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We are reaching out to share our current market perspectives as well as recent adjustments by our Asset Allocation Committee. At the end of last week, the S&P 500 Index touched bear market[1] territory and the risk of recession[2] is growing in terms of market consensus. It is not just high-flying technology stocks that have corrected—recent price action has seen staple bellwethers like Walmart fall sharply on disappointing earnings. 

 

Inflation pressures are squeezing corporate profit margins as well as consumers’ personal savings. These dynamics are driving down equity valuations. Additional capital flows are also leaving equities based on more reasonable yields being available in fixed income and cash markets. This combination of fundamental pressure (earnings) and technical pressure (capital flows) has dramatically weakened investor sentiment. Further liquidity drain will be coming from fiscal spending slowing and the shrinking of the Federal Reserve’s balance sheet.
 
Bonds have also been down, but much less lately as they start to revive their safe haven status somewhat and also price-in the gloomy prospect of recession, which would ultimately slow the Fed’s tightening path.
 

Overall Asset Allocation

 
We have made two risk management adjustments to overall asset allocation in recent weeks:

  1. In mid-March, equity risk was reduced with stocks trimmed in favor of building a cushion of cash safety. Equities were at stretched valuations and the prospect of a more aggressive tightening from the Federal Reserve to combat inflation posed a risk.
 
  1. Last week, commodities were reduced after their long rally and the growing risk of recession, which could depress economic activity thereby dent the demand for commodities. Concurrently, these proceeds and a small portion of cash were reinvested into bonds as those yields are starting to provide opportunity and no longer justified our large underweight.
The combination of these two moves leaves current positioning at neutral toward equities, less underweight to bonds, less overweight to commodities and less overweight to cash. Some degree of cash cushion is still appropriate to protect and preserve capital while being patient for better entry points for risk assets.
 
For taxable clients, we are also swapping to harvest any tax losses, in stocks as well as bonds, to better manage tax liabilities and create room for potentially taking some offsetting gains in highly appreciated positions.
 

Global Equities

 
Equities are more reasonably valued after recent price declines, and we are actively swapping and rotating positions and sectors within our neutral allocation. Certain positions are down sharply but have moved to oversold conditions and, though painful, are now at attractive valuations that make solid long-term investments. We are patiently watching for attractive entry points on some new stock ideas as well. Volatility is extremely high with technical factors and quantitative traders amplifying short-term market moves. We believe that once this volatility clears, quality stocks with strong underlying fundamentals that are core to our philosophy will return to outperformance.
 
We remain underweight international equities (versus the US) relative to benchmarks but are debating reducing that underweight. Though international markets are also challenged in a macro sense, they did not get as stretched in valuation as the US and could offer selective opportunities for active management.
 

Fixed Income

 
Bonds are not fully back to their role as a flight-to-quality asset and a counterweight to equity risk, but they are starting to offer reasonable yields to help diversify portfolio income and are not as vulnerable to further steep declines as equities might be.
 
As discussed in our last quarterly letter, “the market will eventually stop pricing in rate hikes and start to price in a recessionary environment and/or the eventual moderating of inflation—both outcomes would be more favorable to bonds.” Considering this possible scenario and more attractive yields now available in the bond market, we chose to selectively add some high-quality fixed income back to portfolios. We do have dry powder to add more investments should spread widening get more dramatic and offer attractive entry points.
 

Other Asset Classes - Commodities

 
The Bloomberg broad commodities index is up approximately 33% year to date. This rally has benefited portfolios and provided a partial offset to the stock and bond market volatility. However, the rapid rise in commodity prices was also a contributor to the inflation fears that upended the stock and bond markets. We believe in commodities (and renewables for SRI[3] clients and others) for the long term but decided to trim this position on the concern that a potential recession, or growth slowdown, could limit upside in the medium term.
 

Conclusion

 
The Fed might ultimately not have to tighten as aggressively as planned because the market drawdown and economic stagnation might help do some of the work denting demand and cooling inflation for them. However, the Fed is clearly not in a position to protect the stock market in the short-term. Inflation-fighting is now their top priority, and this stance will continue to have consequences for the cost of capital.
 
Whether the economy officially experiences a recession in the near term remains to be seen, but the growth outlook has clearly weakened. Earnings are at risk across the economy, but in many cases, valuations have already reset to a lower valuation that now offers opportunity for the long term. Though there is a very real chance of further weakness in markets as the harsh economic and earnings realities hit home, the markets are resilient and will quickly be looking forward to identify the winners further out on the horizon. We are carefully managing portfolio risk but are balanced in our outlook and staying vigilant for new, exciting entry points to our favorite ideas.

For further discussion of economic outlook, particularly the implications of inflation, a replay of our May 18th client conference call with Ryan Hanna (Director of Equities) and Eric Jussaume (Director of Fixed Income) can be found here.

[1] A “bear market” is technically defined as a 20% drawdown from a market peak.  It is also used to generically describe prolonged weak markets.

[2] A recession is technically defined as two consecutive quarters of negative GDP growth.  It is also used generically to describe any deep economic slowdown.

[3] Clients in the Sustainable & Responsible Investing (SRI) strategy are not in the diversified commodities position, and we continue to research renewable energy investments and related themes for those portfolios.