First and foremost, we are impressed by your composure. Stocks and bonds are falling, the economy contracted in the first quarter, mortgage rates surpassed 5%, and the Nasdaq posted the worst monthly performance since 2008. Even with the negative headlines, we have yet to hear from almost all our clients. Maybe you are enjoying your life, or perhaps you have been desensitized by the market turmoil in early 2020. Either way, we feel it is vital to communicate our thoughts on what has transpired, our perspective on the investment landscape, and how we are positioned in the portfolios we manage for our clients.

What Transpired

The S&P 500 index dropped 4.9% last month, its worst April since 1970. Sentiment toward stocks remains terrible, with just 16% of respondents in a sentiment survey by the American Association of Individual Investors calling themselves bullish. The S&P 500 has tumbled 13% to start the year (4/30/2022), the worst four-month decline since 1939. Furthermore, the Fed hiked rates by 50 basis points (or 0.50%) for the first time since 2000 - and the Fed is not done. As of May 4th, 2022, market pricing implies additional half-point hikes at both of the FOMC's June and July meetings. You have to go back to the mid-1990s to find the last time the Fed hiked rates by a half-point or more multiple times during the course of a year. Here we are again. This backdrop caused the bond market to have the worst start to the year, with data going back to 1990.

Our Synopsis

In the first quarter of the year, the U.S. economy shrank by an annualized -1.4%. This reading on GDP was weaker than economists projected and was the first negative print since Q2 2020. However, the negative reading was driven by surging imports and lower inventories on the back of robust domestic demand, reflecting underlying economic strength rather than persistent negative growth. On May 6, 2022, the job report corroborated the economic vigor, with 428,000 jobs added in April for the twelfth straight month of gains, and the jobless rate remained at 3.6%. Not what I would call a premonition of an economic collapse.

Source: FactSet, Standard & Poor's, J.P. Morgan

On the other hand, recent developments in the stock market should not be overlooked. Investors exhibited a clear defensive tilt this year, indicating a perturbed market. The proverbial safe plays in the stock market - utilities and consumer staples have outperformed their cyclical counterparts. Investors have fled to safe assets like cash and have not rushed to “buy the dip” as the market subsided.

Much of the angst stems from investors’ fixation on the actions of the Federal Reserve (the Fed) as they begin tightening monetary policy once again. The tightening cycle was overdue, given the Fed’s 2% inflation target was breached at the beginning of 2021.

A brief rant - in my opinion, it’s unfair to blame the Fed as they would have been scrutinized for “slowing the recovery” if they had taken any action last year. The Fed is the quintessential scapegoat for politicians’ mistakes. The Fed has little or no influence over the confluence of factors contributing to recent inflation readings. Unfortunately, they will be blamed for exorbitant inflation emanating from the supply bottlenecks caused by the pandemic, unprecedented economic stimulus, and raging energy prices resulting from both the conflict in Ukraine and energy producers laying down rigs when oil prices went to $0 in 2020.

The Fed has responded to a hot labor market and inflation pressures by hiking rates by 0.50% on May 4, 2022. While it seems drastic, this is normal behavior from the central bank. From early 1994 to early 1995, the central bank raised its target rate by a total of three percentage points over seven meetings. Before then, half-point or greater increases were most common in the 1980s, when the Fed was battling high inflation. Normalizing rates is prudent amid one of the hottest job markets going back to WWII and inflation readings well above the Fed’s target. The Fed is hiking rates for the right reasons, and this development, by itself, should not be a reason to jump ship.

Furthermore, bonds could get a lift as the market appears overly pessimistic, expecting a federal funds rate of 2.75% to 3% at the end of the year. Meanwhile, the median FOMC dot sits at 1.875%. The disconnect stems from a market that believes the Fed will have to be more aggressive than initially planned. A common phenomenon as the bond market assumes more hikes will occur in the nascent stages of Fed tightening and assumes fewer hikes occur as the Fed loosens policy.

Inverted yield curves are the archetypical harbinger of recessions and are commonly measured by subtracting the yield (i.e., interest rate) on the 2-year Treasury Bond from the yield on the 10-year Treasury Bond. Aggressive action by the Fed can tighten financial conditions faster than warranted, which has been a common cause of many recessions. When this occurs, the excessive Fed hikes lift the federal funds rate above the yield on 10-year Treasury bonds - the result is an inverted yield curve. For this reason, the yield on 2-year Treasury Bonds may not be the best indicator of a recession. The yield on 2-year Treasury Bonds tells us what may happen, not was is happening. Pessimism in the bond market drove yields on the 2-year Treasury Bonds above 2.75% at one point this month. These conditions taint the validity of using the yield on 2-year Treasury Bonds to predict economic weakness.

Measuring yield curve inversions using the yield on 3-month Treasury Bills does not suffer from these shortcomings and has proven to be an equally effective measure presaging an economic downturn. Using this measurement, the yield curve is nowhere near inverting. It’s also worth pointing out that an inverted yield curve usually does not indicate impending doom. Even when the curve inverts, the stock market has demonstrated strength in the subsequent 12 months, rising 67% of the time with an average gain of 9%, albeit with additional risk.

Last year, we told clients we were “cautiously optimistic.” Now, we are only cautious. We find ourselves balancing geopolitical and economic risks, with constructive earnings growth, and more reasonable valuations in the stock market. As we digest the data, it’s our assessment that it’s likely brash to hit the brakes and abandon your long-term goals.

Our Positioning

Equities

A recent shift to high dividend stocks has been a boon to our performance. Our preference for large companies instead of their smaller counterparts, the miners of precious metals, has benefited our clients. Other contributing factors were positions to give our clients commodity exposure and other uncorrelated assets.

Fixed Income

High-quality bonds with long maturities have fallen almost 20% this year. The bond market also demonstrates a defensive posture with lower quality bonds underperforming. High yield or junk bond credit spreads continue to widen. We feel good about our fixed income positioning - having sold out of junk bonds last year and keeping our duration short with a focus on high-quality bonds, including TIPS (treasury inflation protected securities). We also added a position in bank loans which have outperformed the other sectors of the bond market. We have also been pleased with our municipal bond exposure relative to the taxable counterparts. International bonds continue to see pressure. Fortunately, this is an asset class we have avoided for over five years. We added emerging debt over the past few months, given the relative yields compared to high yield bonds and a potential currency boost. It was unfortunate this occurred a few months before the invasion of Ukraine.

We continue to have conviction in high-quality bonds, despite the recent headwinds. We prefer to keep the duration (or interest rate risk) low, but we are becoming constructive on longer bonds as underperformance seems less likely after an unprecedented rise in yields. As we alluded, the bond market could be too pessimistic, and high-quality bonds are positioned for solid performance.

Final Thoughts

Our posture is defensive as we head into what may be the final stages of a bull market. It's true risky assets outperform at the end of bull markets, but we don't want to find ourselves picking up quarters in front of a steamroller with your hard-earned savings. If you are concerned, understand that stock market volatility and the developments we are witnessing are normal. Stay focused on your financial objectives instead of the headlines, and any temporary fluctuations in the stock market should not impair your long-term goals.

We love talking to our clients, so please don’t ever hesitate to reach out with additional questions or concerns.

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