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Market Quarterly: Q2 2022

by M. Burke Koonce, III

Going Below the Hard Deck

After seven consecutive quarters of positive returns, the markets have now coughed up two quarters in a row of negative returns. The broad market selling that first appeared during the first quarter continued during the second quarter, with the S&P 500 posting a total return of negative 16.1 percent. The other major domestic indices were also negative, with the Dow Jones down 10.8 percent, and the tech-heavy NASDAQ down 22.3 percent. Frankly, the second quarter’s only positive development appears to have been the debut of Top Gun: Maverick.

There were bogeys everywhere throughout the first half of the year, which was the worst performance to start the year since 1970. Just stating for the gloomy record, the S&P 500’s total return for the first half was negative 20 percent, while the Dow was down 14.4 percent and the NASDAQ was down 29.2 percent. The S&P 500 officially entered a bear market on June 13, closing more than 20 percent down from its January peak. While the second quarter did not match the first quarter’s peak volatility, the selling that began in January and February came back with a vengeance in April and then again in June. One could not be blamed for holding on too tight and losing one’s edge.

Just like in the Top Gun films, the second quarter’s villains were Russians (1986 film) and also a mysterious source of hostility (2022 film). That hostile foe was inflation. Inflation and the expectation of higher rates caused a broad revaluing of the market during 2Q. This continued to impact prices of longer-duration assets more than shorter-duration, value-oriented assets. However, the trend reversed somewhat during June, with new probability emerging that rate hikes and tighter monetary conditions might cool the economy sooner and to a greater extent than had been expected. This sentiment appears to be ascendant, with growth stocks staging a bit of a comeback and beating value for the first time this year in June. This has continued into July, which has featured a decent market rally so far.

The Fed appears quite keen to avoid letting inflation take root, though the labor market continues to buzz the tower. Even so, signs are emerging that the Fed’s tightening cycle is closer to the end than it is the beginning. Ten-year treasury yields, which hit almost 3.5 percent on June 14, have fallen almost three-quarters of a percentage point. As one might expect, this has provided some relief to financial markets, with the S&P 500 up more than 11 percent since June 14 and the NASDAQ more than 14 percent.

“Because I Was Inverted”

Maverick’s words to his instructor as he was explaining how he obtained a Polaroid of a then-new MiG fighter, could have just as well described the yield curve this month, with the 10-year plummeting faster than that fabled MiG-28 in a 4G negative dive. Though the difference between the yield on the two-year Treasury and the ten-year went briefly negative in April, it has gone consistently negative this month, suggesting that an economic recession is on the horizon. Inverted yield curves don’t always mean a recession is coming, but no modern U.S. recession has happened without being preceded by one.

Moreover, the more hawkish Fed appeared at a time of historical change in fiscal support for the economy. Last fiscal year, the federal budget deficit clocked in at 12.4 percent of GDP—this coming fiscal year, it is expected to be less than 4 percent—that’s the largest decline as a percentage of GDP since the aftermath of World War II.

So, what would a recession mean for the prices of financial assets? Well, of course, it would depend on the depth of the economic malaise, but it’s worth noting that the market has likely already discounted a significant amount of slower growth. That’s what this year’s re-pricing has been all about. To start the year, the forward P/E ratio on the S&P 500 was around 22.0x—this week it was below 16.5x, which is below the benchmark’s 25-year average. There are ample reasons to conclude that a recession would be mild, given the otherworldly strength of the labor market and the comparative lack of leverage on corporate balance sheets.

“This Is What I Call A Target-Rich Environment”

During the two-year period ending June 30, the S&P 500 returned almost 26 percent. Value outperformed growth by a mile, with the Russell 2000 Value Index returning 44 percent during that period while growth was basically flat. Value tends to outperform during periods of market turbulence, particularly when that turbulence is caused by economic growth in overdrive.

However, circumstances can change in a hurry. With forward rates behaving like they’ve just flown through Iceman’s jet wash, suddenly volatility is falling and prices are rising again. While this particular set of circumstances does not necessarily favor strong relative performance by value vs. growth, it could be constructive for overall markets in the near term. Of course, if inflation persists and the economy powers ahead, value could be expected to outperform, though overall returns might be lower. One thing is for certain, historically it has been easier to markets to rise after they’ve been trading at less than 16.5x forward earnings than when they’ve been north of 22.0x, as the chart below illustrates.

After a first half that stunk worse than Slider, markets are experiencing strong crosswinds. Covid-19 continues to bedevil us, but nothing like before; the virus’s primary effect at the moment is through China’s struggles with full economic re-opening as it pursues a Zero-Covid policy. Inflation may well have crested, as commodity prices have been falling. On the other hand, much tighter fiscal and monetary policy will present real headwinds for the economy going forward, and it would be foolish to count on a Goldilocks scenario in which the Fed gets everything just right. In short, the market is as complicated a beast as ever, and it remains our view that “time in the market” is far more important than “timing the market. As the chart below demonstrates, for the last 71 years, the longer one’s time horizon has been, the more likely one was to experience positive outcomes.

While we are not managing client portfolios by trading in and out of every market decline or rally, you can be assured that we continue to monitor markets with an aviator pilot’s eye. Moreover, while we are not attempting to predict every minute of the future, we can confidently say that equity portfolios are performing as we might expect in this environment, with our value tilt having provided a significant tailwind to performance.

