Investment Commentary – June 2022

When we shared our Investment Commentaries in April and May, we noted economic headwinds from high inflation, expected Federal Reserve rate hikes, and declines experienced in the stock and bond markets.  We also focused on increased volatility levels in late April and early May, with the observation that elevated fear levels may remain for the near future.  Unfortunately, but perhaps unsurprisingly, none of these issues have been resolved and asset prices have moved lower.

While we are still a couple weeks away from the mid-point of the year and in light of the Federal Reserve bank raising interest rates by 75 basis points, let’s examine the magnitude of the downturn for some perspective.

Just how bad has this downturn been?  On January 3, 2022 the S&P 500 closed at an all-time high of 4,796.56.  Since that time, the index has contracted nearly 24% and dropped into bear-market territory.  Results have been more painful for the tech-heavy NASDAQ Composite Index (down 33%) and small-company Russell 2000 Index (down 27%).  Bonds have not provided shelter from the storm as rising interest rates have impacted year-to-date total returns negatively, with very short-maturity bonds being down slightly and longer-duration bonds down in the low double digits.  Well-diversified portfolios with asset allocations of 2/3 stocks and 1/3 bonds are generally down between 15% and 20% year-to-date.

What happened?  (1) Inflation heated up more than was expected – with inflation forecasting complicated by the economic impact of the Russian invasion into Ukraine and the supply chain snarling impact of China pursuing a zero-Covid policy. (2) The Federal Reserve has reacted to higher-than-expected inflation by raising their target interest rates faster and higher than markets had projected earlier this year.  When we sent our April commentary, we noted Fed guidance prepping us for a 2.8% peak rate with markets expecting rates would not go quite that high. The Fed guidance is now closer to 4.0% peak rate and interest rates, especially those for new mortgage borrowers, have risen substantially. (3) The loss of consumer confidence, much of it triggered by rising costs, especially in food, fuel, and housing.  (4) A tapped-out central bank and federal government which cannot initiate interest-rate cuts or stimulus payments without worsening the inflation problem.

As the world economy is constantly adapting to new information, we wonder are we headed into a recession, and do we have other perspectives we should consider?  You do not have to do an exhaustive internet search to find economic forecasts and recession predictions.  A consensus of economists appears to anticipate a recession later this year or in 2023.  However, markets tend to anticipate recessions by adjusting expectations well ahead of when the National Bureau of Economic Research declares that we have a recession.  In 2022, we have certainly experienced market adjustments in anticipation of a recession.  Investors have been reducing full-year 2022 earnings estimates, and they are paying a lower multiple of future earnings to buy stocks.  Those multiples are now below the 25-year historical average; however, analyst consensus for 2022 full-year forecasted earnings of $229.35 remains above 2021 actual earnings of $208.53 and represents slightly more than a doubling of earnings from the 2013 level of $109.68.  Bonds have repriced to new interest rate expectations with the 10-Year Treasury approaching 3.3%.  Credit spreads (the amount investors require to own a AA rated corporate bond instead of a Treasury bond of the same maturity) have expanded slightly from 0.6% to 0.9%.  Mortgage-backed bonds have adjusted in value for higher mortgage rates as the average 30-year rate has gone from 3.3% at the beginning of the year to over 5.7%.  So, while we need to be aware of recession risks, we should recognize that markets have already factored in many of the repercussions of a recession.

In an early 2018 interview with CNBC’s Becky Quick, Warren Buffett stated some people shouldn’t own stocks because they will damage themselves by selling when stocks go down in value.  He said those stockholders should recognize they own part of a business and the longer they own well-run businesses, the less risky that ownership becomes.  He cautioned to be mindful of the potential damage of selling prematurely.  We agree that keeping emotions in check and maintaining the discipline of your Investment Policy Statement (IPS) will lead to the best results in the long-term.  As always, please reach out to your Summit team if market volatility has you uneasy, or if it would give you additional peace of mind to have a conversation specific to your situation.  In the meantime, your Summit team will continue to review your portfolio for rebalancing and tax loss harvesting opportunities.

If you are interested, read on to learn more about historic drawdowns for balanced portfolios, stock/bond correlation, past market rebounds from bear markets, current Federal Open Market Committee interest rate forecasts and changes in inflation breakeven rates.

