| 2nd Qtr.
| 12 Mo.
|10-yr Treas. yield||2.97%||2.33%||+0.64%||1.443%||+1.527%||+1.46%|
|Fed funds rate||1.5-1.75%||0.25-0.5%||+1.25%||0-0.25%||+1.50%||+1.50%|
(stock indices are before dividends; yield and rate changes are absolute changes)
The market slide from the first quarter gained speed, wiping out positive one-year returns for stocks and leading to the worst first half of the year for the S&P 500 in 52 years. All the major stock indices dropped into “bear market” territory, or 20% below their recent highs. The Fed abandoned its slow approach to interest rate increases, jumping to +0.50% and then to +0.75% (the biggest one-time increase since 1994) in consecutive months. The “headline” inflation number was +8.6% from May 2021, although core inflation (excluding energy and food) was 6.0% and the Fed’s preferred measure of core inflation was at 4.7%. The bond index fell more than 9%, with 1994 the last calendar year that both stocks and bonds were down.
Housing sales tightened, despite continued short supply, as prices (+20% from the prior year) and financing costs (average 30-year mortgage rates at 5.78%, the highest in 14 years) both increased. First-time buyers are fewer, while cash buyers are greater. On the plus side, home equity also grew, reaching a record $27.8 trillion. Durable goods and capital goods (business investment) both increased, bucking the consumer slowdown. European economies slowed more than the US, heavily affected by dwindling supplies of oil and natural gas, and the eurozone had higher inflation than the US.
Bond yields hit their highest level in 11 years with the benchmark 10-year Treasury as high as 3.48% before dropping to end the quarter. The Fed acknowledged that a “soft landing” (taming inflation without extinguishing growth) would be a challenge, but they reiterated their commitment to bringing inflation down. Rates are forecast at 3.5% by year-end and the inflation forecast for year-end was increased to 5.2%. Unemployment stayed at a very low 3.6% and labor participation remains stuck at a low level, with many potential workers still not re-entering the market. The US dollar index hit 20-year highs against major currencies and the US trade deficit was double its pre-pandemic levels.
There were plenty of legal and geopolitical developments, not the least of which is the continuing war in Ukraine. Russia has found more success with its shift to focus on eastern Ukraine, although fighting is heavy and their gains are slow. Russia officially defaulted on their foreign debt, which is somewhat symbolic because they have the funds to pay their debt but are blocked from the international payment system. Contributing to the public discontent were Supreme Court rulings that returned abortion rights to the states, overturned a century-old gun licensing statute and reined in the scope of government agencies like the EPA in setting rules that are not specified in legislation.
The final GDP figure for the first quarter was -1.6% after strong growth in the preceding quarter, dragged down by reduced personal spending. Consumer confidence hit a 16-month low and expectations were at a nine-year low, but expectations have trailed current confidence for years. Oil hit $110 near the end of the quarter and cryptocurrencies plunged, with bitcoin down over 70%, a high-profile “stablecoin” (supposedly designed to maintain a $1 value) collapsing to zero and several crypto firms suspending depositor withdrawals.
Recession has surged to the forefront of concerns; will we have a recession, and if so, will it be a dip or a plunge?
The case that a recession is looming is pretty persuasive. The Treasury yield curve (the graph of the yields of Treasury securities of various maturities) has inverted a couple of times (shorter yields are greater than longer yields) and an inverted curve is supposedly a reliable predictor of recession. Inflation remains persistent, dampening consumer spending, and consumer expectations are the least positive since March 2013. High prices and higher mortgage rates have increased the monthly payments for a home and made them even less affordable, with existing home sales down for four straight months. One survey of CEO’s showed that 60% expect a recession before the end of next year. And since the definition of a recession is two consecutive quarters of decline in GDP, we are already halfway there after the first quarter GDP figure came in at -1.6%.
Having acknowledged that they waited too long to raise interest rates and to stop adding money to the economy, the Fed may be more reluctant to act decisively to dampen a recession. They still have inflation to fight, and their other main goal of strong employment seems well in hand. Don’t expect any relief from the Fed until inflation has shown signs of easing.
On the other hand, employment remains strong and wages are rising as employers struggle to fill openings. A recession, even a brief one, could help in the battle against inflation. The yield curve inversions have been both slight and brief, so that signal may be weak. Even with higher prices and cost, the housing shortage remains significant, and it will take years of creating more housing supply to ease the shortage of both purchase and rentals. Supply chain constraints still have to be worked out, which will keep demand high until they are resolved. Debt levels for households and businesses are not overly burdensome, and commercial bank deposits (personal and business balances) are $3 trillion greater than a normal trend line would suggest because of stimulus and Fed programs. This cash may be fueling inflation, but it is also a cushion to support continued buying in a downturn.
A recession may ultimately prove to be self-fulfilling, as media have more influence than in the past.
A down market understandably gives rise to questions about portfolio management, and we are not immune (nor should we be). Here are three obvious concerns when markets and the economy teeter.
