Market Navigator – July 2022 edition

Monthly letter

Complicated. Challenging. Painful. Grinding. Unrelenting. These are a few adjectives that describe the 2022 investing environment. On a price basis, the S&P 500 finished the first six months of the year down 20.6%. This is the third worst return at the halfway point since 1950 and the weakest since 1970. The tech-dominated Nasdaq fell nearly 30%. Core bonds are down double-digits. Outside of select commodities, there were limited places for investors to hide.

So, what’s behind the broad-based decline? Much of it can be traced to the unwinding of pandemic-related policies. During the early stages of the pandemic, policy makers had a tradeoff to make –provide massive stimulus to halt the sharpest recession in modern history, which included a pop in the unemployment rate from 3.5% to 14.7% in just two months—or worry about the unintended consequences of overstimulating the economy. Resuscitating the economy won.

Indeed, the massive stimulus led to the strongest economic rebound in more than 40 years, and the abundance of liquidity was a boon to markets. But now, the unintended consequences of the massive stimulus, as well as other factors such as the Russian-Ukraine war, have led to a generational high in inflation. And with it, the Fed’s singular focus has shifted from employment to bringing down enemy number one – inflation.

To make things more complicated, while taming inflation is now the focus of the Fed, the market is rapidly shifting its focus to economic growth concerns.

This is evident in not only the equity market decline, but also the sharp drop in commodities, the significant decline in the 10-year U.S. Treasury yield from its recent peak as well as waning market inflation expectations, deteriorating credit markets, and the underperformance of economically-sensitive areas of the market.

Where do we stand?

After being very bullish throughout the pandemic rebound and advocating for a risk-on posture, we had a timely downgrade of equities to neutral in early April and have been encouraging a more defensive posture since then. This included raising fixed income and upping the quality of portfolios. Still, with hindsight, an even more defensive posturing would have made sense given the steepness of the decline.

We continue to see markets in choppy waters over the next several months. The enormous amount of global tightening that is underway works with a lag. We fully anticipate that this tightening will continue to slow the global economy. The odds of a recession in Europe are high, and the probabilities of a U.S. downturn have risen sharply given the Fed’s more aggressive tightening stance into a slowing economy.

Still, some of these challenges are why stocks have already fallen. At the June lows, the S&P 500 was down 24%, which is in line with the median decline of past recessions. Granted, the average decline is 29%, and we could overshoot that, but at least some of the challenging environment is reflected in stock prices.

Historically, buying stocks after they have been down 20% from record highs has been a good risk/reward proposition for longer-term investors: Following past instances, the S&P 500 has been higher three years later in eight out of nine cases with a solid average return of 29%. However, the short-term return outlook was more mixed and influenced greatly by whether the economy went into recession.

Likewise, following the ten weakest first-half starts to the year since 1950, the S&P 500 was up in the second half of the year 50% of the time. So, there was not much of an edge for investors.

What could go right?

With so many challenges in front of us –it’s worthwhile to think about what could go right for the market. A low hurdle rate for positive surprises is among the biggest market assets today. An economy that slows down but sidesteps a recession as well as earnings that prove more resilient than currently feared are among the outcomes that could provide an upside surprise. Also, inflation easing at a quicker pace than anticipated, which is not out of the realm of possibilities given the softening already evident in the goods side of the economy and in commodities, would bring welcome relief.

Different type of market recovery

Still, any potential recovery in stocks will likely be different than what investors have become conditioned to over the past decade. That is, V-shaped market recoveries were supported by a Fed perpetually on call. Given the inflation challenges and lessons from the past year, the Fed will likely prove less aggressive in their support, even when they do eventually pivot.

Thus, a more traditional market bottoming process, with a time element and a lot of back-and-forth trading action, is more probable. In this environment, a more tactical asset allocation approach, as we have been focused on this year, should prove beneficial.

Positioning

Our overall message remains in place. Given the wide range of outcomes, our view is that this is not the time to be aggressive, but we are also not advocating reducing equities for investors who are aligned with their longer-term equity allocations. At this point, a lot of the excesses have been wrung out.

From a global perspective, we remain biased towards the U.S. given its higher-quality companies. Within the U.S., we are sticking with large caps but also see relative value in the equal-weighted S&P 500, where there is less of a tech orientation. Our bias remains tilted towards defensive sectors, including healthcare and consumer staples paired with the energy sector given supply constraints. On the fixed income side, we remain focused on higher quality and taking on less credit risk. We see value at the short end of the Treasury curve but also see some benefits in longer-term bonds to hedge against a more pronounced economic slowdown. We see value in municipal bonds, where fundamentals remain very favorable and is an area that benefits from higher inflation.