MARKET RETURNS: Global markets extended year-to-date declines during the second quarter as the Federal Reserve signaled it would prioritize fighting inflation over supporting economic growth. Major stock market indexes fell by double-digits, bringing first half totals to nearly -20% across global regions. Relative performance patterns reversed, with emerging markets demonstrating more resilience following underperformance last year and in the first quarter. U.S. large company stocks fell most in the second quarter after leading in 2021 and early this year, despite an ongoing tailwind from dollar appreciation. Lower valuations headed into 2022 combined with higher weightings in cyclical sectors likely helped bolster overseas equities as growth stock multiples came under pressure from investors emphasizing cash flows today over potential future opportunities. The selloff in high quality bonds continued as well, though at a slower pace than in the first quarter. Intermediate term interest rates were volatile as inflation levels remained elevated and investors pulled forward expectations for the economic cycle. Several larger interest rate increases began to be reflected in cash returns, with Treasury bills returning 0.18% for the quarter.
|Asset Class||Index||2nd Quarter
|Year to Date|
|US Large Cap Equities||S&P 500 Index TR||-16.10%||-19.96%|
|Int’l Developed Equities||MSCI EAFE Index NR USD||-14.51%||-19.57%|
|Emerging Market Equities||MSCI EM Index NR USD||-11.45%||-17.63%|
|Fixed Income||Bloomberg Barclays U.S. Agg Bond Index||-4.69%||-10.35%|
|Cash||US Treasury Bill Auction Avg 1-month||0.18%||0.20%|
|See “Index Descriptions” for more information at the end of this document|
Recession Risk: The Fed’s emphasis on inflation fighting, potentially even at the expense of economic growth, has brought recession concerns to the forefront. Economists surveyed by the Wall Street Journal in mid-June put the probability of a recession in the next 12 months at 44%, as shown below. While it’s still possible for the Fed to engineer a “soft landing”, bringing inflation under control without initiating a recession, the pathway to that outcome appears increasingly narrow.
Though nobody would wish for a recession, there are some beneficial aspects of economic cycles. Downturns can have a rejuvenating effect on the economy, eliminating some of the inefficiencies that tend to build up late in an expansionary period. The associated scarcity of capital often leads to its more prudent allocation.
Even if a recession does come to pass in the near-term, we would not expect it to be particularly severe. The type of widespread private sector excesses that have characterized prior recessions are not readily apparent. Household, corporate, and municipal finances are generally in good order. It will be important to monitor the state of the labor market for signs of whether tightening in financial conditions has materially altered business confidence and hiring plans, since associated strength has been one of the main sources of support for the economy overall.
Recessions often create buying opportunities in financial markets. Stock investors attempt to reflect expectations for likely future outcomes in the prices at which they are willing to buy and sell shares. In practice, this means that equity markets tend to peak ahead of recessions and bottom at some point during recessions as investors anticipate a recovery. Bond prices also tend to recover partway through recessions as monetary policy eases near the end of a recession to help stimulate economic activity. As a result, recessions often prove opportune times to deploy capital into traditional asset classes.
Maintaining the Long View: Given recession concerns, it’s important to keep the distinction between the real economy and financial markets in mind. Economic data reflects trends and events that have already occurred and is typically reported with a delay. In contrast, investors attempt to embed information about likely future outcomes in securities prices, albeit without the benefit of perfect foresight. As noted above, prices of riskier assets such as stocks often decline in advance of official recession declarations and bottom midway through recessionary periods as investors begin to anticipate recovery. As a result, it’s nearly impossible to predict when market peaks or troughs might occur.
Maintaining a disciplined approach to asset allocation has been a far more reliable route to long-term wealth creation. The chart below shows that the probability of generating positive returns extends with the investment horizon. Going back to 1950, individual years have varied significantly but a blended portfolio of stocks and bonds has never lost money if held for at least five years. Even stocks alone have always produced positive returns over 20-year periods, including those beginning during bull market peaks.
Our approach emphasizes “time in the market” over “timing the market” for this reason, though that doesn’t necessarily imply static asset allocations. We employ moderate shifts periodically as opportunities present themselves, with an awareness of transaction costs and tax implications. A contrarian approach can help improve expected returns, heeding Warren Buffet’s advice to be “greedy when others are fearful.” The recent selloff has left equity and credit valuations at or slightly below historical averages. We have begun rebalancing into those public market asset classes using available funds while monitoring conditions for a compelling enough entry point to merit larger portfolio adjustments.
Though the first half of 2022 has been a challenging investment environment to say the least, an allocation to alternative investments outside traditional asset classes and a bias towards value stocks trading at more reasonable multiples have generally provided a degree of support within client portfolios. Persistently high inflation has prompted global central banks to change course, with the Fed prioritizing price stability over economic growth. Stocks and bonds have both been impacted by the related shift in interest rates and associated pressure on equity valuations. Economic reports and company results released in the coming weeks should provide indications of monetary policy effectiveness as well as business and consumer sentiment. These factors are likely to inform the future direction of the economy and markets: signs of slowing inflation and resilient confidence could spark a relief rally, whereas the opposite could result in further downside for asset prices. We will continue to monitor conditions and take advantage of opportunities that arise while maintaining diversified portfolios of stocks, bonds, and alternative investments in strategic proportions designed to achieve longer-term client objectives.