Second Quarter Commentary
Second Quarter 2022 Commentary
Every period, market participants face the risk of seeing the value of their portfolios decline in value. Throughout history, no matter the level of decline, the market has always returned to the previous highs and surpassed those highs. This year, we have experienced two consecutive quarters of market turmoil, but unlike many past periods when equities declined and bonds increased, we have been hit with big declines in both stocks and bonds in the first and second quarters. U.S. large-cap stocks were down 16.1% in the second quarter while the main fixed income index declined 4.7%. Year-to-date, stocks are down about 20% and bonds are off about 10%. The performance so far this year is rare, in fact, since 1976 stocks have experienced eight negative years and in each of those years, bonds were higher at an average of 6.7%.
There are two sources of investment return. One is the fundamental return, or earnings and cash flow growth, and there is the speculative return, which manifests as a change in the price-earnings (PE) multiple. In a normal year, the type of return investors should expect is the fundamental return, the speculative return derives from how investors feel. During the pandemic, the Fed kept short-term rates near zero, which made investors feel good and gave them a “license” to speculate, increasing the PE multiple, resulting in huge returns on both bonds and stocks. This year, however, the Fed changed course and started increasing short-term rates and even signaled rates would increase more than previously thought. This reduced investor appetite for speculation and the PE multiple has plunged 27.3% as of June 30. The fundamental return, on the other hand, is up 6.7%. The sum of the fundamental return and the speculative return results in an equity decline of 20.6%.
Fueling the change in short-term rates and Fed comments was the jump in inflation, which hit 9.1% in June. Historically, when the Fed increases rates, economic, job, and price growth, among other items, decline. As of this writing, one of the few items to decline has been economic growth. GDP was down 1.6% in the first quarter and current expectations are for about 1% growth in the second quarter. Job growth has been resilient as 372,000 jobs were created in June and 2.74 million have been created so far this year. The job growth this year is very atypical from nearly all past economic slowdowns and adds to speculation that inflation will run hotter in the second half of this year, causing the Fed to push rates even higher.
We believe the Fed will mistakenly increase rates at the July meeting by 0.75%, and this increase will be enough to send the economy into a recession. Thus, we expect volatility in equity markets to remain elevated and the sell-off of the first half of the year to continue until the Fed states that the environment of rate increases is over. When that happens, and we believe it will be sooner rather than later, equity markets are likely to rally and bond yields to decline. We are not certain when this will happen exactly, but we do believe it will take place in the third quarter.
Performance in Allen Trust Company client accounts has been negative, but our policy of holding higher quality investments benefited clients through better relative performance in the second quarter. As noted above, U.S. large-cap stocks declined 16.1% in the second quarter, but our client’s equity holdings declined 12.86%, net of all fees. On the fixed income side, our client’s bond holdings declined 3.27% in the quarter while the aggregate bond index was down 4.7%. It is disappointing to experience negative returns, but we are accepting less risk in our client’s portfolios which means we are more likely to meet or exceed client goals for their investment portfolios over the long term.
Outlook
It is unsettling to come to the conclusion that a recession is imminent. With inflation hitting 40-year highs and the Fed stating a 0.75% rate increase is necessary in July, the Treasury yield curve has gone deeper into inversion, so short-term rates are greater than long-term rates. In fact, on July 13th, the yield on the 6-month Treasury increased to a level above the 10-year Treasury, and 100% of the time this inversion happened, the economy dropped into recession. We think it is likely this time as well. But portfolios remain invested in recession-resistant holdings, the recession will not last forever, and when the economy comes out of the recession the better performance relative to the benchmarks means client portfolios will begin in a better position. This environment is also creating buying opportunities for both stocks and bonds and that better positioning of portfolios means we will be able to take advantage of better pricing as we move through a recession and come out the other side.