It never feels good when market volatility arrives. We all know it is bound to happen, but nonetheless, it is unpleasant.  But does it feel worse this time?  Behavioral finance states that people frequently make financial decisions based on their emotions and biases. One of those biases is “recency bias”.  As defined by Investopedia, recency bias is “the tendency for people to overweight new information or events without considering the objective probabilities of those events over the long run.”  This makes us think extremities like “this is the best/worst market ever” or “this market is going to keep rising/falling forever.”

Even though biases play on our emotions and perceptions, is it still possible this is the worst market ever? Let’s look at some of that data.

Below is the performance of a traditional 60% Equity / 40% Fixed Income portfolio going back 25 years.  The current market is on par with the Covid crash. While certainly a painful drawdown, the Dot-Com bubble and the Great Financial Crisis had larger drawdowns than where we are today.

 

 

Most times when your portfolio declines, the diversification creates pockets of your portfolio that outperform while other areas underperform. Bonds tend to offset stock declines in portfolios. That has not been the case this time. Investors have found few places to hide as stock and bond correlations have increased (reminder: positive correlation means moving in the same direction, negative correlation means moving in opposite directions). Stock and bond correlations move up and down, and they are currently nearing a level they top out at. Based on the historical tendency, it would be reasonable to expect a forthcoming decline in the correlation.  Said another way, we do expect stocks and bonds to work as a yin and yang again.

 

 

Poor performance across asset classes feels awful, but what’s the takeaway? You have endured a lot at this point. Some of us may be rapidly hitting refresh on our account balances screen. Some may be losing sleep. Some may be wondering if retiring last year was a good idea or if your plan to do so next year is still on the table. Dimensional Funds looked at the last 95 years of stock market data to identify how future returns stacked up after periods of drawdowns.

“On average, just one year after a market decline of 10%, stocks rebounded 12.5%, and a year after 20% and 30% declines, the cumulative returns topped 20%…Over three years, stocks bounced back more than 30% from declines of 10% and 20%, although—while still positive—returns were not as impressive after 30% declines. But five years after market declines of 10%, 20%, and 30%, the average cumulative returns all top 50%.” (full Dimensional post)

 

 

We have already hit the 20% decline threshold. While we do not know what next week or next month will bring, Dimensional points out the average 1-year return after a 20% market decline is +22%. The 3-year average return is +41%, and the 5-year average return is greater than 70%.

In other news, the Federal Open Market Committee announced a 75 basis point (.75%) increase to the Federal Funds Rate. This is the target rate for overnight lending between commercial banks, which serves as the foundation for market participants to establish short-term interest rates. The last time the FOMC hiked 75 bps was November of 1994. They made such a big move this week to try to tame the hottest inflation we have seen in 40 years. The “dot plot” implies 3.4% Fed Funds for 2022 year-end – or another 175 bps from where we are today. Each dot on the plot represents the Fed Funds projection of one Fed official. Though the projections of the Fed officials are published, it does not mean the uncertainty is over. Looking out to 2024, the span of the dot range is 2%, which is the biggest spread in the history of the FOMC, which indicates a large difference in projections amongst Fed members.

 

 

So can the Fed get inflation under control? The Consumer Price Index (CPI) for May revealed an 8.6% increase in the last 12 months. Looking at inflation expectations and breakeven rates shows the thoughts on the matter by market participants:

 

The 5-Year breakeven inflation rate reveals what the market thinks will be the average inflation of the next 5 years.

 

The 10-Year breakeven rate shows the market’s inflation expectations over the next 10 years.

 

The 5-Year, 5-Year forward inflation expectation rate is a measure of expected inflation (on average) over the 5-year period beginning 5 years from today.

 

Seeing each of these expectation figures at 3% or below indicates the market is convinced the Fed has a handle on the inflation issue. Additionally, seeing each of these figures decline from the March/April time frame shows the increase in that belief. As the confidence in the Fed’s plan grows, uncertainty starts to drain from the market. As uncertainty declines, so does volatility.

Summit is here to help you focus on the long-term and not let those emotions get the best of you during times like these. Despite recent storms making it feel like it will be cloudy forever, the sun will shine again.

 

 

 

 

Quick Links

About Summit  |  Important Disclosures  |  Access Your Portfolio Reports  |  Investment Philosophy Presentation

 

 

 

Read More:

Learn more about Summit Financial