Quarterly Review - Q2 2022 Inflation and the Fed's Late Response; Too Little Too Late

SUMMARY

• We believe both stocks and bonds struggled in the quarter due to inflationary pressures and the Fed’s response.

• As fears of recession took center stage late in the quarter, quality-oriented equity assets performed better; although all equities and risk assets struggled, in our view.

• We believe the next quarter is likely to be defined by inflation and the Fed’s response. Relief from inflation might come from improvement in supply chains or resolution of the conflict in Ukraine but is more likely to occur if a slowdown in activity takes hold; potentially turning into a recession.

We believe continued high inflation readings in the second quarter of 2022 put the Federal Reserve (Fed) in a precarious position; they can either let inflation damage the economy or get more aggressive with monetary policy and potentially put the economy into a recession. The Fed has chosen the latter path of raising interest rates aggressively and hoping the economy can prove resilient. The Fed increased interest rates by 50 basis points at their May meeting and ratcheted that up an additional 75 basis points at their June meeting. The Fed Funds rate is now 150-175 basis points, with an additional 75 basis points expected at the next Fed Funds meeting planned for July 26th and another expected 50 basis point increase at the September 20th meeting, according to Fed Funds futures markets.

Equity markets have continued to grapple with higher inflation rates, driven in part by continued supply chain issues, COVID-19 overhang, and the ongoing conflict between Russia and Ukraine, in our view. Towards the end of the quarter, the market began to reflect fears of recession in asset prices, pummeling equities and credit spreads, and lowering commodity prices. We think it is too early to tell whether the Fed would consider changing policy if the market’s view proves right, and economic data continues to slow.

Currently, we believe the challenge for equity investors is that, so far, expectations for corporate earnings have not been terribly impacted, and actual earnings, with some exceptions, were strong in Q1. This could mean either the companies will weather this slowdown, or we have yet to see the worst impacts on earnings from inflation and higher interest rates. While we are beginning to see slowdowns in the retail industry and mortgage applications, which tend to be leading indicators of a slowdown, we are not yet at a point where “bad news is good news", and we can count on the Fed to relent.

Our response to this unfavorable set of economic circumstances has been to reduce equity weightings and to seek out places where yields are higher or where we think the market has overreacted (‘beware of the crowd at the extremes’). We call this strategy P.A.T.T.Y. (Pay Attention to The Yield), because we expect volatility to be elevated for an extended period of time, and we believe there’s potential for investors who take these market risks to be rewarded.

Performance: A Closer Look

The second quarter of 2022 proved to be even more challenging than the first quarter. The only haven from a broad asset class perspective in Q2 was cash, and the further deterioration in returns in the second quarter turned the performance of all non-cash asset classes negative by more than 10% over the trailing 12-months (See chart, right). While developed markets and emerging markets struggled in this environment, US equities performed the worst of all, largely due to the US’ relatively high weighting to growth-oriented stocks.

Growth stocks had their price-to-earnings (P/E) multiples severely impacted in the quarter, as fear of higher interest rates slowed investor appetite for companies and sectors in the more speculative areas of the S&P 500 and small-and-mid-capitalization indices. High yield bonds declined meaningfully as well, consistent with their historical correlation with equities in negative markets, as fear of recession increased the perceived risk of defaults.

Sector Returns: All Sectors Negative, Growth-Oriented Struggled Most of All

Not a single sector in the S&P 500 had positive returns for Q2 (Chart, left). Energy and defensives continued to be the safest investments. Industrials, Materials, and Real Estate declined by double digit percentages but were still better than the S&P 500. Financials, Technology, Communications, and Consumer Discretionary performed the worst (Chart, left). The fact that ‘defensive sectors’ held up better reflects both strong earnings from those companies and a view that their future earnings may prove more resilient in a recession, in our view. We believe weakness in the more cyclical growth sectors was attributable to negative guidance from several bellwether companies, as well as fears associated with rising interest rates and their impact on the sector’s future growth prospects.

Going forward, one of the things we will be watching is revisions to earnings in the sectors that have seen major P/E multiple contraction. So far, many of the losses are more reflective of multiple compression than of expected earnings compression, in our view. We anticipate the coming quarters will indicate that either the market has overreacted (if earnings do not come down), or that the market has correctly predicted major earnings decline in these companies. Our future selection efforts will focus on areas where we see an overreaction in price and stability in earnings.

International Returns also related to Inflation, Rates, and Geopolitics

International markets mostly struggled during Q2 (Chart, right). Even the commodity-sensitive countries (such as Canada, Brazil, Norway, and Australia) that were able to buck the negative trend in Q1 were pulled down as well. China ended up being one of the strongest markets internationally in Q2 after a negative Q1 and had a positive 3.52% return for the quarter. We believe this strength was driven by China’s major technology and consumer positions, which had underperformed international indices in Q1. Outside of China, most other regions struggled, and losses in their markets were compounded by losses in currencies of those countries versus the dollar.

Conclusion:

The first quarter of 2022 was challenging for investors, and the second quarter was no different. At RiverFront, we believe maintaining a focus on long-term plans is critical in these market environments. In our view, impatient investors who panic, could lose more money to inflation through lost purchasing power if they step out of the market or deviate too far from their long-term plans. We believe that our ability to make tactical shifts in positioning will be important, as the market generally overreacts to some themes as it processes rate increases and Fed actions. Just as we reduced risk and raised cash across our portfolios throughout the quarter, we will be looking for signs of a shift in Fed policy to potentially put some capital to work. For example, crowd sentiment is already at a negative extreme, so signs of the Fed becoming less restrictive or additional market weakness may cause us to become more opportunistic. Aside from meaningful changes in our tactical indicators, we will likely remain underweight equities to protect the portfolio through this challenging market environment.