The Entryway – 2022 Q2: Market Update & Outlook

Market Check-In

The U.S. stock market has continued its downward slide from recent highs made in late 2021 and early 2022. As of this writing, the S&P 500, Nasdaq and Russell 2000 are down roughly 14%, 23% and 24% respectively from their recent highs. While short-term volatility is common, this is the first 10% correction on the S&P 500 and the first 20% “bear market” (Nasdaq & Russell 2000) we have experienced since the beginning of the COVID-19 pandemic in March 2020. In addition, traditional bond investments have also experienced an abrupt sell-off with the Barclays Aggregate Bond Index, Corporate Bond Index and Long-term Index down roughly 9%, 12% and 19% respectively year-to-date. In short, traditional stock and bond investments have sold-off in concert.

While the war in Ukraine is both shocking and heartbreaking, the main driver of the recent declines in the stock and bond markets is a result of the Federal Reserve’s significant shift in its monetary policy over the last four to six months. The Fed’s new shift in policy comes during a period of sustained economic growth but also during a period of sustained inflation. By the close of March 2022, the consumer price index (CPI) was 8.5% higher year-over-year from March 2021 and was the highest year-over-year reading in the last 40 years. While there are numerous reasons for the significant rises in pricing, the main takeaway is the Fed is taking demonstrable actions to fight it.

In the Fed’s most recent policy meeting in March, Federal Reserve chair, Jerome Powell, stated that “inflation is much too high,” and made clear that the Fed will take any and all necessary steps to tamp down the inflation threat. After the March meeting, the Fed began to tighten monetary policy, by raising short-term interest rates 0.25% and ending its asset-purchase program that has provided liquidity to the bond markets since March 2020 (Fed had been purchasing $120 billion per month of Treasury and mortgage bonds). According to Powell and other members of the FOMC, this is just the beginning of the Fed’s money-tightening measures, and we expect more to come in the upcoming Fed meetings. Our expectation is for the Fed to raise short-term interest rates by 0.5% in May, June and July with smaller rate increases to come at future meetings.

As we always remind our clients, the market is forward looking and is currently trying to price in assumptions around how quickly and to what degree the Fed will move interest rates to combat inflation. Currently the two-year Treasury note, i.e., the short end of the yield curve the Fed can influence, is yielding 2.7%. To put that “move” in perspective, the two-year Treasury note was yielding 0.157% one year ago. That is now 15 times higher than it was this time last year. The good news for investors and the Fed is that the market is doing some of their job for it by potentially pricing in all the remaining year’s rate hikes.

The other big unknown, and something we are watching very closely, is what the Fed will do with their balance sheet. As mentioned in our January letter, the Fed’s balance sheet has grown from approximately $4.5 trillion pre-pandemic to roughly $9 trillion in size. Powell stated at the Fed’s March meeting that the committee expects to begin reducing its holdings of Treasury and mortgage-backed securities at their May meeting. We will continue to watch vigilantly as they announce their plan as this reduction is another form of monetary tightening and has a direct impact on the financial plumbing of our economic system.

Our Plan

At the end of last year and into Q1 2022, we started to de-risk client portfolios by shifting some of our large U.S. stock positions to more of a value tilt that has worked relatively well during this volatile period. However, we felt that more needed to be done based on the higher, and likely “stickier,” inflation numbers and correspondingly more aggressive Fed. Therefore, we have also made tactical shifts out of more growth-tilted investments in the medium-size and smaller-size companies we own to either market-neutral strategies or more value-oriented strategies. While circumstances and outcomes seem to change daily and the markets are moving fast, we are evolving with them. We will continue shifting our stock allocations to better protect our clients as best we can, while still following our prudent and disciplined process.

One benefit to investors as the Fed moves interest rates higher is our ability to again purchase individual bonds for our clients where it makes sense. As we mentioned in our January letter, we have been moving for the past year to “shorter duration” fixed income in anticipation of future higher rates but are also now able to opportunistically purchase high-quality fixed income securities yielding 2.5-3.5%,beating cash and closer to where we think inflation may be over the long term.

Lastly, we continue to believe in the alternative investment space and will continue to recommend and reposition client accounts more into more of these strategies. To us, we are looking for investments that are not related to the stock or bond markets, can increase client diversification and downside protection, and will likely outperform traditional fixed income and cash. Generally, these investments are related to stores of wealth, such as land, cash-flowing real estate, farmland, precious metals, etc., that tend to rise with inflationary pressures and/or have pricing power. These strategies should do well over the next three to five years with still historically low interest rates, rising rates and higher than normal inflation.

Our Outlook

We continue to believe the next six to12 months will be volatile as the markets try to find their footing amidst high inflation, a tightening Federal Reserve, changing supply chains, and fallout from the war in Ukraine. While this will be a challenging time, we will come out the other side and the sun will continue shining. As we always say, panicking is not a strategy. You must have a plan, a process and the perseverance to see it through. It is not always easy, but you are not alone. We appreciate the trust you have put in us, and we will continue to work tirelessly to protect your family and to help you achieve your long-term goals.