- Wealth Management
The second quarter of 2022 (Q2’22) was extremely difficult across both equities and fixed income. As we noted last quarter, the biggest consequence of the war in Ukraine and COVID lockdowns in China has been that higher commodity prices and ongoing supply chain constraints exerted pressure on headline inflation, thereby forcing the Fed and other central banks to pivot to a more hawkish policy.
U.S. headline inflation, as measured by CPI (consumer price index), reached 8.6% year-over-year in May, the highest reading since 1982. After quarter-end, June CPI rose further to 9.1%, as both food and energy prices have climbed dramatically in the past year. While the Fed’s preferred inflation metric of core PCE (Personal Consumption Expenditures) shows a less alarming picture, at +4.7% YoY for May, it remains far above the Fed’s 2.0% inflation target.
During the second quarter of 2022 (Q2’22), the US dollar index (DXY) gained 6.5% (up 9.4% YTD), the benchmark 10-year US Treasury rate (UST10) moved up 66 bps to end June at 2.98% (up 146 bps YTD), and the price per barrel of WTI oil increased by 7% (up 43% YTD), trading at $107.76 at the end of June.
In June, the Fed raised the Fed funds rate by +75 bps, the largest single move since 1994. This supersized hike was a direct result of the elevated inflation metrics as measured by realized inflation, and just as importantly, an uptick in inflation expectations. Also in June, the Fed’s “dot plot” showed a much faster pace of expected future rate hikes, with the median projection for the Fed funds rate at year-end 2022 ratcheting up to 3.4% compared to the March expectation of just 1.9%. As of mid-July, the markets are pricing in a total of 8 more +25 bps hikes in 2022, which would bring the fed funds target rate to a range of 3.50% to 3.75% by year-end. As well, the Fed’s balance sheet run-off started in June, with planned reductions of $30 billion per month in Treasuries and $17.5 billion in mortgage-backed securities. The Fed’s “quantitative tightening” (QT) serves to mop up excess liquidity from the economy, albeit at a relatively slow pace. All of these factors (rate hikes, hawkish forward guidance and QT) combine to demonstrate the Fed’s only priority right now is to bring down inflation. Although the Fed is trying to drive inflation down without causing a recession, markets are signaling this will be a very difficult task. The yield curve has once again inverted, with 2-year rates (3.10%) higher than 10-year rates (2.91%) for US government bonds, which is often taken as a market indication for the possibility of a recession.
The current forecast of Q2’22 GDPnow is -1.5%, and other recent data has confirmed that the U.S. economy is facing a slowdown. As of the June 2022, the OECD forecast is for U.S. GDP to be up +2.5% for 2022, down from its 5.7% rate in 2021 but still positive. Similarly, projected growth in Eurozone GDP has been downgraded to 2.7% for 2022, from over 4% at the start of the year.
Given this backdrop of higher interest rates along with slowing global growth, equities declined for both the second quarter and year-to-date with valuation compression taking center stage. P/E ratios are now more attractive, with 2023 forward P/E for the S&P 500 (US Large Cap equities) about 15.5x, which is in-line with the long-term average. So, the key question is whether the denominator “E” -earnings- can hold up as the economy slows down? On this front, we expect to get a lot more color during Q2’22 earnings season, giving management an opportunity to provide forward guidance.
Globally, other central banks are also embarking on tightening campaigns, with the European Central Bank (the “ECB”) expected to raise rates by +25 bps at its July meeting, and signaling a further +50 bps hike in September, as well as ending net purchases under its asset purchase program. The Swiss central bank enacted a surprise hike of +50 bps in June, and the Bank of England (the “BOE”) has continued to raise rates. This leaves Japan as the last major central bank which has not yet moved away from accommodative monetary policy.
Outside of rate policy, the war in Ukraine rages on, as the Ukraine army continues to fight Russia in the eastern section of the country. Sanctions against Russia were ratcheted up further in Q2’22, with the sovereign defaulting on a sovereign bond as sanctions made it impossible to pay its debt, despite nominally having capacity to pay. NATO reached a compromise with Turkey which will allow Finland and Sweden to join NATO.
China’s growth for Q2’22 slowed to a barely positive 0.4%, compared to 4.8% in Q1’22, demonstrating the impact of China’s zero COVID policy on its own economy. China has recently announced various stimulus policies to boost growth going into the second half of the year.
As the world has adapted to recent headwinds, commodities began to plateau. Oil remains around $100 bbl as OPEC announced a small increase in production targets and global economic growth slows. Commodities such as wheat, copper, and nickel were all down in Q2’22, after being up in Q1’22.
Looking forward, economic conditions are slowing in the United States, but it is too soon to declare a recession to be inevitable. Importantly, the unemployment rates remain low, at 3.6% for June, and it is difficult to see a recessionary picture without deterioration in this metric. To be sure, inflation and lower equity market valuations are impacting consumer confidence, with readings at multi-decade lows. Still, confidence metrics are known to be volatile and not always predictive of actual consumer behaviors. If financial markets are able to show some stability, both in interest rates and stock valuations, we believe there is a chance for the Fed to pull off a soft landing. As we approach the second half of the year, market focus may shift to forecasting the end of the Fed’s hiking campaign, especially if we continue to see softer macro data points. The upcoming midterm elections are likely to block any major transformational legislation, such as Biden’s green energy policy or tax hikes.
Although we believe any progress toward resolution of the Russia-Ukraine crisis would likely benefit European stocks more substantially, at this time there is little indication that either side is inclined to put down arms. The battles in Ukraine’s east may be shifting into a war of attrition, and Europe has begun preparing for reducing its dependence on Russian gas for the winter.
While the first half of 2022 has been exceptionally difficult, this repricing builds a more solid base for future gains. In terms of fixed income, the asset class is now the most attractive it has been in many years, with 1Y Treasury rates over 3%, investment grade corporate bonds yielding close to 5%, and high yield corporates yielding over 8%. In short, clients focused on income can finally see the return of income in bonds. Meanwhile, equity valuations are also much more attractive, particularly in growth stocks that were hardest hit. Dividend-paying equities are traditionally more defensive in an economic slowdown, and can also be a good place for investors that are concerned about the possibility of recession. As always, we emphasize the need for diversification and patience to stay invested for the long-term in light of recent market conditions.
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 two quarters of this year as well as those for the complete first semester of 2022 above.
Q2’22 once again saw negative returns across all asset classes.
As mentioned in the “Markets Overview” section above, the backdrop of higher interest rates along with slowing global growth caused equities to fall in the second quarter even more than during the first one, with valuation compression taking center stage. The tech-heavy Nasdaq was the worst hit index in the U.S., down 30% through the first half, as many growth companies’ valuations are weighted toward future earnings streams. With these future earnings discounted back at higher interest rates, current valuations declined. US Large Caps in general held up somewhat better, but were down a significant 20% year-to-date, making this the 8th worst 6-month return and the 3rd worst first semester (H1) return for these at least since 1976.
Rates sold off, with UST 10y down 4.9% for the quarter (-11.3% YTD), which caused US investment grade bonds to fall 10.3% YTD, making this their 3rd worst 6-month return and their worst H1 return since 1976.
The combination of such dismal returns during H1’22 for both equity and bonds also meant that this was the worst H1 return for the proverbial 60/40 balanced portfolio since 1932!
(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 was originally invested. Actual returns might be better or worse than the one shown in this informative material.
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