Q2 2022 Market
Experienced. Objective. Passionate.
Tightening Monetary Policy
As we start the summer, financial news headlines continue to be dominated ad nauseam by Jerome Powell and the Federal Reserve. Increasing interest rates, tightening monetary policy, inflation concerns, and recession probabilities- to name a few. Combating inflation is the Fed’s primary job, and tightening monetary policy, specifically by raising interest rates, is the only viable option to truly slow the economy and, in turn, lower the current inflation rate. Doing so causes a chain of events that essentially forces the economy into a “recession,” a technical term tied to consecutive quarters of falling GDP and a rise in unemployment. Define it however you want; this current moment feels like a recession. We are facing high-priced products, rising mortgage rates, housing fears, and a market marked by falling stocks and bonds. The unemployment rate and robust job market are outliers. By the time the Fed starts using the term “recession” in the present tense, the market will likely have already turned over and be heading in a new upward trajectory. Expansions and recessions are cyclical in nature, and today’s rapid spread of information hits the market quicker than ever before. The stock market is a forward-looking discounting machine, and even if the country is not yet in a technical recession, the market is already priced as though it is. So, where can we expect the cycle to go from here?
Market/ Business Cycles
While investment markets ultimately grow over long horizons, businesses and the markets that trade their public securities run through cycles. Recovery, expansion, slowdown, and contraction are widely used terms in a cycle that economists and analysts will point toward. The U.S. is currently somewhere between a slowdown and a contraction phase. Economic data points toward a slowdown, as does the recent market performance. But the silver lining for investors is that the contraction phase is when new market rallies begin. Throughout the slowdown, you will see several “rally bounces” where the market will trade higher for a period before heading back down. The rally bounces tend to clean out the pipes, sector rotation occurs, and retail and institutional investors rebalance portfolios. It is impossible to perfectly pinpoint when a phase will end, and by most metrics, the recent bull market expansion lasted well over a decade. Given the relative global strength of the U.S. economy, we believe the slowdown and contraction phase will be a fraction of the past and future expansions. (See chart below on historical lengths of bear vs bull markets)
Dislocation in the market leads to opportunity. In the current environment, we see tremendous opportunities for investors to position themselves for the future. Starting with the more predictable asset class of fixed income, the rapid increase in interest rates has decreased bond prices and increased the available yield to a purchaser, benefiting both corporate and municipal bonds. Using a corporate example, a reputable equipment rental company whose 5.25% 2030 maturity bond traded close to ~$109 on the last day of 2021 yielded ~3%, is today trading at ~$95 and yielding over ~6%. Nothing fundamentally changed with the company; this was simply a price move related to rising interest rates. By purchasing the bond today and holding it to maturity, you lock in an annualized return of over ~6%, regardless of future price movements other than the extreme scenario of a corporate default/bankruptcy. We are confident in our ability to assess credit risk and see this fixed income environment as one to take advantage of, both actively in making swaps of current positions and when short-term bonds come due in accounts.
In equity markets, something essential for our near to mid-term outlook is that most typically, the winners of a previous bull market are likely not going to be the top performers as a new bull market begins. For instance, technology has been the darling of the last decade, but there is reason to believe that tech maynot lead the way over the next 6-12months. This is not to say we are out on technology moving forward, and we certainly still believe innovation will continue to drive the economy. So, what sectors will lead? The environment is ripe for value-oriented consumer staples with solid balance sheets and the ability to continue business-as-usual through a challenging recessionary environment. Most Q1 2021 Market Commentary of our focus will be on finding those opportunities and the complementary sectors they make up. The financial sector is another to watch as rising interest rates and volatility benefit banks. We continue to allocate to financials predominantly through fixed income instruments but will also consider thoughtfully adding on the equity side. Energy has been the 2022 standout, with the S&P500 energy index rising over 45% YTD through the middle of June as the Russia/Ukraine war continues to threaten global oil supplies. Oil and gas prices could very well drop with any peace negotiations. Therefore, we are keen to be allocated toward energy infrastructure, an area that will continue to grow regardless of the price of oil. This takes us to our inflation trades. This year, it has been well documented that we increased our allocations to broad commodities baskets, one of our stronger performers. Commodity cycles are known to last for several years, and we want to take advantage by participating throughout this one. However, based on the rapid rise in recent months, we find it prudent to trim back some profits with the idea of redeploying back into commodities after a brief cool-down period. Finally, it is essential to note that just because our focus is now on value does not mean we are exiting growth. We will always have deliberate, thoughtful allocations to large-cap growth, as well as specific sectors tied to the growth of our economy, i.e., technology, cloud, and biotech.
We look forward to the challenges ahead, and our investment committee is ripe with ideas and motivation to navigate any market environment. It is times like now that communication is the most important. As the summer wears on, we are excited to continue having meaningful conversations and strategy discussions with all our clients, colleagues, and trusted advisors.
Market Data Sources: Bloomberg L.P., First Trust, JP Morgan Asset Management
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