2nd Quarter 2022 Market Commentary

With a -20.0% return during the first half of the year, the S&P 500 officially met the somewhat arbitrary criteria for a bear market. 

An unbiased appreciation of uncertainty is a cornerstone of rationality—but it is not what people and organizations want. …Acting on pretended knowledge is often the preferred solution. –Daniel Kahneman, Thinking Fast and Slow

Technology stocks continued to underperform, with the Information Technology sector returning -26.2% and the Communications Services sector, home to Alphabet and Meta, returning -30.2%.  This recent underperformance is not sufficient to offset the outperformance of tech stocks over the past three years.  Despite a sharp correction in the second quarter, Energy remained the lone positive sector, with a 31.6% year-to-date return. Returns for foreign stocks largely matched the S&P 500, with the MSCI EAFE Index, primarily comprised of Western Europe and Japan, returning -19.6%.  The MSCI Emerging Markets Index returned -17.6%, but this outperformance was due to China’s -11.8% return.  Removing China from the index brings the YTD return for emerging markets down to -20.8%.

The Fed provided a convincing demonstration of its resolve to fight inflation in its June meeting, increasing interest rates by 75 basis points and indicating an additional 50-75 basis point increase in July.  Accordingly, investors shifted their primary concern from inflation to recession.  One-year Treasury yields fell below 3%, indicating the market’s belief that inflation would come under control.  The Fed also announced it will shrink its bond holdings. This action will withdraw liquidity from Treasury market and put pressure on longer term rates.  They forecast real GDP growth to slow to 1.7% this year, down from a 2.8% forecast in March.  The Fed projected unemployment could rise to 4.1% at the end of 2024, an increase from the current level of 3.6%, but far below levels experienced in past recessions.

Despite current concerns, it remains far from clear that the US economy is headed toward a significant recession; although, given the 1.6% decline in first quarter GDP, it is possible we are currently in the midst of a mild one.  Second quarter GDP will not be released until July 28, but the Atlanta Fed publishes a real-time estimate based upon available data.  As of July 1, they estimated second quarter GDP at -2.1%.  The official arbiter of recessions, the National Bureau of Economic Research (NBER), defines a recession as a significant decline in economic activity that is spread across the economy and lasts more than a few months.  Given the similarities of this long bull market and mania for tech stocks to the 1990s, it may be worth examining the 2001 recession as a possible comparison.  During 2001, the first quarter 1.3% decline in GDP was followed by 2.5% growth in the second quarter, then by a contraction of 1.6% for the third quarter, then GDP remained positive each quarter after that until 2008.  In July 2003, the NBER declared that the US economy was in a recession from March through November of 2001 (even though economic growth over the period was slightly positive).  The equity markets did not recover with the end of the 2001 recession, the worst declines came a year later in late 2002, so a mild recession unfortunately does not necessarily translate into a mild bear market.

Employment and consumer balance sheets remain strong, which makes a severe recession unlikely.  While recent wage growth has not kept up with the rate of inflation, consumer incomes adjusted for inflation, remain above pre-COVID levels.  The commodity prices that drove the spike in inflation over the past year have begun to weaken.

Profitability and debt levels for investment grade companies also remain healthy. Leverage in lower rated companies remain a source of concern.  While the debt levels of S&P 500 companies declined since the 2008 financial crisis, overall non-financial corporate debt to GDP increased from around 70% of GDP in 2007 to a current level of just over 80%.  Companies that issued investment grade bonds will benefit from locking in low interest rates – on average they have 11.4 years to maturity and a coupon rate of 3.6%. The market yield on these bonds today is 4.7%, translating to a 110 basis point increase in interest rates should they issue new debt.  Non-investment grade borrowers face tougher conditions.  They have a shorter average maturity of 5.9 years and they currently pay 5.7% on average.  Market rates for high yield bonds are now 8.8%, an increase of over 300 basis points for new borrowing.  The combination of inflation and economic growth can ease the burden of high debt levels, as price increases allow earnings to increase while inflation erodes the real value of debt.

While COVID-19 originated in China, the country escaped the first wave of COVID through strict lockdowns that stemmed the spread of the first generation virus.  However, the country lacks effective mRNA vaccines and continues to rely on lockdowns and social distancing to contain the virus.  When the more virulent Omicron variant hit Shanghai last year, the government responded with a brutally strict lockdown that caused a severe economic contraction.  Relaxed restrictions and economic stimulus have led to a recovery in the second quarter, but China’s economy has not recovered to pre-COVID levels.  Future lockdowns remain a risk, as the government remains committed to its zero-COVID policy.  High youth unemployment, weakening export demand and distress in the real estate sector also continue to weigh on growth.  China’s support for Russia and concerns over the security of Taiwan also weigh on financial markets.

China contributed to over half of the global economic growth during the 2010s.  The country is unlikely to make similar contributions in the future.  China’s economic growth will slow over the course of the decade, as its declining work-aged population, combined with decades of overinvestment in real estate and infrastructure, begin to take a toll.  The Chinese workforce peaked in 2016 and will have declined by nearly 4% by the end of the decade.  The total population will begin declining in 2027, accelerating during the 2030s[1].  China will remain an important global economy, but will play a reduced role in driving global economic growth.

Western Europe continues to face the prospect of an energy and heating crisis as it scrambles to find ways to replace Russian oil and gas imports.  France re-nationalized its over-levered nuclear energy utility EDF, which had been struggling with government-mandated price caps on what the utility can charge consumers.  The French government also plans to expand nuclear capacity.  Germany announced backstops to its struggling gas utilities.  While increased uncertainty and higher energy costs will take a toll on European economic growth and productivity, the European companies in which our clients invest tend to be larger multinationals, with global networks of customers and production facilities.  The current valuation discounts in non-US stocks in most cases more than compensate for any additional risk.

During periods of volatility, our psychology can often become our worst enemy.  Researchers have documented several biases which negatively impact investment performance.  Recency bias, where investors extrapolate short term trends, can play a destructive role in portfolio performance.  Investors first project the abnormally high returns of a speculative market phase and increase their risk exposure, causing them to ‘buy high’.  When market performance inevitably sours, the tendency then becomes to unrealistically project negative performance forward and sell low.  This bias also manifests itself when a few years of outperformance of a particular sector, investment strategy or individual stock makes it appear invincible (or when comparable underperformance makes it appear to be a loser in perpetuity). Another well-documented bias is loss aversion, which refers to the fact that losses cause more pain to investors than gains.  This often leads investors to avoid realizing losses and take gains too soon.  Investment decisions often become based upon the purchase price of the investment rather than its fundamental prospects.

The remedy for these behavioral biases lies in formulating a long-term investment plan based upon realistic return and distribution goals.  A portfolio focused on owning companies that can reliably generate free cash flow through good times and bad will serve investors better than chasing high flying concept stocks or trying to time entry and exit points in deeply cyclical businesses.  Attempting to time equity markets overall remains a fool’s errand.  With volatile markets likely to persist, we look to the safe liquidity portion of the portfolio to meet distribution requirements.

[1] https://www.nytimes.com/interactive/2019/01/17/world/asia/china-population-crisis.html

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