What did you do to avoid or cushion the decline? In a word, (almost) nothing. This is the classic hindsight dilemma and belies the idea that an investor can enjoy the gains while avoiding the declines. As all experienced investors acknowledge, timing the market successfully is impossible. We prefer to take what markets give us and do our best to help our clients manage their finances in a way that those market results (good and bad) will allow them to meet their goals. We use our discipline to rely on a long-term allocation and to rebalance when clients add or withdraw funds or annually in the absence of cash flows.
There will be plenty of articles claiming that some pundit successfully called some market decline or another, and so we should listen to their current prediction. What is missing is all their other predictions that were wrong. We prefer the philosophy of Vanguard founder (and Dave’s former boss) Jack Bogle, even if it is seen as stodgy by some.
“Stay the course,” Bogle said in 2018. “Don’t let these changes in the market, even the big ones … change your mind and never, never, never be in or out of the market. Always be in at a certain level.”
What did you do to navigate the downturn in technology and growth stocks? We did not chase the large tech stocks when they were soaring, and we did not make shifts on their decline. Likewise, we did not make any shifts into the value-oriented stocks that have held up so much better. Our use of index funds, with their own quarterly rebalancing, will reflect those changes in market leadership.
At the same time, we have maintained our allocation to small cap stocks, which have also lagged the overall market. We continue to believe that small stocks are a long-term benefit to a portfolio, and when they recover, we’ll be there.
Bonds are supposed to be safe, and they got creamed. Why did you hold them when it was obvious the Fed would raise rates? There is no question it’s been an historically bad year for bonds, with the aggregate bond index (investment grade corporate bonds, mortgages, government agencies and Treasuries of all maturities) down well over 9% even after income. Our portfolios have ben “short” the index for years, which means that the combination of funds we use is less sensitive to interest rate changes that the index. Still, we maintained a full bond allocation and participated in the overall decline in bonds. (Denis wrote an excellent article explaining that the bond decline was perfectly in line with interest rate changes.)
That also means that our bond allocation did not increase as much as the index in the prior very strong years, and that highlights the idea of investing through the full cycle of a market, with its ups and downs. Having stomached the price drop in bond funds, the funds’ higher income will gradually help the total return recover. Bonds will always have much less volatility and downside risk than stocks, so their relative safety role remains intact.
We did take the opportunity to realize some capital losses on bond funds in taxable accounts, while using similar but not identical funds to maintain bond exposure. (With the big gains from prior years, there were very few losses available in stocks.)
We appreciate the confidence our clients have placed in us, but we are frankly uncomfortable if a client says they don’t know what’s happening in their portfolio. We not only welcome but encourage discussion and questions about our portfolios, especially when things are bad. It’s easy to look good when everything is going up.
From TINA to TAPA’s
For the last several years, with low interest rates and the Fed pumping money into the economy, stocks were about the only area to earn a decent return (the last year of real estate being an obvious exception). The trend even earned an acronym: TINA, meaning “there is no alternative” to stocks. Generally, risk was rewarded, including cryptocurrencies, meme stocks, money-losing companies going public and non-fungible tokens (NFT’s).
With interest rates rising, inflation high and markets sagging, things have shifted from “risk on” to “risk off”, with capital preservation, steady profits and reliable income being highly valued. I have coined a new acronym as the flip side of TINA – “there are plenty of alternatives”, or TAPAs.
All of a sudden, there is some high-quality income to be had – one-year CD’s approaching 3%, short-term high quality corporate bonds at over 3.5%. Inflation-protected Treasury securities, which adjust every six months to reflect recent inflation, now have a yield of 9.62%. (These bonds adjust their principal rather than paying income, so you pick up the gain when the bond is sold.) A recent survey of global money managers showed that 47% were holding larger-than-average cash levels in their portfolios, the highest percentage since 2020.
Of course, these conservative approaches have their own unique risks, the main one being ‘inflation risk”, or the erosion of purchasing power over time when the interest rate on a bank account or CD is not as great as inflation. That risk seems slight in comparison to the huge losses in more risky assets.
But this shift does not mean all investors are hunkering down. As the bond market decline rattled the traditional use of bonds as a hedge to the risk of stocks, inflows to so-called “liquid alternative” funds are on track to set a record in 2022, after the previous record of $38 billion last year. While these funds vary widely in their exact strategies, they almost all employ far more complex techniques than straightforward stocks, bonds, cash, and real estate. Their fees are high (2.5% or more in some cases) and because there is no restriction on withdrawals, they can be forced to sell in a down market if investors get nervous. These alternatives are reminiscent of income investors who, in their quest for income when interest rates were historically low, took on significant risk without even knowing it. The impulse to flee volatile traditional markets and to naively ignore the tradeoff between risk and return will likely leave these investors with a similar bad experience.
The shift to “risk off” also confirms a couple of things. First, investment trends like money-losing companies, meme stocks and NFT’s never had any economic underpinning and were just speculation all along. Second, the time-tested law that declining markets weed out the speculators and are therefore healthy in the long term is indeed true. When the tide goes out, it’s obvious who was swimming naked.