Effective Date: June 30, 2022
World equity and bond markets had a difficult quarter as investors adjusted to the possibility of a prolonged war in Ukraine, higher inflation, and aggressive monetary policy actions from central banks. All three of these headwinds are intertwined with each other. Over the course of the last three months, the possibility that the US and Europe enter recessions has risen but recessions are not certain, and if they do ultimately occur it is not clear when or how severe they will be. It is possible markets get worse before they get better, but they will get better. With all downturns, it is our goal that your portfolio comes out of the downturn in better shape than when it entered the downturn. We have been conducting tax loss harvesting trades and rebalancing accounts as opportunities arise. 2022 so far has not been good for investors, but we continue to be optimistic about the long-term future of the economy and markets.
INDEX RETURNS YEAR-TO-DATE
MSCI EAFE International
MSCI EM Emerging Markets
Barclays Aggregate Bond
10 YR Treasury Yield
You received several market updates this year from our firm, and from the table above it is evident the declines in equity and bond markets were widespread. What is important to note is that markets and your portfolio were prepared for the Fed interest rate tightening cycle. Even after the first month of the Ukraine war at the end of March, market losses were contained and about what was expected. What changed the last three months is that the Ukraine war intensified and prolonged. The US and Europe began supplying Ukraine with increasingly more advanced weapons and in greater quantities. The prospect that it would be a lengthy war or could escalate impacted food and energy prices, which in turn impacted inflation, which in turn caused the Federal Reserve and other central banks to tighten monetary policy more aggressively. The Fed raised interest rates 0.75% at their June meeting, the largest increase since 1994. They also indicated that further hikes of that magnitude may be forthcoming. The Fed’s next meeting is in late July and we expect an additional 0.50% or 0.75% increase in Fed Funds rate at that time.
MARKET INDICATORS & OUTLOOK
US equity valuations
Interest rates stabilizing
Inflation expectations rising
Thus far, the economy and overall corporate earnings have been holding up reasonably well. Real time indicators like jobless claims, travel information, home sales, etc. are starting to show modest slowdowns but that is the desired effect of the Fed tightening monetary policy. The chance of a recession has increased as inflation remains elevated, and it is forcing the Fed to be more aggressive. The longer the war continues without a settlement, the more likely there are recessions in the US and Europe. However, there are signs inflation is peaking and is beginning to improve even though the war is ongoing. On June 30th, the Fed’s preferred measure of inflation called PCE (Personal Consumption Expenditures) came out, and it was better than expectations, showing improvement compared to recent months. Oil and natural gas prices declined 14% and 45%, respectively, in the past two weeks. Unfortunately, gasoline prices have only declined 3% during this time but will likely decrease if oil prices stabilize or decline. Consumer expectations about inflation are uniquely anchored to gasoline prices, so if gasoline prices decline people will start to have a better inflation outlook. It is likely that one or two consistently better inflation reports are the catalyst for markets making a meaningful recovery and that could occur anytime over the next several months.
A subtle but important development for investors is that equity market valuations have drifted back to average levels they have not been since the 1990’s and long-term interest rates are likely near sustainable long-term levels. Both data points suggest the markets are finding an equilibrium which is positive for investors. For example, 10-year US Treasuries are yielding 3% and 30-year mortgage loans are 5.75%. These rates are high enough to adequately reward long-term investors, but not so low that they encourage excessive borrowing like 2.5% mortgages. Interest rates at these levels going forward are an improvement for investors, particularly investors with conservative and moderate allocations as low interest rates have been a structural problem for those allocations for the last ten years.
Lastly, we use a variety of technical and quantitative indicators to help us better understand markets. While these indicators are not foolproof and do not work 100% of the time, they are based on math, and we find them to be more reliable than opinions and financial commentary. The exact indicators that were positive in March 2009 (Financial Crisis) and March 2020 (Covid) among other times are once again suggesting returns one year from now will be above average with a high probability of success (past results do not guarantee future performance). Perhaps more so now than before, indicators that are derived using entirely different data sets are saying the same thing. One example is from Bespoke. There have only been eight quarters out of three hundred and four total quarters (2%) in which the S&P 500 declined 15% or more like now, so the decline we just experienced has been rare historically. Following these previous declines, markets were positive one year later every time and the average return was 26%. Markets could get worse in the short-term, but they could also better rather quickly.
PORTFOLIO IMPLICATIONS & RECOMMENDATIONS
We have recently rebalanced many accounts and conducted tax loss harvesting in some taxable accounts. Most of the tax loss harvesting was conducted in bond, small cap and international positions. If there are signs inflation is peaking and interest rates stabilize, we will further adjust bond positions by reducing TIPS and short duration bond positions and buying intermediate term bonds. The equity part of your portfolio is well positioned for recovery with the overall market.
Our new portfolio accounting system and online portal is being rolled out this quarter. We are also upgrading our trading software, which will enable better execution of portfolio strategies. We look forward to your feedback about your portal experience.