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Monthly Market Update: May 2022

May 02, 2022

As global growth slows, the US economy is too strong for the Federal Reserve, yet too weak for investors. Nevertheless, opportunities are emerging. Here’s what to expect in May.

Central bank tightening is belatedly here, and aggressively swift action is expected. Market participants responded in-kind for the month of April, as the sell-off in stocks and bonds was broad and distinct. Although typically a high performing month, the large-cap benchmark S&P 500 index shed nearly 9 percent while the tech-concentrated Nasdaq dropped over 13 percent, the worst monthly performance since March 2020 and the 2008 financial crisis, respectively.

It was the worst April for stocks in 52 years. Including the first quarter, it has been the worst start to the year for the market since 1939. Bond prices systematically plunged as yields from the 2-year Treasury bond out to the 30-year bond soared and the curve flattened out in the anticipation of Fed movements and entrenched inflation. The 10-year U.S. Treasury note yield notched its largest monthly increase in more than a decade, touching close to 3 percent.

What’s to blame for the collapse in prices?

The shifting tone and decisively hawkish rhetoric of the Fed is only partially to blame for the collapse in prices. Earnings reports in the first quarter were satisfactory for the most part, but that simply will not cut it these days. Around 80 percent of companies beat earnings estimates by an average of 7 percent, but they are not beating estimates as strongly as the past few quarters.

More importantly, guidance on revenues and profitability is looking bleak, due to inflation and supply chain pressures exacerbated by Russia’s attacks on the Ukrainian people and infrastructure. Forward earnings projections are lower, now incorporating the shift in central bank policy. Gross Domestic Product [GDP] reports out last week showed a surprise 1.4 percent annualized contraction accounting for inflation, after almost 7 percent growth in the prior quarter. Manufacturing, spending, and sales indexes all appear to be pointing to slower growth.

As rough of a month as it was for the overall market, it was an even wilder one for big tech companies. Amazon stock was crushed on negative earnings (down 14 percent in one day), Alphabet (Google) lost over 20 percent, and even Apple lost over 3 percent the day after its earnings report, despite a relatively good quarter, due to worsening forward guidance. Elon Musk is finalizing a deal to buy Twitter and is selling Tesla stock to finance a portion of it, causing a drop in Tesla stock. Netflix losing almost 50 percent of its market value was a prime example of the risk that is out there with earnings peaking or missing estimates. Disney is another example, and they are also dealing with headline risk. Both have been caught in the streaming war competition.

Certain subsectors within tech are experiencing the most pain, post earnings announcement, such as communication services (Meta, Twitter, and Alphabet). Therefore, quality in earnings and balance sheets will continue to be an important factor within our investment strategy. We have been significantly underweighting some of the largest growth and tech names that were highly appreciated and facing earnings pressure by way of our value/quality tilt. Investors are looking for any reason to sell a stock right now with such a sensitive market as the Fed tightens monetary policy.

Should we worry about a recession?

While rapid and difficult to stomach with not many places to hide, we did see similar stock market declines in 2018 and 2020. We still have quite a bit more room to fall before we see a recession as well. In fact, one could be optimistic at the lack of structural issues and weakness in the overall economic environment. It all appears to be part of a healthy normalization process coming off such excessive gains over the long-term average, much of it generated from central bank and fiscal policy. With broad steep declines in certain companies that are long term buys, opportunities are starting to emerge.

The velocity of declines across asset classes can feel alarming, but unlike other sharp declines in history, the domestic economy remains quite strong - especially the demand for labor and goods. We have the strongest labor market on record and household balance sheets are in good shape. Consumers are sitting on $2.5 trillion in savings, so once prices finally stabilize, the hope is to have a short-lived recession, or avoid it entirely.

Rather than natural contraction in economic activity, the core issue has been a lack of supply to match the unyielding demand. Overseas, China's zero-tolerance approach to Covid and the war in Ukraine are dragging on international markets and supply chains. The ultra-strong US dollar is creating headwinds for foreign firms as well, as investors avoid investing outside the US. Aside from raising rates, the call has been to fix the supply chain, specifically by shoring things up at home relying on more American made goods.

