Market Update August 2022
August 30, 2022 by Interchange Capital Partners
Markets have struggled with their worst start to a year in decades. Stocks officially fell into the bear market territory, and bonds did little to cushion the blow. For the second time in 40 years, stocks and bonds posted losses for two consecutive quarters.
The primary culprit was rising interest rates. Thanks to stubbornly high inflation, the Fed has targeted rapid tightening of financial conditions, including the largest single rate hike since 1974 of 75 basis points in June. The combination of COVID-19 lockdowns in China and Russia’s invasion of Ukraine escalated volatility further, and many market watchers began talking about a possible recession.
The 1-year forward PE multiple for the S&P 500 at the end of June was around 16 times, down from 21 at the beginning of the year. The 25-year average is 16.85. While difficult to say that equities are cheap, value has improved.
Following are some key performance numbers through the end of the second quarter:
- US equities, as measured by the Russell 3000 index, fell 17.03%, bringing losses to 21.10% for the year. This is the worst start to a year since 1970.
- Bonds extended losses from the first quarter, with the Bloomberg Barclays Aggregate down 4.69%. Year to date, bonds are down 10.35%. After the Fed hiked 75 bps in reaction to the higher-than-expected inflation report in mid-June, the index fell to -12.65% but rallied into quarter-end amid rising growth concerns.
- While faring slightly better than US stocks, international and emerging markets equities also continued their declines. International developed stocks (MSCI EAFE) were down 14.51%, and emerging markets (MSCI Emerging Markets) were down 11.45% in the quarter, bringing losses to 19.57% and 17.63% on the year, respectively.
- Value outperformed growth. Large-cap value outperformed growth by approximately 9% in the quarter, and small-cap value outperformed growth by about 4%.
Inflation is High But Has Likely Peaked
Inflation in the U.S. is at the highest level in decades. It also surprised the Fed, as they were initially convinced it would prove transitory. Today, the message from the Fed is clear—the potential for persistently high inflation justifies aggressive tightening of financial conditions. The key issue driving the market is the Fed’s success with raising rates without stoking inflation or stifling economic growth. Tighten too much, and send the economy into recession. Tighten too little, and inflation spirals out of control. Threading the needle on monetary policy and allowing for a “soft landing” as policy transitions is the Fed’s central challenge.
While central banks are unlikely to provide relief from their aggressive stance until several months after headline and core inflation reports cool, there are numerous data points to suggest that inflation pressures are abating meaningfully:
- Commodities prices have fallen sharply.
- Iron ore is down 50%
- Copper is down 30%
- Cotton is down 40%
- Corn is down 25%
- Lumber is down 60%
- Wheat is down 40%
- Fertilizer down 30%
- Retailers are reporting high inventories relative to sales which point to inventory liquidation by competing on price.
- Mortgage purchase applications, a leading indicator of housing demand, are at the lowest levels in 22 years.
- Trucking prices have fallen 35% since the start of 2022, and shipping costs (Shanghai to Los Angeles) have dropped 40% since peaking in mid-2021.
- While still remarkably strong, the labor market is showing signs of cooling as private businesses plan to hire fewer workers/cut jobs from their payrolls.
- Inflation expectations are coming down. After rising to nearly 3.6% in late March, the 5-year TIPS/Treasury Breakeven Rate (the market’s collective guess for the average inflation rate over the next 5 years) has fallen by approximately 1% to 2.58% at quarter end.
This does not demonstrate that inflation will come down quickly, nor does it indicate that the Fed has accomplished its mission. But for now, forward-looking indicators point to much weaker inflation prints in the months ahead.
Views & Commentary within Spend, Live, Give™ (SLG™) Framework
Spend (Time Horizon: 0-3 years): Maintain Lifestyle
Perhaps the most challenging aspect of markets in 2022 is that the traditional relationship between stocks and bonds—where bond prices rise when stock prices fall—has broken down. Historically, high-grade U.S. treasury/corporate/municipal bonds are among the few asset classes negatively correlated to equities during significant corrections. But with low starting bond yields, the diversification benefit from bonds disappeared and did little to soften the blow.
Heading into the year, we forecast rising interest rates and increased volatility and held higher cash levels in our Spend strategy. This helped relative returns, but the unexpected pace of rate hikes (the 2-year treasury rate began the year at .73% and ended the quarter at 2.92%) wreaked havoc on fixed income across all maturities.
With aggressive Fed rate hikes now baked into short-term rate markets, returns should be better for our Spend strategy fixed income allocations in the year’s second half.
