2022 2nd Quarter Client Letter
By Will Klein, CFA
Quarterly Investment Commentary
Hot inflation, Fed tightening, and growing recession risks came together to weigh on markets over the first half of this year. The S&P 500 returned -20% over the first six months of 2022. The more growth skewed NASDAQ Composite Index performed even worse, returning -29.2% YTD. Bond markets similarly came under pressure, with the Bloomberg US Aggregate Index, the most widely used core fixed income benchmark, returning -10.7% YTD.
Today, with the S&P trading 20% below its highs, US equities have officially entered their fourth bear market this century, following the bursting of the dotcom bubble in 2000, the global financial crisis (GFC) in 2008, and the COVID crash in 2020. Considering those macro and market challenges, we think it’s timely to compare this environment to previous recessionary bear markets in order to understand what could come next.
Recessions, and the bear markets that accompany them, fall into three categories: Structural bear markets, exogenous shocks, and cyclical recessions. Structural bear markets, like the 2008 GFC, have historically been the deepest and longest. Exogenous shocks, like the 2020 COVID crisis, have historically been the most violent but shortest lived. Meanwhile, cyclical bear markets, which are characterized by economic overheating and monetary policy tightening, have typically landed somewhere in the middle.
The current environment we are in has the hallmarks of a cyclical bear market. Over the last year and a half, the economy has grown quickly, as vaccinations, loose monetary policy, and fiscal stimulus drove rapid employment growth and record demand. This economic overheating led to extreme inflation. Moreover, commodity market disruptions from the war in Ukraine have added fuel to that fire, pushing Consumer Price Index (CPI) inflation to a 40-year-high of 8.6% this May. Today, the Fed is responding to hot inflation by hiking rates. They’ve increased the fed funds rate from 0 to 1.5% over the first half of this year, and the pace of rate hikes could accelerate from here. The combination of hot inflation, stressed commodity markets, and monetary policy tightening has pushed equities into a bear market and threatens to push the economy into a recession.
While the current backdrop is concerning, we take some comfort in the history of comparable cyclical bear markets. Looking to the 1968, 1980, and 1990 market selloffs, all three of those corrections were less severe than the GFC and Dotcom bear markets, and that is consistent with the longer-term history. A recent report from Peter Oppenheimer at Goldman Sachs showed that, over the last 100 years, the average cyclical bear market declined ~28% vs. a ~60% decline for the average structural bear market or financial crisis. If this environment continues to resemble previous cyclical bear market, the risk/reward proposition in equities could be increasingly balanced from here.
Though this cyclical vs. structural vs. exogenous shocks framework informs our outlook, it’s not a market timing tool. No one has a crystal ball for predicting when this market cycle will inflect. Therefore, we continue to believe in holding a balanced portfolio through the business and market cycle – this is especially true today given the rapid pace of this economic cycle. The speed with which we have moved from economic recovery to late cycle conditions over these last two years underscores how the “new normal” regime of long business cycles, characterized by slow and steady growth, paired with modest inflation, could be giving way to a more volatile macro regime. The growing macro and market uncertainty underscores the need for a strategic approach to portfolio construction, which helps inform our approach to asset allocation.
Across asset classes, we believe high quality, large cap US equities will continue to represent an appropriate core allocation for most clients. In addition, fixed income will continue to play a role in portfolios; however, fixed income can be an unreliable diversifier during periods of hot inflation and Fed tightening. Given this, we are looking for opportunities to diversify around those core portfolio building blocks to manage macro and market risks. In equities, tight labor and commodity markets are central to today’s challenging environment. Our approach to ESG integration, which incorporates factors including energy efficiency and identifying firms which treat employees as stakeholders, should help us identify portfolio companies with structural competitive advantages in this environment. We similarly believe that our focus on high quality, secular growth companies with strong balance sheets should be rewarded during challenging market conditions. Lastly, we continue to partner with investment managers whose people, processes, and philosophies should help them create value through the cycle.
We remain focused on building portfolios to help you achieve your long-term goals through today’s volatile markets. Please do not hesitate to reach out if you have any questions about recent market trends or your portfolio.