What’s Brewing: Mid-Year Market Update – June 2022
June 27, 2022
The Situation as I See It
The world is grappling with two opposing forces – rising inflation and slowing growth. It’s hard to solve one and not thwart the other. We haven’t had to tackle both with this exact set of conditions in recent history. That creates fear. We need inflation to subside and the main way to do that is to slow economic growth. One key way to slow growth is to raise interest rates which makes it more costly to borrow on big ticket items like houses, cars, credit card balances, or business expansion. That forces less spending. Yet we don’t want government policy decisions like raising interest rates to slow inflation too quickly. It’s a tug-of-war between inflation control and economic growth. This is what the news is talking about every time they get a chance. Most economists suggest we will be in a transition period for 12-24 months. These times likely will look and feel different from the past few decades. Making money may be more challenging, but this is why you hire us to navigate in times like these.
My take is that we are experiencing a normal correction after three profitable years of stock market gains. With the onset of the Ukraine war, the slow re-opening of large economies, and higher costs, economic growth is slowing. Needless to say, these are negatives. Yet the financial health of many companies is good. So we have a positive in the middle of bunch of negatives. Markets have mirrored these mixed signals with losses early in the year, a brief turnaround, and now a backtrack. Not all markets fell at the same rate, several falling double the S&P 500 averages. Even with reducing risk overall in our client portfolios, losses have been painful.
A closer look into the stock market shows an extremely wide range of investment returns. There are those who have lost some, and those that have lost big. In times like this, owning active managers (good stock pickers) can reward investors more than taking a more diversified approach – assuming the managers do a good job of selection. The theory is that if you don’t have to own the whole market as mandated by diversified portfolio, you avoid some potentially lackluster performance. Less diversification, however, can add risk, yet we believe is an environment where strong stock and bond selection may prove advantageous to portfolios.
Meanwhile, the bond market experienced some of the largest price drops in history as the Federal Reserve Board began even talking about raising interest rates. Bonds are intended for safety yet in this correction, most all fixed income categories suffered loss. And while many managers have been saying the worst is over, bond prices have still continued to slip. With two more expected rate hikes planned within the short term, I am concerned bond volatility will be front and center for a bit. That gives me pause as to owning a full allocation in these sectors until their prices show some more stability.
What gets my attention is how we land after the transition period. My fear is we will have a noticeably higher long-term inflation rate in a time when companies may not be as profitable, so that will likely lower return in the overall stock market over time. These two things together could well be enough to move the needle for long term decisions. While I don’t want to declare that definitively, I’m open to this possibility. We’ve been talking about slowing growth for some time now, but we are seeing it now happen. And we now see there is a real possibility of growing slower than anyone really thought while also living with elevated inflation levels – both for an extended period of time. In my time as an advisor, I’ve used the words “volatility, changing landscape” and the like a lot. I cannot express enough how different – and it doesn’t have to be land-slide inflation – that portfolio choices in this type of environment.
The handling of the situation is complex. The Recovery Strategy for this time in history is different because we haven’t exactly been here. I say this with 30+ years of experience under my belt and having lived through the three full years of the Tech Bubble where the NASDAQ lost around 80% of it’s value. That period makes the corrections of 1987, 1995, and even the 2008 crisis look like a walk in the park and the market losses during Covid seem like a blip on the radar. My experience has taught me to “stay the course” – but my investment philosophy is, and always has been, far from “set it and forget it”. Numerous white-papers support the case to stay in the market during times of loss instead of running to cash. Missing the recovery that erases those painful downswings cannot be talked about enough. With all I see today, it is my strong opinion that our client portfolios now need some very different types of repositioning. And, because we may land materially different in the next decade relative to the past, further repositioning may be warranted. Because there are so many variables in play, the rate at which these are adopted should remain fluid and executed according to a time-tested, well-thought-out process.
What We are Doing
Strategy 1: Continuing to reduce overall risk. We have been reducing our stock exposure since year end. We have also been reallocating to lower volatility equities at the same time. In the event of further market losses or unexpected volatility, these actions aim to better insulate us from loss and give us a reserve if markets make another substantial move downward to do some selective buying. Our plan of slowly reducing risk has been a solid one.
Strategy 2: Repositioning to buy at deep discounts. There were several opportunities for capturing potential return when most all asset classes lost money, some at double the pace of others. Partially selling some of the assets which lost the least and buying those who lost more, we believe, will be a good move once markets normalize and recovery begins. We were able to take advantage of that opportunity within the large cap value space, moving some of those assets back to growth. And, we were able to do a similar strategy with our bond positions.
Strategy 3: Adding to actively-traded, less diversified positions. We exited some additional ETF positions in favor of actively managed mutual funds. While we like the lower cost of those ETF’s and still plan to have a diversified base, we are shifting more assets into the hands of who we think are expert stock pickers as we think the environment will allow them the opportunity to outperform the averages.
Strategy 4: Re-tooling our bond strategy. Within a portfolio, we use bonds or alternative investments as tools to insulate us from volatility. Because bonds have generally failed to hold their values in this correction, we have taken the position that sitting out of the bond market partially may add value for the short term. Where we have prescribed an allocation to this category, we retain some in cash for the short term, with the intention to be “right” on a portion rather than be either “dead wrong” or “really right” by being fully invested. We also are incorporating more inflation hedges within the mix as we see where inflation goes from here. There is incredible opportunity within this sector now with very attractive interest, but until the volatility can dampen some, we are entering partial positions and holding higher than normal cash.
Strategy 5: Incorporating inflation friendly assets. We have begun to incorporate a few additional types of investments into our stock allocations. If we are going into a period where corporate profits may not be as high, we need some mechanisms to add value to the portfolio that perform well during inflation or in more stagnant markets like infrastructure, currencies, commodities, and real estate. Likewise, we will continue to look for specific sectors we think will outperform the averages when markets look better. The challenge will likely be finding these investments in an era where we can’t rely on past return data since these investments may have been around, but not in the coming environment.
What This Means for You
I suppose the biggest message is that we have a plan. And I think it’s one you can have a lot of confidence in and something you’ll hear us talk about a lot in all likelihood. Because of that plan, you don’t have to be concerned over negative headlines. Remember the chances of recession have gone up (most estimates range from 25-40%) – not that we are heading there. And while inflation is high and may persist especially in gas and groceries, it’s probably headed down. I also like to chuckle that although economists are smart, they are often wrong.
I also think most can continue to spend from your portfolio – albeit we hope at a measured pace during this transition period. Our financial planning projections build in a safety net for you which take into account the effects of bad markets. We do this so that you don’t have to put your life on hold when you get severe corrections in the market. It’s just there may be a different way of executing the plan.
And last, keep in mind that not all recessions and times of inflation don’t look the same. Remember investment opportunities can be found in those times too.
We are happy to discuss these and other items in your Progress Meeting, but I wanted to take this opportunity to update you on all the work that’s been going on within our office these last couple of months. Thank you for your relationship with our firm. It means the world to us! And it’s in times like these that I feel we “earn our keep” the most!
Please note: This material is for illustrative and educational purposes only. It is not individualized financial advice; nor is it a recommendation to buy, sell, or hold any specific security, or engage in any specific trading strategy. Results will vary. Past performance is no indication of future results or success. Market conditions change continuously.