April Showers

  by Brad M. Weafer, CFA | Chief Investment Officer

EXECUTIVE SUMMARY

• A host of macro-economic risks have increased in recent months, putting pressure on both stocks and bonds
• Shares of high-quality companies have suffered, particularly those that experienced strong growth and outsized equity performance in recent years
• Fixed income is not providing the relative protection to equity weakness it has for the last two decades, requiring investors to be creative with asset allocation
• Despite the challenging environment, there are things we can do today to help position portfolios for the challenges that may still come

2022 has been a hard year for financial markets. April was one of the more challenging months in recent memory and the activity has not improved in the first week of May. The S&P 500 had its worst monthly showing since the Covid-induced March 2020 decline, falling nearly 9%. Growth-oriented investments fared even worse with the NASDAQ falling over 13%, its worst month since October 2008 in the teeth of the financial crisis. As I write this, these two major equity indices are now down 13% and 21% for the year, respectively. The decline has not been isolated to speculative companies and has taken a toll on some of the world’s largest, most respected, and well-known companies. The acronym “FANG” refers to the stocks of four prominent technology companies, Meta (formerly Facebook), Amazon, Netflix, and Alphabet (formerly Google). These companies have been stock market darlings in recent years, enjoying impressive growth and strong stock market performance. While these stocks have all doubled over the last five years, the group is down a collective 39% this year with Netflix alone down almost 70%. If you expand this group to include the two largest companies globally, Microsoft and Apple, the picture doesn’t improve much (see below). According to WisdomTree, nearly $2.8 trillion of market cap has been wiped out from these 6 companies alone, with four of the six down over 20% through the end of April.

Sources: WisdomTree, FactSet. Data as of 4/29/2022.

Making matters worse, traditional areas of relative safety have had a challenging 2022. The MSCI USA Quality Index is down nearly 17% year-to-date through the end of April, underperforming the S&P 500 by almost 4%. The Bloomberg Aggregate Bond Index, the standard index measuring fixed income performance of the U.S. bond market, returned a negative 10% to start the year through April. The magnitude and speed of the decline in bond prices has few precedents in history. There have been limited places to hide for investors thus far in 2022.

Why all the turbulence in financial markets? The aftereffects of the pandemic and policies put in place to mitigate Covid’s impact are having a significant and lasting effect on the economy. Consumers have been flush with cash and ready to spend on goods. This was fueled by pent-up demand, fiscal stimulus checks, and low financing rates. This outsized demand met a global supply chain that itself was in disarray due to Covid-induced shutdowns and labor constraints. The result has been high and persistent inflation, the likes of which we haven’t seen in 40 years. This has caught many off guard, including policymakers. In reaction, the U.S. Federal Reserve has promised to, and has already started, raising interest rates more than they have in decades to counteract rising prices. This has had an immediate impact on mortgage rates and stock market valuations which tend to be inversely correlated with prevailing rates (e.g. valuations get higher with lower rates and vice versa). Equity holdings and housing values are significant financial assets for main street consumers, and pressure there can be expected to curtail spending. To make things even more challenging, the devastating situation still unfolding in Ukraine has put ever more pressure on a host of commodity prices impacting household budgets. As these factors mount, the odds of a weaker economy in the coming year have increased. Policymakers have a difficult path ahead to try to slow down inflation while managing to avoid pushing the economy towards recession. The environment is equally difficult for investors to navigate with both bond prices and stock prices in decline.

The challenges are clear, but the issues are never as one-sided as they seem and there are still some positives near-term. The Conference Board’s Leading Economic Indicators Index, an index published monthly that aggregates ten important economic data points, made new highs in March, and suggests continued growth. The highlight is a strong labor market with the unemployment rate at just 3.6%. And corporations have thus far been able to take advantage of rising prices, with earnings for S&P 500 companies expected to be 9.6% ahead of 2021 levels¹. Data tracking the financial health of the corporate and consumer sectors imply there are no significant imbalances in the economy that were present in many of the most recent recessions. As an example, Deutsche Bank reports household cash exceeds debt for the first time in 30 years. This should limit the magnitude of economic weakness should we enter a recession. In addition to fundamentals, the risks to the market we cited are widely known. This suggests some level of damage has already been discounted by market participants. Sentiment data like the American Association of Individual Investors (AAII) survey finds only 16% of respondents bullish, a 30-year low and a positive signal from a contrarian perspective.

Taken together, prospects are not completely bleak, but do suggest that we are in store for continued elevated levels of volatility and increase the need for additional caution. Managing portfolios and emotions through this will be important in the year to come.

There are things we can do and are doing to help position portfolios. First and foremost, it is important to put this recent decline into a longer-term perspective. As challenging as the last 4 months have been, the S&P is only back to levels first reached a year ago. That may be of little consolation to many, but even after recent declines, the index has still compounded at 13.6% over the last 5 years and 14.5% per year over the last 10 years.

We believe it is important not to overreact, but that does not mean we are sitting idly by. We are redoubling our efforts on the companies we own and will use volatility and share weakness to add new portfolio companies and increase our positions in companies we think have been unfairly punished. This also may include jettisoning shares of companies where prospects are not as sound as we originally believed. As always, careful individual stock and equity-index selection will be an important component of total returns.

Away from equities, the weakness in the fixed income market is creating opportunities. We are keeping our portfolio of bonds relatively short in duration (i.e. near-dated maturities). This reduces interest rate risk should rates continue to rise. However, short-term government bonds are starting to provide more attractive income than they have in years. Twelve-month treasury notes are currently yielding over 2%, and two-year paper is yielding 2.8%. Risk-averse investors haven’t seen interest rates this high since 2018, and before that one had to go back to before the great financial crisis to generate commensurate interest income for that level of risk. The volatility in fixed income is also creating other opportunities to improve returns and add after-tax income within bond allocations, including the use of municipal and corporate bonds that have materially repriced in recent months.

Since 2000, the correlation between stocks and bonds has been negative. This means that for the past 20 years, when U.S. stocks have gone down, U.S. bonds have generally gone up and vice-versa. The experience this year has reminded investors that this relationship is not set in stone. A more lasting shift could mean that stocks and bonds will not offer the same hedge against each other that they have in the past. This necessitates us being more creative when allocating amongst asset classes. The standard 60/40 balanced portfolio (made up of 60% stocks and 40% fixed income) that has served investors so well for multiple decades needs to be looked at with more scrutiny. Adding alternative asset classes that have low correlations to traditional stocks and bonds could help provide attractive total returns while reducing the emotionally challenging volatility in performance. Having some parts of a portfolio zig when other asset classes zag can provide a smoother return stream over time. We have been adding to investments in alternative asset classes such as private credit. Alternative asset classes carry their own risks but can be a valuable addition to balanced portfolios. We continually look for ways to diversify portfolios and are exploring additional options for further investment.

Equity drawdowns are never easy, but they do occur with regularity. For long-term investors, equity market weakness provides attractive prices to purchase stakes in strong businesses that should reward investors in the future. During times when equity prices move significantly (up or down) it is appropriate to explore the balance between riskier and less risky assets in your portfolio and the level of volatility you are comfortable with in the pursuit of your financial objectives. When those balances get out of line, it is prudent to bring portfolios back in line with long-term targets. In the meantime, we will continue to be diligent in our goal of growing and protecting capital over time.

1. Source: https://www.yardeni.com/pub/yriearningsforecast.pdf