Live (Time Horizon: 3 years-End of Plan): Improve Lifestyle
The market’s primary focus in the second half of 2022 will likely shift from inflation to decelerating economic growth and a potential corresponding hit to company earnings. Earnings expectations for the next 12 months are still close to record levels, and the current consensus is that given downside risk to earnings and the increasing possibility of the Fed overtightening, we err on the side of caution for our equity exposure in the Live strategy. We lean into quality in our sector allocations with exposure tilted toward healthcare and established technology companies. Our preference for healthcare comes from its mix of defensive and consistent growth characteristics. Select large tech companies also have appeal—their products and services have become increasingly less discretionary, have flexible cost structures, carry little debt, and have low failure risk. While consumer staples and utilities appear modestly overvalued relative to the market, their defensive characteristics warrant a neutral allocation. Energy is one cyclical sector we keep above benchmark weight as the uptrend in oil prices, and secular supply constraints will likely continue.
The conflict in Ukraine continues to weigh more heavily on developed European markets, with the region seeing significantly higher energy prices alongside tighter monetary policy. Still, international equities are cheap on a relative basis and would stand to benefit from a retracement of the strength in the U.S. dollar should the Fed become less aggressive. International markets also tend to outperform in higher inflation environments as the indexes have more “short-duration” companies (those with immediate cash flows) than those that suffer.
Following a challenging 2021 and 1Q2022, Chinese equities staged a relative comeback in the second quarter. While COVID-related shutdowns continue to dampen growth and the country’s ties to Russia warrant caution, China is in a markedly different economic cycle with benign inflation and falling interest rates. The People’s Bank of China is cutting the reference rate for mortgages and its required reserve ratio to revitalize bank lending. Additionally, they have announced pro-growth stimulus programs, including tax rebates/reductions and expanded credit support to businesses and infrastructure investments. These accommodative policies could present an opportunity. Emerging markets equities, in general, would benefit should the Fed slow the pace of tightening, energy prices subside, and the U.S. dollar weakens.
Lastly, given our cautious short-term outlook, as equity markets stage short-term rallies, we continue to reduce equity exposure and redeploy that cash using a dollar cost averaging approach.
As noted in the Spend strategy review, we expect second half returns to be better for short-term fixed income, and that sentiment also extends to longer-term bonds. We believe most of the expected U.S. tightening is now embedded in yields. We believe many high-quality bonds can again produce portfolio income and diversify risk and look to these opportunities to help defend purchasing power against inflation.
We continue to see value in alternative and real asset allocations seeking to increase portfolio diversification and generate non-correlated returns. Our non-traditional portfolio includes private/alternative credit allocations, options-based overlay, managed futures, and volatility-managed strategies.
Give (Time Horizon: Lifespan): Improve Lives of Others
We are amid one of the largest drawdowns in history for high growth stocks. Over the past century, declines of this magnitude have only occurred a handful of times (Great Depression, 1974 crash, Tech Bubble, Great Recession, Covid). All prior crashes proved to be buying opportunities and we do not believe the world is about to reduce expenditures on the trends set to transform human lives at an accelerated rate during the next five to ten years. Themes we continue to allocate toward include:
- Cybersecurity: Cybercrime continues to intensify, and large-scale spending on cyber security is likely to accelerate. Security software ranks amongst the least likely I.T. projects to be cut in an economic slowdown.
- Cloud Computing/Data Analytics/Business Intelligence: As enterprises continue to move workloads to the public cloud, the need to generate valuable insights quickly and cost-effectively is vital. Only 10-15% of enterprise I.T. spending has moved to the cloud.
- Autonomous Technology: Shortages of e-commerce, warehouse logistics, and long-haul truckers are impacting the distribution of goods, and an increase has not matched renewed demand for transportation in drivers. The potential to lower costs for consumers (in the form of affordable ride-hailing) and businesses (through improved supply chain efficiency) point to the potential benefits of autonomous technology.
- Financial Technology: The pandemic accelerated the already powerful shift toward digital payments and lending. Even amid slowing economic conditions, fintech companies can continue to drive important process improvements for businesses and provide consumers with better access, faster service, and lower costs.
- DNA Sequencing: COVID-19 revealed a small glimpse of the possibilities offered by genomics, a field leading us towards predictive and personalized health care. We stay invested in this promising scientific and technological trend through companies engaged in the research of genomic sequencing, analysis, synthesis, and instrumentation.
There is no question that the volatility and market declines in the first half of the year have been unsettling. The good news is the market now sits at more historically attractive valuation levels, and long-term return expectations have improved. We believe a significant amount of the risk related to inflation and tighter financial conditions has been priced in at current prices.
We continue to lean on our SLG™ framework, ensuring our clients have the cash to weather market swings. We stick to our diversified, long-term asset allocation strategies and take positive action by harvesting losses and making tactical changes as economic data dictates.
While substantially reducing long-term equity allocations in favor of cash in the hopes of timing a bottom is not a viable strategy, raising cash on rallies and dollar cost averaging back into the market is a tactic we continue to employ. Eventually, as the market gets more clarity around inflation, the path of Fed tightening, and economic growth, conditions to establish a bottom and shift into the beginnings of a new bull market will emerge.