As we all know, the dearth of supply and inflation continues to shock the consumer. Crude Oil still hovers above 100 dollars per barrel and natural gas is well above average level prices, but policies are in place to alleviate price pressures. Unfortunately, we have witnessed in real time, what happens when the Fed temporarily ignores higher prices to only focus on one side of its dual mandate - aggressively pursuing full employment.

Now that we know the Fed is playing catch up and they have realized it, how fast do they move? How dramatic are those moves? Will they create demand destruction?

The forward guidance from the Fed will be even more important than the earnings guidance we just received when they gather for their meeting this week. It will be of paramount importance as to what direction they take in reigning in higher prices and how unafraid they will be to spook markets. The unique aspects of the Fed’s predicament after years of easy money monetary policy and a globally disruptive war is unprecedented and that adds to the unpredictability in the range of market outcomes.

We know that a 50 basis point (.50 percent) rate hike announcement is priced in at near certainty along with several more later this year and beyond, according to the fed-funds futures market. A 75 basis point hike is not off the table as well. We could be in for several of these higher rate hikes until inflation is under control.

Now, raising rates is one thing. The unwinding of the central bank’s enormous balance sheet of bonds is quite another. That will put even more selling pressure on bonds, further increasing yields to the tune of another 2 percent across the yield curve potentially. This has caused many bond investors to sell off ahead of time, avoiding the rising-rate steamroller and pricing in some of the anticipated hikes.

Again, taking the optimistic viewpoint here, there are benefits to the bond market normalizing as rates go higher, providing future bond investors and savers long awaited coupon income. Investment grade credit spreads (correlated to US Treasuries) are widening, and you are starting to already see higher yields that are becoming attractive. Coming off the zero bound will also give the Fed future ammunition to fight a recession or another systematic or structural issue with the economy. Zero percent interest rates probably could not and should not go on forever. In other words, bonds will be bonds again – providing some safety and income, acting as a shock absorber to an equity portfolio.

We anticipated sharply rising rates and valuations would lead to growth stocks on average being pummeled and we maintain an overweight to quality, higher dividends, and value domestically. This is more of a defensive trade, being thoughtful in our risk reduction across all our exposures.

While it feels like there is nowhere to hide given high inflation, higher rates, and slowing growth, we see certain areas positioned well to take advantage of this environment. There is potential for recession in so called “long duration assets” that have dominated market performance, but we have continued to allocate for a secular bull market in inflation sensitive asset classes. We have discussed these in the past (commodities, industrials, healthcare, REITs, etc..) and remain overweight them as well.

What’s new on the international front?

There is still too much risk outside of the US to have significant international exposure in the same way we are bearish on longer maturity, interest rate sensitive bonds for now. China and other emerging markets are further along in their business cycle with growth slowing substantially amid battling covid and out of control inflation. Punitive measures taken against Russian leadership has not deterred or stopped their military from carrying out war crimes and atrocities against the Ukrainian people. The impact on European companies is overwhelmingly negative and remains unclear at best. This continues to add to the uncertainty of the terminal global world order.

Broad declines lead to stronger opportunities

As mentioned, broad declines provide a lot of short-term pain, but the volatility was to be expected and it provides stronger opportunities to deploy cash outside of the “buy the dip” mentality. Meaningful discounts on otherwise healthy companies with long-term prospects is a great way for long-term investors to either enter the market or increase allocations. Some cash can help take risk off the table and provide liquidity, but it is another losing asset class considering inflation. The next few months may be difficult, but we are positioned for the long run and look for ways to unlock value. Overall, our defensive posture and targeted approach will help to dampen volatility in our current portfolios and give us greater opportunity to take advantage of growth at cheaper levels.

The markets may be in transition and difficult to watch, but our vision and philosophy remains firm as we navigate the ups and downs. We are here for you and watching the markets, so you do not have to!

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