerate the balance sheet reduction later this year. Given the Fed’s inability to improve supply-driven contributions to inflation, their monetary policy tools to deal with inflation will likely result in lower aggregate demand. The difficulty here lies in bringing down aggregate demand enough to cool inflation and the labor market, but not so far as to push the economy into recession. If history is any guide, the likelihood that the Fed successfully threads the needle is quite low. If the Fed’s tradeoff here ultimately boils down to a (hopefully) mild recession in the short-run or a period of sustained above-target inflation, we believe that they would be correct to opt for the short-term pain of the former.

While the Fed has been on the tightening path for some time now, they no longer appear to be alone in aggressively tightening financial conditions with the aim to quell inflation. The European Central Bank (“the ECB”) announced their intentions to raise rates in July for the first time in over 10 years. They also provided guidance that additional, potentially larger, rate hikes would follow later this year. This announcement sent European bond yields sharply higher. An emergency ECB meeting followed only a few days later in which they announced additional support for Southern EU members that markets feared would struggle to deal with higher interest rates given their significant debt burdens. With inflation truly being a global problem, much of the world has now followed the Fed’s lead by starting the process of aggressively tightening monetary policy.

While China ended the two-month lockdown of Shanghai in May, President Xi stated publicly in late June that he still thinks their Covid Zero policy is the most “economic and effective” policy for China and it will remain in place for the next five years. This suggests that this may not be the last time we see a city of 25 million people or more shut down. Given the lack of natural immunity in China (a result of the successful lockdowns to prevent spread) and the fact that local Chinese vaccines are far less effective against the newer and more prevalent strains of COVID-19, this policy is likely to cause ongoing issues for the global economy for years to come. As we have written about in the past, problems with global supply chains cannot be alleviated by monetary policy.

Portfolio Strategy
The S&P 500 is now trading around a 16x price to earnings ratio. Many who have followed the market for a long time feel much more comfortable at these valuations than the higher multiples observed at many points over the past five years. In our view, the significant increase in interest rates warrants these downward adjustments, just as low interest rates supported higher multiples in the recent past. As the market absorbs higher interest rates into equity valuations, earnings estimates have remained fairly steady. The fact that investors have maintained positive earnings growth expectations in light of a potential recession is a major reason why we have held off on going overweight stocks at this time despite the significant decline in prices.

Our allocation changes this quarter continued to shift portfolios to a more defensive stance. As interest rates increased, we added exposure to long term U.S. Treasury bonds. In the event of recession, it is likely these bonds will perform well as interest rates fall to meet lower growth expectations and eventual rate cuts.

Additionally, we reduced our allocation to U.S. value stocks by exiting our deepest value equity holding. In our view, much of the outperformance in this position has been made, and in the event that we enter a recession, deep value’s outperformance will likely come to an end.

We encourage clients to continue to focus on their long-term goals and caution against big reductions in risk due to feelings of uncertainty. Much about how the global economy will navigate more restrictive monetary policy remains to be seen, and we will continue to monitor these developments and allocate client portfolios appropriately. As always, we would encourage you to reach out if you have any questions or concerns about your portfolio or the current market volatility.