We thank you for your continued trust in our stewardship.

Burke Koonce

Market Quarterly: Q1 2022

by M. Burke Koonce, III

There’s Lots of Bad News. That’s Good News.

After seven consecutive quarters of positive returns, the S&P 500 finally turned in a clunker in the first quarter of 2022, posting a negative total return of 4.6 percent. The other major domestic indices were negative also, with the Dow Jones down 4.1 percent, and the tech-oriented NASDAQ down 8.9 percent on a total return basis.

There was no shortage of gloom and doom on which to blame the market’s downturn. From the first week of the year, just as the Omicron variant was entering a hopefully final blow-off stage, markets turned their collective concern away from COVID-19 and onto inflation, the byproduct of massive fiscal and monetary stimulus, supply chain disruptions, and a post-pandemic hiring bonanza. While a certain amount of inflation was to be expected, these historically large year-over-year price increases have proven stickier than many economists predicted. Then of course, the coup de grace was the horrific Russian invasion of Ukraine, which served to not only exacerbate surging energy prices but to cast a pall over global growth projections as well. Rising inflation was already poised to erode strong annual real economic gains—but war in Ukraine threatens to dampen those gains further and cause the economy to teeter into a recession next year.

The U.S Treasury yield curve, a generally reliable predictor of future recessions, went negative on the first day of the second quarter and financial markets took notice, with broad market indices continuing their decline. While the move was brief and the curve has since steepened again, rising interest rates have had a severe impact on financial markets this year, especially on the more speculative areas.

Markets are now pricing in 50-basis-point interest rate increases at each of the next three Fed meetings, expectations that in January would have seemed completely fantastical. During the teeth of the Covid lockdown, the Federal Reserve abandoned its primary mandate of price stability in favor of promoting maximum employment, indicating it would allow inflation to “run a little hot.” Well, it would appear the Fed achieved that objective, with the U.S. unemployment rate at 3.5 percent, a level last seen in 1969, and the highest headline inflation since 1981. Now the Fed finds itself in the unenviable position of having to quash inflation without choking off the U.S. economy, and there is increasing momentum behind a plan to “front-end load” the interest rate increases it will use to tighten monetary conditions. There’s little doubt the Fed will eventually douse the flames of inflation, but the prices of financial assets will react in perhaps some unpleasant ways in the near term, especially in the more speculative areas of the market.

Rising interest rates tend to make for volatile markets, and these rate increases have differing effects on different assets. Broadly speaking, the rising price of money has the greatest impact on assets with the longest duration—assets that require the longest “payback” period, often called “long duration” assets, see their prices change the most when rates are changing. Examples of these assets are long -dated bonds and expensive growth stocks—stocks that investors have bid up in hopes of a substantial payback in the distant future. The problem is that when rates are at rock-bottom, it’s a lot easier to make the case to wait years to get paid back than it is when rates are shooting up and investors can earn money elsewhere instead of waiting.

This is being borne out in real time in markets right now. During the first quarter, as rates were rising, the Russell 2000 Value Index lost about 2.5 percent while the Russell 2000 Growth Index fell 12.7 percent. So far in April, the trend has continued, with value outperforming growth by about 1300 basis points for the year at the time of this writing. Some of the best performing stocks over the last several years have been caught in brutal sell-offs, with names such as Facebook (now known as Meta) and Netflix down 46 percent and 67 percent, respectively.

Value strongholds such as energy and materials have not been completely immune either. With recent reports of new Covid lockdowns in China and lower global growth expectations, these sectors have tumbled also.

Rising interest rates and inflation also tend to have an outsized impact on small cap stocks. Intuitively, this makes sense, with smaller companies more likely to feel the impact of these factors in the real world, but there’s also the reality that as interest rates rise and liquidity recedes from financial markets, small cap stocks react more negatively, just as they react more positively when liquidity increases at the margin.

Market volatility has spiked, which is unsettling, but it’s also worth maintaining a little perspective. The S&P 500 is now down about 10 percent for the year on a total return basis. Going back to 1980, the market averages a 14 percent intra-year drawdown every year, despite an average annual return of 9.4 percent and positive returns for more than 75 percent of those years. What the broad market is experiencing may seem extreme, but it’s only extreme in comparison to extremely recent experience. It’s also worth pointing out that for the two years ending with the first quarter, the S&P 500 returned more than 89 percent. The Dow Jones returned almost 75 percent and the NASDAQ almost doubled.

So while the bears are having their day, our contrarian impulses are quickening a little. Market volatility is well-above long-term averages, which suggests better times might not be too far ahead. Lastly, consumer confidence is as low as it has been in more than a decade, understandably driven down by stubbornly high inflation. This, counterintuitively, is also good news, as such dismal expectations are often followed by powerful rallies.

While we are not managing client portfolios by trading in and out of every market spike or downturn, you can be assured we continue to monitor markets with a gimlet eye. Moreover, while we are not attempting to predict the future, we can confidently say that equity portfolios are performing as we might expect in this environment, with our value tilt providing a significant tailwind to performance along with our international tilt while our small-cap tilt is a headwind. In a nutshell, diversification is paying dividends, as it does over the long term.

We thank you for you continued trust in our stewardship.

Burke Koonce