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Much has changed since our 2022 outlook. The tragic war in Ukraine has resulted in a global commodities shock, which will make inflation even more persistent. The impact differs greatly by region, and central banks have made hawkish pivots in response.
In just a few weeks’ time, the threat of a Russian invasion of Ukraine has become the reality. Though the invasion was widely predicted, the scale was larger than many anticipated and the uncertainty it has created continues to rattle global markets. Shortly after Russia’s invasion of Ukraine, the European Union, the United States, and their international partners imposed unprecedented sanctions on the Russian financial system, including the Bank of Russia (CBR).
The most obvious consequence of the conflict and the sanctions responses is that higher commodity prices will put upward pressure on price levels that are already increasing at their fastest pace in decades. Another consequence, also inflationary, is the disruption and possible bifurcation of global supply chains and payment systems. European growth will be most notably affected due to the region’s close economic ties and reliance on Russian gas and oil. Russia and Ukraine represent a small percentage of the global economy, but they have an outsized role in European energy and global agriculture. Beyond the risk of war-related supply disruptions, there is the potential for “weaponizing” the supply of key commodities. Russia and Ukraine are major producers of palladium, used in many industrial applications, and neon gas which is used in semiconductor production. In emerging markets (EM), exporters of commodities should benefit, though higher commodity prices will tend to increase already high inflation pressures in most EM economies.
During the first quarter of 2022 (Q1’22), the US dollar index (DXY) gained 2.8% (up 6.4% for 2021), the benchmark 10-year US Treasury rate (UST10) moved up 80bps to close March at 2.32% (up 59 bps for 2021), and the price per barrel of WTI oil increased by 33% (up 56% for 2021), trading at $100.5 at the end of March.
As expected, the Federal Reserve (the “Fed”) raised short-term rates by one quarter of a percentage point (25 basis points) in its March meeting, the first rate hike since the end of 2018. Even more important, the Fed signaled a new level of hawkishness in terms of future rate hikes as well as “Quantitative Tightening”, stating that they could raise rates by a half-percentage point at their meeting early next month and begin reducing their $9 trillion asset portfolio as part of their most aggressive effort in more than two decades to curb price pressures. The Fed’s hawkish tone prompted Treasury yields to rise significantly, particularly on shorter-term debt causing an inversion in the yield curve -when 2-year rates are higher than 10-year rates for US government bonds- for the first time in years. Although the yield curve inversion has since reversed, U.S. Treasury yields remain much higher across the entire curve than levels at the beginning of 2022.
The Fed’s hawkish pivot took markets somewhat by surprise, sent rates higher and caused significant pain for bonds. One major worry is that such an approach -if the Fed digs in to fight inflation- might trigger a recession. Rates sold off, with UST10 down 6.8%, which is the worst quarter for total returns since 1980. As of late April, 10 more 25bp hikes are expected in the remainder of 2022, which would bring the fed funds target rate close to 3% by year-end.
In late March, Chinese Vice Premier Liu He essentially promised the rollout of market-friendly policies that should bolster economic growth. China’s top financial policy committee swung into action. It vowed to ease a crackdown on technology firms, support the battered real-estate market and stimulate the economy. That was swiftly followed by the country’s central bank intervening to weaken the yuan and the government distancing itself from Russia’s attack on Ukraine to minimize the risk of drawing Joe Biden’s ire and potential U.S. sanctions. Xi then signaled a shift in a longstanding Covid-fighting strategy by pledging to reduce its economic impact. He also said that any regulatory actions should be better coordinated and should not threaten stability, so not only more transparency and less surprise around upcoming regulation, but also less actual regulation going forward should be expected. Following these dramatic interventions by Beijing, the worst selloff in Chinese markets since 2008 turned into a historic surge, catapulting the country’s U.S.-listed technology firms into a rebound not seen before. The People’s Bank of China recently cut its reserve requirement ratio by 25 basis points to stimulate an economy that has been weighed down by COVID-related challenges. This is a more conservative cut than anticipated, though policymakers have left the door open for further monetary easing.
Significant uncertainty clouds the outlook as the global economy confronts a shock that is negative for growth and will likely spur further inflation. The range of outcomes following Russia’s invasion of Ukraine is impossibly large. The possibility for military escalation by Russia, through unconventional war tactics or the invasion of the Baltics and other NATO countries cannot be ruled out. Other possible outcomes such as a negotiated truce or the ceding of some Ukrainian territory to Russia could potentially lead to a de-escalation in the war and calmer market conditions.
Recession risks have increased, but equity investors should be mindful to not overreact when the yield curve first inverts. It is a red flag, but not a great near-term timing tool. But even in the cases when the 2s10s correctly foreshadowed a recession, the average time from inversion to the start of recession was about 15 months. And the peak for equity markets was on average 13 months later, after a gain of nearly 22%.
It is not the first rate hike of the cycle that typically matters for equities, it’s usually the last one. In fact, the spread between the 10-year and 3-month US Treasury yields has recently widened, suggesting we could avoid a recession. Developed central banks, especially the Federal Reserve, may still be able to engineer a soft landing.
Economic conditions largely remain good in the United States, with a tight labor market, and leading economic indicators also continue to show solid readings. In addition, stocks have generally become more attractive to investors given the significant pullback they recently experienced.
Right now, the US economy is a battle between forces boosting growth and forces dragging it down. What is supporting growth? First, continued re-opening from COVID-19. Americans are still in the process of returning to normal, but we are not completely there yet. Second, monetary policy is still very loose. Even if the Fed raises “only” rates by 2.25 percentage points this year, real interest rates will still be negative and monetary policy will not be tight. Third, tax rates remain relatively low and are likely to stay that way. Major transformational legislation seems unlikely. Meanwhile, the economy also faces some headwinds. The Russia-Ukraine War and lockdowns in China are further disruptions to supply chains and the Biden Administration is ramping up regulation, adding to business costs.
