Staying Poised for Better Days
Contributed by Doug Walters, Max Berkovich, David Lemire,
The market sell-off continued in Q2 2022. Inflation was the buzzword of the quarter, and all eyes were on The Fed to see how they would respond. There were many pain points for investors, but those that strayed into questionable “shiny objects” like crypto and SPACs had the deepest wounds to lick.
Inflation Concerns Inflating
If there was one common theme in Q2, it was inflation and, more specifically, whether or not it is peaking. Personal Consumption Expenditures (PCE) inflation, TheFed’s preferred measure, has weakened over the past two months.
- However, the more famous Consumer Price Index (CPI) inflation has broken away from PCE due to the heavier weighting of energy inputs like oil. The price of oil remains high partly due to the war in Ukraine and partly due to tight pandemic supplies. Oil ended the quarter just 7% off its 2022 high (with little sign of abating).
- Other prices are starting to moderate from their peaks. Since March, lumber is down nearly 60%, copper is down over 20%, and cotton is down almost 40%.
- Food and automobile prices have yet to weaken.
Only time will tell if inflation has peaked, but the Fed has its sights set on ensuring that is the case.
Chart 1: Some measures of inflation are off their peak
The Fed’s preferred measure of inflation is off its peak (for now?)
Source: US Bureau of Labor Statistics, Bureau of Economic Analysis
A Singular Focus
The Fed has its sights set on reducing inflation, using all the tools in its arsenal – most notably rate increases and quantitative tightening (balance sheet).
On rates:
- The Fed Funds Rate is rising fast but is still below the 2.4% level discussed as being the neutral rate. The neutral rate is where the Fed believes its rates are neither stimulative nor restrictive.
- The Fed is currently projecting to raise rates to 3.8% in 2023 before beginning an easing path back toward the neutral rate.
On the balance sheet:
- The Fed’s balance sheet has ballooned to $9T through “quantitative easing” (bond purchases). This month they began the process of tightening by simply ceasing the reinvestment of maturing securities proceeds.
Bond yields are on the rise due to both of these actions. Bond yields have been very low recently and are still low by historical standards. Long-term, investors will benefit from bonds that provide a more attractive yield.
Chart 2: the Fed Response to inflation Accelerates
The Fed is addressing inflation with rates and its balance sheet
Source: The US Federal Reserve
Stock Challenges
US stocks had a historically bad start to the year, with the S&P 500 recording its fifth-worst start to the year since 1930, falling 21%.
- The average decline of the ten worst starts to the year was 20%.
- Of those, the average price return of the next six months was 6%.
- The average price return of the next 12 months was 18%.
There is significant variation in the months following poor equity performance, but on average, patience has been rewarded with a rebound. There is no way of knowing what the future holds, but as evidence-based investors, we always look to ensure history is on our side.
Chart 3: A Historically Bad First Half
US stocks had a historically bad start to the year, but that does not mean H2 will suffer the same fate
Source: Factset, S&P 500 price return
Not So Shiny Objects
The first half was bad for equities generally, but it was a much worse H1 for previous market darlings. The many shiny objects that have been drawing investor attention in recent years have had a dreadful run this year. What happened?
- Easy money from the Fed and Congress led to excess risk-taking and the chasing of shiny objects.
- With easy money disappearing, assets driven up by nothing more than speculation and FOMO (fear of missing out) have predictably come crashing down.
- The pain may not be over for some of these assets that have little-to-no fundamental value backing their prices.
A focus on evidence (not emotion) based investing will have successfully steered investors clear of these enticing objects of affection.
Chart 4: Shiny Objects Lost Their Luster
It was a much worse first half for previous high-flyers
Source: Price return data except for NFT Art; Factset, Coindesk, NonFungible
Few Places to Hide
It was a difficult first half, even for a diversified portfolio. Risk assets fell across the board in the first half of the year. Protection assets such as bonds were also down, but not as much, and therefore provided some rebalancing ballast.
- Equities fell across regions and market cap. However, value significantly outperformed growth.
- Gold proved once again (as it did in 2020) to be a good store of value in a challenging equity environment.
- Commodities spiked primarily due to oil which is elevated by pandemic supply constraints and the war in Ukraine.
- TIPS have done relatively well. We believe that dynamic has played out and have recently moved to underweight.
Difficult investment years are not uncommon. Investments are risky assets, and the reward we get for taking that risk is attractive long-term returns.
Chart 5: H1 2022 Asset Class Performance
A Difficult First Half for Equities
Source: Factset
We recently wrote about how a handful of years can shape your long-term investing success. We are not talking about those exceptionally good years but rather the bad ones. And 2022 has clearly been one of those bad ones. The challenge with a really bad year for investment markets is the higher potential for “permanent loss of capital.” That permanent loss can come in two common forms:
- Bad investments. Look at the list of “shiny objects” above for examples. There is a good chance that many of those losses are permanent. If the market weakness continues, there will be more examples of low-quality securities that suffer permanent loss. As discussed above, investing based on science and not speculation can avoid most of these pitfalls.
- Behavioral biases. As humans, we are not wired to be good investors and years like 2022 bring out the worst of our instincts. Action bias, overconfidence, and loss aversion are all examples of biases that contribute to the urge to actively enter and exit investment markets. Market timing has two outcomes: you get lucky and outperform, or you suffer permanent loss of capital.
Our challenge to investors in Q3 is to steer clear of harmful behavioral biases. Knowing is half the battle. Being aware of these innate biases allows you to take control of them through process and discipline, focusing on logic, not emotion. Stick with your well-diversified portfolio and take advantage of market moves through opportunistic rebalancing. Better days will come, and when they do, your portfolio will be poised to capitalize.
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