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The word “stagflation” is seeing a revival among economists, politicians and investors. We believe the “stag” portion (stagnant growth) is more likely than sustained inflation, especially given that the Federal Reserve stands ready to squelch inflation at all costs, even if it causes a recession in the process. Recent inflation readings remain red hot. Eventually though, consumer retrenchment, eroded purchasing power and demand destruction should allow some moderation in prices.
 
In Q2, confidence suffered across the board as consumers, CEOs and investors all lowered risk tolerance. While the current market may not be as rife with excesses as the dot-com era or the subprime era, some untested and risky areas of the market did show cracks as easy money and ample liquidity reversed more forcefully. For example, Bitcoin was down 56%.
 
As shown in the interesting chart below, a degree of volatility was present nearly every day in the first half of the year. These conditions are likely to continue.
 
Source: Strategas, 7/1/2022

We continue to debate different scenarios to test if we are being creative enough when assessing how the economy could evolve in these truly unprecedented times. The current market is one in which creative, thoughtful scenario analysis is as important as cold, hard, numeric fundamental analysis. Whether we technically go into a recession does not alter our investment approach. Our base case is for a hard and bumpy landing, with only low odds of a successful soft landing, and we continue to invest conservatively through that perspective. Importantly, as we also say during good times, the economy is not the same as the market (and vice versa). Though the economic outlook is gloomy, lower valuations and dislocations in asset prices like we are currently experiencing offer solid opportunities and entry points for patient, long term investors.
 

Market Outlook and Q2 Summary

Overall Asset Allocation

Our current positioning remains neutral (market-weight) to equities, though we have been swapping and rotating positions throughout the volatility. Generally, we have moved to more defensive value and quality names funded by some trimming of technology and growth stocks. Our net positioning moves have been to get more balanced across risk factors in client portfolios, without any major deviations from benchmarks, considering the uncertainties facing the market.
 
During May, our Asset Allocation Committee trimmed commodities after their huge run and redirected the proceeds, plus some of the cash raised in the mid-March reduction of equities, toward an increase of fixed income. We remain slightly underweight fixed income, but to a much smaller degree than at the start of Q2. Conversely, our commodities position was prudently reduced[1] as recession odds rose (and the demand outlook fell). However, commodities do still offer diversification to weather and geopolitical risks even during times of otherwise weak growth. For example, heat waves and drought are seemingly everywhere, and we also have only just begun hurricane season in the Northern Hemisphere.
 
We maintain a slight overweight to cash as “dry powder” for better opportunities that are likely to arise as the market corrects. Some extra cash is also prudent because the current outlook does not yet justify an aggressive stance.
 

Global Equities

The S&P 500 was down -16.1% for the quarter with all 11 major industry sectors down. International markets saw varied returns but turned in similar performance overall with the MSCI All Country World ex-US down -14.6%.
 
It is difficult to say if we have seen the bottom in the stock market, but recent up moves have been tentative, and there is a distinct chance we could revisit the lows before full capitulation and investor sentiment truly bottoms out such that a more constructive recovery can take hold. We are using the volatility to adjust and improve portfolios but are largely staying the course without trying to make dramatic “all in” or “all out” market timing calls.
 
It is possible that earnings will grow and outperform the worst of expectations. However, we believe that current consensus is still too optimistic in this regard. Revenue, profit and margin pressures are all a serious risk to forward earnings. The market sell off has priced-in some of this risk, but when the reality hits home and forecasts are revised down more broadly, either by analysts or by the companies themselves, the market could find another leg down. Through this volatility for the overall market, there will still be attractive investment opportunities on an individual or sector basis.
 
The current earnings season should also see US multinational companies citing the extremely strong US dollar as a serious hit to overseas revenues. However, in the short term, a hawkish Fed, comparatively higher US bond yields, and the safe haven status of the US make it difficult to predict when the dollar will reverse. The Japanese yen bears monitoring due its extreme weakness and interconnectedness with the rest of global capital markets, particularly bond markets.
 
Regionally, a recession is even more likely in Europe where the issues of Ukraine (and Russian energy) are more profound. This does not mean that there are not interesting opportunities in individual companies though. Elsewhere, China is considered to be largely on the backside of its recession and therefore poised to re-open and resume economic growth alongside more stimulative/supportive policy. It has an improved outlook, as does much of Asia.
 

Fixed Income

Bonds were down in Q2 with most major indexes down low-to-mid single digits while stocks were mostly in the mid double digits in terms of return. Investors are starting to move from fear of a hawkish Fed and the negative implications for bonds to a slightly more constructive stance where bonds at least offer some shelter during recession while waiting for the Fed to eventually return to a more bond-friendly stance.
 
Our recent additions have been generally toward conservative and high-quality bonds. We are waiting patiently for spread widening and better entry points into credit risk.
 
The US Treasury yield curve has inverted with longer-term bonds offering lower yields than short-term term bonds on the general theme that the Federal Reserve will continue hiking interest rates and slow the economy in the short term, but also eventually regain control of inflation and bonds will offer decent value while the stock market recalibrates and muddles through a recession.
 

Other Asset Classes - Commodities

The diversified commodity basket ended the quarter down approximately -5.7% as the focus shifted more toward the realities of a looming recession and the demand contraction it could bring. Despite recent weakness, commodities were a helpful contributor and offset to stock/bond losses in the first half. We trimmed this position during May to take some profits on the successful allocation and to reduce exposure in case recession and interest rate hikes curtail demand.
 

Conclusion

We may not have seen the bottom of markets, but we believe that valuations have reset to a reasonable enough level to stay invested with a balanced, conservative posture. A recession in the US, as well as most of Europe, is likely. Global stock markets will start to look through the worst of this gloom and out further on the horizon when growth will eventually resume. Similarly, the tightening of global financial conditions will get worse before it gets better, but here again, the bond market will already be looking ahead to where the Federal Reserve will slow tightening and eventually reverse course back to more supportive policy. While this path should create patience to stay the course with high grade bonds, we are more cautious on lower-rated credit and yield spread product and would remain only lightly allocated to credit risk for now.

In cases where client portfolios have drifted from their baseline investment policy targets due to market volatility, the decision to rebalance portfolios is being made according to the client portfolio manager’s expertise and knowledge of each specific client’s liquidity needs and risk profile. Additionally, for taxable clients, we have been harvesting losses in both stock and bond positions where appropriate for our comprehensive strategies, demonstrating the benefits of our custom and individualized approach.

As we work through this difficult economy, we will manage through the turbulence, remain patient and be in a good position to take advantage of market opportunities in the coming months and into 2023. We will continue to provide our thoughts on our next Market Update Webinar on August 10th at 4 PM. 
[1] This does not apply to SRI portfolios – they are not invested in commodities on a standalone basis as most other portfolios are.

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