Investment Management - Second Quarter 2022
Breaking? Or Just Breaking Bad?
As inflation remains an issue around the world, central banks have ramped up their hawkish rhetoric. Will they be able to get inflation under control? Heisenberg’s uncertainty principle comes into play here, simply the “position and momentum of an object cannot be measured simultaneously.”i Although the principle is used in the study of quantum mechanics and as the foundation for Bryan Cranston’s character in AMC’s Breaking Bad, it has interesting relevance considering how complicated the U.S. Bureau of Labor Statistics calculation is to determine the Consumer Price Index (CPI). Basically, understanding inflation’s momentum between releases is impossible.
The implications are that the Federal Reserve (“Fed”) and other central banks, which have been slow to comprehend how “sticky” inflation has been, are also the same groups that will need to time when to ease off the monetary brakes. Of course, there are other extenuating factors that need to be monitored, mainly the war in Ukraine. The invasion caused many commodity prices, including crude oil, to soar. While the Fed usually removes food and energy from their “core” measurements, the ripple effect of higher prices for everyday necessities has dramatically lowered consumer savings and sentiment, and could possibly have longer-term consequences.
As a result, risk assets across the world have been re-rated lower as stubbornly high inflation remains elevated and concerns increase that a monetary policy mistake is approaching. Over the last three months, the large capitalization S&P 500 fell 16.10%. Mid and small capitalization indices, tracked by the S&P 400 and S&P 600, fell 15.42% and 14.11%, respectively. International stocks outperformed their domestic large capitalization peer, the MSCI EAFE only fell 14.51%.
Performanceii for various indices for the year-to-date (not annualized), one-year, three-year, and five-year periods appears below:
Bond Indices
| Dates | ICE BofA 1-5 Yr. | ICE BofA 1-10 Yr. | ICE BofA 1-12 Yr. Muni |
|---|---|---|---|
|
12/31/21- 6/30/22 |
-5.98% | -9.08% | -5.60% |
|
6/30/21 - 6/30/22 |
-6.52% | -9.54% | -5.48% |
|
6/30/19 - 6/30/22 |
0.41% | -0.03% | 0.12% |
|
6/30/17 - 6/30/22 |
1.54% | 1.58% | 1.27% |
Equity Indices
| Dates | Dow Jones Ind. Avg. | NASDAQ Composite | S&P 500 (Large) | S&P 400 (Medium) | S&P 600 (Small) | MSCI EAFE (Int'l) |
|---|---|---|---|---|---|---|
|
12/31/21- 6/30/22 |
-14.44% | -29.23% | -19.96% | -19.54% | -18.94% | -19.57% |
|
6/30/21 - 6/30/22 |
-9.05% | -23.43% | -10.62% | -14.64% | -16.81% | -17.77% |
|
6/30/19 - 6/30/22 |
7.24% | 12.18% | 10.60% | 6.87% | 7.30% | 1.07% |
|
6/30/17 - 6/30/22 |
9.98% | 13.47% | 11.31% | 7.02% | 7.20% | 2.20% |
The decline in the S&P 500 was largely driven by a significant contraction of its price-to-earnings (P/E) multiple. At the end of 2021, the S&P 500 traded at 21.5x forward earnings expectations, compared to 16.1x forward expectations at the end of the second quarter. Higher commodity prices are pressuring input costs across a number of industries. A recession would hurt revenue growth and likely exacerbate the decline in profit margins. Both have large implications for corporate earnings and the overall earnings-per-share expectations for the index.
Fed Chairman Powell has pledged to do “whatever it takes” to bring inflation under control.iii In this case, it appears raising rates will be the catalyst to bring inflation down from 8.6%, the fastest increase reported in 40 years, to an anticipated 5.3% by year end. There are four remaining FOMC meetings in 2022: July, September, November and December. The current dot-plot, which is an indicator of future interest rates but not a forecast, shows we may enter 2023 with a Fed Funds rate of above 3%.iv Recent rhetoric is pushing for a 75 basis point hike at the July meeting.v
With rapid rate increases, we have yet to see how quickly they will trickle through to the economy. Along with the increase, we also have the Fed reducing their balance sheet.vi This tightening reduces money supply and the availability of credit. According to Luis Alvarado, vice president and investment strategy analyst at the Wells Fargo Investment Institute, this is the equivalent of raising rates another 1%.
Will this aggressive tightening force the U.S. economy into a recession? If so, will it be a mild or extended slow down? As we discussed in our June 21st article, “The Weather Improved Last Week, Though Investors Remain Gloomy,” the picture is mixed, though the negatives are outweighing the positives. While the employment picture remains strong, it is a lagging indicator. Surprisingly, despite low consumer sentiment, spending on durable goods orders exceeded expectations in the most recent report. Tighter financial conditions are having the desired effects, raising mortgage rates and slowing down home sales. Consumer expectations for the economy are deteriorating, with the June release of Consumer Confidence falling to 98.7, the lowest level since the start of the pandemic two years ago.vii The economy is decelerating, and while the probability of a recession is on the rise, there is not a foregone conclusion that we are in/ nearly-in a recession.