Finally, we believe any progress toward resolution of the Russia-Ukraine crisis would likely benefit European stocks more substantially.
Now, more than ever, we reiterate the importance of diversification. A world where interest rates are not falling is harder for all investors. Against this background, it is highly likely, in our opinion, that the sources of future return will be very different to those of the past.
Notes: Asset class performance is in USD and refers to the following indices: Equities: US Large Caps (S&P 500), Emerging Markets (MSCI EM), Europe (MSCI Europe), Japan (MSCI Japan). Fixed Income: 10-Yr. US Treasuries (BofAML US Treasury Current 10-Yr.), Emerging Markets Sovereign (USD) (JPM EMBI Global), Emerging Markets Sovereign (LCL) (JPM GBI EM Global Diversified), US High Yield (BofAML US HY Master II), US Investment Grade (BarCap US Aggregate Bond), and Developed Markets Sovereign (excl. US) (JPM GBI Global Ex US). Source: Morningstar. (1) Strategy returns net of mutual fund expenses and Amerant Investments standard management fees.
You can see the returns for the first quarter of this year as well as those for the full year 2021 above.
Q1’22 saw negative returns across all asset classes except commodities. European equities, deeply affected by the conflict in Ukraine, recorded the lowest return at -7.2%. Energy was the best-performing global equity sector in Q1 (+21.5%).
Rates sold off, with UST 10y down 6.8%, which is the worst quarter for total returns since 1980.
The US dollar strengthened 2.8%, which proved to be an additional headwind for foreign-denominated assets.
(1) Strategy returns based on the total return of the underlying mutual funds, including reinvestment of dividends and change in NAV. Net of mutual fund expenses and Amerant Investments standard management fees. Returns may vary. Past returns are no indication of future performance..
(2) Monthly returns before February 2010 are those of the offshore corresponding strategies. For the Dynamic portfolio, monthly returns before November 2009 are those of the Income & Growth portfolio, which is the neutral positioning of the Dynamic portfolio. Dynamic portfolio started in November 2009..
During Q2’22, the Income Portfolio posted its worst (fourth worst for the Income & Growth, Growth, and Dynamic) quarterly results since it began in June 2003.
The Income Portfolio returned -7.9% (-13.9% YTD), the Income & Growth Portfolio returned -11.1% (-17.6% YTD), the Growth Portfolio returned -13.5% (-21.0% YTD), and the Dynamic Portfolio, positioned in the Income & Growth Portfolio, returned -11.2% during the quarter (-17.7% YTD).
As mentioned previously, there were few places to hide this year as markets have contended with four significant headwinds: High and persistent inflation (exacerbated by the Russian invasion of Ucraine), tightening monetary policy, rising interest rates, and slowing economic growth. During the second quarter, the confluence of these four headwinds pushed markets down deeper into negative territory.
You might have also seen purchase and sale activity taking place in all portfolios in early May and early July. We have made these changes to better position the portfolios for the environment we described in the Market Overview above.
During late April and early May, in the Income and Income & Growth portfolios, we reduced exposure to credit (EM debt and High Yield bonds) and used the proceeds to increase our exposure to US Investment Grade bonds. At that time, the UST10 was close to 2.9% and we took the opportunity to add duration at these levels. We believe this increased exposure to duration will now serve as a ballast for diversified portfolios in time of increasing risk aversion. In the Income portfolio we also reduced slightly our exposure to bonds denominated in foreign developed currencies and added to US short term bonds, as we were expecting further US dollar strength in the near term. In the Growth portfolio, we slightly increased exposure to US large-cap growth equities -the worst equity performer through the end of April- funded by a reduction in US small-cap value equities.
During late June and early July, we replaced two of our US investment grade managers by one that is more core, meaning with less credit and EM debt exposure, thereby also slightly increasing our exposure to US government bonds. At current UST10 levels (close to 3%) we are starting to see more protection value in adding to US government bonds, which we expect will do well if recession concerns start to pick up.
We have positioned portfolios more defensively to be better prepared to withstand an environment of increased volatility due to continued fears of recession and geopolitical risk, and to take advantage of what, in our view, will be continued dollar strength in the near term.
As always, we take the trust you have placed in us very seriously. In our day-to-day operations, we continue to follow current events and the reactions of the markets closely, and we stand ready to adjust your portfolios accordingly.
To obtain more detailed information on our market views or the performance of your advisory portfolio, please contact your investment consultant at Amerant Investments by calling (305) 460-8599.
Amerant Investments, Inc.
The model portfolios offered by Amerant Investments and described herein invest solely in mutual funds. Before investing, you must consider carefully the investment objectives, risks, charges, and expenses of the underlying funds of your selected portfolio. Please contact Amerant Investments to request the prospectus of the funds containing this and other important information. Please read the prospectus carefully before investing. Past performance is no guarantee of future returns. The value of the investments varies, and therefore, the amount received at the time of sale might be higher or lower than what was originally invested. Actual returns might be better or worse than the ones shown in this informative material.
This release is for informational purposes only. Past performance is no guarantee of future results. While the information contained above is believed to be from reliable sources, no claim as to their accuracy is made. Amerant Investments, Inc. provides no advice nor recommendation, or endorsement with respect to any company or securities. Nothing herein shall be deemed to constitute an offer to sell or a solicitation of an offer to buy securities. Member FINRA/SIPC, Registered Investment Adviser. Amerant Investments does not provide legal or tax advice. Consult with your lawyer or tax adviser regarding your particular situation.
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