Quarter in Review
• Despite some positive economic data, increasing risk of recession and persistent inflation weighed on investor sentiment.
• Equity markets had a tough close to the second quarter with the S&P finishing lower by 8.26% in June. Recession worries hit every sector during the second quarter, with Discretionary being hit the hardest.
• Bond returns were negative during the quarter. The ten-year Treasury yield increased 67 bps. from the end of the first quarter to finish with a yield of 3.01%.
Commentary
Challenging conditions continued to hinder financial market performance for the second quarter. The war in Ukraine, lingering supply chain disruptions, persistent inflation, rising interest rates, and higher recession risk all weighed on investor sentiment across nearly all segments of the financial markets. Even gold and other commodity prices took a hit, mainly due to the last factor noted above — higher recession risk.
We recognize that investors may be confused and frustrated by these results, but it is encouraging that policymakers are laser-focused on rectifying the inflation problem with the tools at their disposal — interest rate hikes and quantitative tightening. These tools raise the cost of borrowing money and reduce the amount of money in the system.
Curbing inflation will take time and may extract enough of a toll on growth that a recession becomes impossible to avoid. Should that happen, we do not expect a deep recession based partly on these factors:
• First, the consumer and business segments do not appear overly burdened with expensive debt after taking advantage of refinancing opportunities in the last couple of years.
• Next, interest rate-sensitive sectors like housing and autos are not saddled by high inventories, making any adjustment process less painful for those sectors. The underwriting excesses that characterized the mortgage market before the ’08 Great Financial Crisis also appear absent.
• Lastly, labor market conditions remain extremely positive and therefore less likely to deteriorate significantly. Job openings will be the first area to be cut, followed by temporary jobs and hours worked, with actual employees the last to be impacted. The unemployment rate will rise in a recession but should not rise drastically if coming off a near-record low (currently 3.6%).
What is the best course of action amidst all the uncertainty? If the fundamental drivers of a company’s earnings potential remain intact, we seek to take advantage of lower prices by adjusting the position sizes of client holdings. Broad economic trends can and will be impacted by changes in interest rates, geopolitical issues, and societal developments. We look to capitalize on such shifts by modifying — up or down — the various parts of a diversified portfolio. Over the long term, positioning portfolios for favorable results require risk management along the way, and these actions will be dictated by changes in market prices and macroeconomic trends.
Similarly, our views on the merits of fixed income sector exposures and individual holdings can be adjusted if the economic outlook shifts. For example, for much of the last two years, we were leery of adding MBS exposure from a number of perspectives. Now that interest rates have normalized and monetary policy is shifting toward quantitative tightening, MBS valuations are becoming much more compelling and could be a sector worth further consideration now that the risk/reward paradigm has changed.
Day-to-day volatility in the financial markets has been higher this year which can be perceived as a reflection of investors’ sentiment. On the one side, you have an economy that is running hot and inflation is out of control, forcing the Fed to raise rates more than expected in order to bring inflation back down. On the other side, the narrative shifts to an economy that is slowing rapidly, inflation is peaking, and the Fed will bring rates down again in 2023. The market seems to be ending the quarter with the latter view in mind since yields on most points along the yield curve have retreated from the intra-month highs set earlier in June:
• The high point in Treasury yields was June 14, the first day of the FOMC’s two-day meeting.
• Yields on two-year, five-year, and ten-year Treasuries were 3.43%, 3.59%, and 3.48% respectively.
• At month end, yields were 2.92%, 3.00%, and 2.97%, respectively. That’s quite a move in two weeks and a great example of how sharp change can be when sentiment is so one-sided.
Scanning the various economic reports released toward the end of the quarter, it appears many offered some degree of both strength and weakness. A good example was the nonfarm payroll report from June 3: May payrolls gained more than expected — 390,000 jobs added compared to 318,000 expected — but the manufacturing component disappointed at 18,000 compared to 39,000 expected. We don’t want to get too far into the weeds with economic minutia, but the point is that recession fears have mounted notwithstanding the continued strength in the headline data. Other signs that economic activity is slowing include falling prices for many commodities (most notably copper), lower freight rates, and rising unwanted inventories at some retailers.
Our final thought is to weather the storm and stay the course. Investing requires committing capital and then letting time work to your advantage, always with an eye on the long term.
Index Definitions
The S&P 500 (S&P 500) Total Return is a market capitalization-weighted index composed of the 500 most widely held stocks whose assets and/or revenues are based in the US; it’s often used as a proxy for the U.S. stock market. TR (Total Return) indexes include daily reinvestment of dividends.
The Dow Jones Industrial Average® (DJIA), is a price-weighted measure of 30 U.S. blue-chip companies.
The Nasdaq Composite Index (Nasdaq) is the market capitalization-weighted index of over 2,500 common equities listed on the Nasdaq stock exchange
The Russell 2000® Index measures the performance of the small-cap segment of the US equity universe. The Russell 2000® Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
MSCI EAFE Total Return Net is the Morgan Stanley Capital International Europe, Australia, and Far East index that is a market-capitalization-weighted index of 21 non-U.S. industrialized country indexes. The index includes net dividends reinvested minus-tax-credit calculations, but subtracts withholding taxes retained at the source for foreigners who do not benefit from a double taxation treaty.
The MSCI Emerging Markets (MSCI EM) Index captures large and mid cap representation across 27 Emerging Markets (EM) countries.
The Bloomberg Barclays U.S. Treasury Bond Index (US Treasury) includes public obligations of the US Treasury, i.e. US government bonds. Certain Treasury bills are excluded by a maturity constraint. In addition, certain special issues, such as state and local government series bonds (SLGs), as well as U.S. Treasury TIPS, are excluded.
The Bloomberg US Credit Total Return Value Unhedged USD (US Credit) measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets. It is composed of the US Corporate Index and a non-corporate component that includes foreign agencies, sovereigns, supranationals and local authorities.
Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD (Municipal Bond Index) covers the US-denominated long-term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and prerefunded bonds.
Bloomberg US Corporate High Yield Total Return Index Value Unhedged USD (US Corporate High Yield) measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.