For all the news about a coming recession, we need to look historically at past recessions. Prior to the pandemic, data since 1950 shows that recessions have lasted between 8 and 18 months.viii The average expansion has seen economic output expand by 25% where the average recession reduced gross domestic product (GDP) by less than 2%. Long-term investors can ride through the volatility albeit not without a feeling of distress.
We are firm believers in “less is more” in these environments. We have continued to trim equity exposure, and will do so on significant rallies. At the same time, we are using this decline in stock prices to make selective purchases. Value-oriented categories that exhibit excellent balance sheets and good current dividend yields will help lower portfolio volatility while adding to current income. We are also seeing valuations in certain growth stocks at the most attractive levels in many years. Microsoft is currently selling for 24x forward earnings expectations, slightly cheaper than Colgate at 25x, despite having better profit margins and superior prospects for earnings growth.
The “red ink” continues to shadow prices in our bond portfolios with the increase in interest rates. The inverse relationship between prices and yields is playing out true to form. As rates have increased, prices in our bond portfolios have fallen. We remain committed to our fixed income allocations as these bonds will mature and be paid back at par. New purchases are taking place with yields not seen in a decade or more. And, for taxable portfolios of clients in higher tax brackets, municipal bonds are attractive and in high demand.
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We would like to welcome our four newest employees. They are all great additions to WFS as we celebrate our 40th year. Marianna Glazov joins our Asset Management team as a portfolio manager. She was in a similar role managing investment portfolios at Wilmington Trust, and has over 10 years of experience. Jack Lawrence joined WFS in November 2021 as a client service associate. Prior to joining WFS, Jack graduated from James Madison University in 2017 with a BS in Business and worked as a universal banker at Sandy Spring Bank. Annalyn (Anne) Espanol is our new accounting specialist/compliance associate. Anne has a BS in Management Accounting from the University of Makati, Philippines. Prior to joining our team, she also worked as a universal banker at Sandy Spring Bank for several years. Brendan Lyons is our new equity analyst and joins us from Cambridge Associates, where he was an associate in investment performance. He is currently enrolled in Georgetown’s Master of Science in Finance graduate program. Welcome all!
Sadly, this will be the last quarterly letter with contributions from Norma Graves, our director of fixed income. After 23 years with WFS, Norma has decided to retire to spend more time with family and friends. We are extremely grateful for her years of dedication, as well as her unique perspective on the economy and fixed income markets. Wishing Norma nothing but the best in sunny southern California, she will be missed! Tanya Carson, who has been working closely with Norma for the past 6 years, will assume leadership of the fixed income department.
On the subject of fixed income, we have replaced the fixed income benchmark in our client reports. The ICE Bank of America 1-5 Year US Corporate Index is a market capitalization-weighted performance benchmark which includes virtually every major investment-grade rated corporate bond with 1-5 years remaining until maturity. We replaced the Bloomberg Credit 1-5 Year Index as of June 15, 2022. We are also replacing the Bloomberg Municipal Index with the ICE Bank of America 1-12 Municipal Index. We believe the ICE Bank of America indices are comparable to and more readily available than the Bloomberg indices. Please contact us if you have any questions regarding these changes.
We have provided performance numbers for the year-to-date, one-year, three-year, and five-year periods, where applicable. We have included our annual Privacy Notice to your report, stating our policy on the confidentiality of client information. If you wish to opt out of sharing information, other than that which is required by law, please complete the form and mail it to West Financial or the Sandy Spring Bank address provided on the form. If you prefer, you may also optout by calling the number listed on the Privacy Notice.
Referrals of family, friends and colleagues who may benefit from financial planning and investment management guidance are always welcome. Thank you for recommending our firm and your continued trust in our financial planning and investment management services.
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President
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Chief Investment Officer
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Director of Fixed Income
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| Glen J. Buco, CFP® | Glenn Robinson, CFA | Norma Graves, CFP® |
i https://screenrant.com/breaking-bad-walter-white-heisenberg-name-alias-meaning/.
ii Each of the S&P 500 Index, the S&P 400 Index, the S&P 600 Index, the MSCI EAFE Index, the ICE BofA 1-5 Year Index, the ICE BofA 1-10 Year Index, the ICE BofA 1-12 Year Municipal Bond Index, the Dow Jones Industrial Average, and the NASDAQ Composite (each, an “Index”) is an unmanaged index of securities that is used as a general measure of market performance. The performance of an Index is not reflective of the performance of any specific investment. Each Index comparison is provided for informational purposes only and should not be used as the basis for making an investment decision. Further, the performance of your account and each Index may not be comparable. There may be significant differences between the characteristics of your account and each Index, including, but not limited to, risk profile, liquidity, volatility and asset comparison. The performance shown for each Index reflects no adjustment for client additions or withdrawals, and no deduction for fees or expenses. Accordingly, comparisons against the Index may be of limited use. Investments cannot be made directly into an Index.
v https://www.reuters.com/markets/us/feds-williams-rates-need-rise-dont-see-recession-2022-06-28/.
vii https://www.conference-board.org/topics/consumer-confidence.
viii https://www.capitalgroup.com/advisor/insights/articles/guide-to-recessions.html.
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