This article is brought to you in collaboration with our colleagues at Laird Norton Wealth Management from their post, Economic Flash: Growth with Inflation Vs. No Growth.
U.S. Economy: Supply Chain Repair
Supply chains are showing early signs of repair with a drop in port congestion and reduced shipping transit delays. Still, China’s rolling COVID-19 lockdowns and restrictions and Russia’s ongoing invasion of Ukraine dampen the possibility of a quicker recovery. The related high inflation helped drive U.S. consumer confidence to a 3-month low. Investors looked past disappointing earnings from major retailers to relatively good inflation news: the PCE Price Index, which measures core inflation minus food and energy, fell to 4.9% annualized in May (down from 5.2% in April) while consumer spending rose.
Foreign Stocks: China Slows
Non-U.S. equities performed marginally better than U.S. equities. While most major global economies are tightening monetary policy, China is loosening to counteract slowing growth (4% expected for 2022) and a sinking stock market (36% drop in the past year). A combination of monetary stimulus and less restrictive COVID-19 policies could lead the world’s second-largest economy to surprise on the upside.
Fixed Income: Rates Fall
The yield on 10-year U.S. fell in May after peaking above 3% on investor concerns that the Fed’s fight against inflation could lead to recession. As interest rates generally fell, bond prices strengthened, displaying for the first time in 2022 the defensive benefits of fixed income. Muni bonds outperformed given their perceived significant discount to U.S. Treasuries.
Real Assets: Commodities Run
Real assets continued their strong run, with the energy sector up 10.4% and driving commodities prices higher. Infrastructure equities have also delivered incrementally positive returns, while the more cyclically sensitive REIT category has struggled, given investor concerns about recession and rising corporate bond yields.
Alternatives: Hedging Additive
Hedge fund exposures have generally added value to portfolios in 2022. Unsurprisingly, long-biased equity managers had more success in May, with the equity market recovering somewhat. Waning investor enthusiasm and tumult in the stablecoin market, cryptocurrencies whose values are backed by assets (typically traditional currencies like the U.S. dollar or commodities like gold), were factors in a difficult month for cryptocurrency and blockchain strategies.
Equities Total Returns
Fixed Income Total Returns
A month that ended with meager net positive returns possibly feels more like relief to investors than a signal that financial markets are likely to turn things around. While some economic data indicates the continuation of the post-COVID recovery, marked by low unemployment, rising wages and excess cash, a fair amount of data on the other side of the ledger limits that enthusiasm.
It remains to be seen whether the contraction in Q1 U.S. GDP reverses in the coming quarters. If growth resumes, a robust pace would be surprising. Inflation is arguably easing but not at a rate that is likely to be cheered by consumers, with indications that disruptions to the supply chain will last at least into 2023. That said, U.S. consumers have been surprisingly resilient in the face of rising costs with spending accelerating. But that has primarily been fueled by swiftly rising credit card debt, a resource that cannot be tapped in perpetuity. Future spending may be impaired as the higher cost of necessities — food, energy, shelter — crowds out discretionary purchases.
Given this backdrop, and consistent with the market regime thesis we presented in January, market volatility is likely to continue at above average levels as we move into the second half of 2022. In terms of what we are watching most closely, tightening liquidity and credit conditions are often the precursor to more difficult environments. Currently, the yield differential between lower-quality U.S. corporate bonds and U.S. Treasuries has widened to levels we haven’t seen since spring 2020, and the Fed has announced it will drain liquidity by reducing its balance sheet at a pace of $47.5 billion per month. Just as important, we will be monitoring whether the Fed’s cumulative actions appear to be pulling down inflation and for stabilization in interest rates.
While most investors tend to dwell on the negative in difficult market environments, these times are often when we are capable of making our best and most impactful investments on a strategic basis. For example, valuations are attractive in many asset classes, including international equities and municipal bonds. Additionally, the banking of tax losses and rebalancing portfolios to targets will allow us to position for success in the long run. As your advisor, our priority is to keep sight of your long term goals and the role each part of your portfolio plays in achieving them, implementing strategies to take advantage of opportunities and protect against risks as they present themselves.
Glossary of Indices
U.S. Large Capitalization = S&P 500 Index
Tracks the performance of a representative sample of 500 leading companies in the major industries of the U.S. economy.
U.S. Small Capitalization = Russell 2000 Index
Tracks performance of the 2,000 smallest companies in the Russell 3000 Index, representative of the U.S. small capitalization equity market.
U.S. Growth Equities = Russell 3000 Growth Index
Tracks the performance of those Russell 3000 companies that have higher price-to-book ratios and higher forecasted growth values.
U.S. Value Equities = Russell 3000 Value Index
Tracks performance of those Russell 3000 companies that have lower price-to-book ratios and lower forecasted growth values.
International Equities (Developed Countries) = MSCI EAFE Index
A float-adjusted market capitalization index designed to measure developed market equity performance, excluding the US and Canada. Consists of the stock market indices of these 20 developed countries: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.
Emerging Market Equities = MSCI Emerging Markets Index
A float-adjusted market capitalization index designed to measure equity performance in the major emerging markets. Consists of the following 25 emerging-market -country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
U.S. FIXED INCOME, TAXABLE
U.S. Aggregate Bond = Barclays Capital U.S. Aggregate Bond Index
Covers U.S. dollar-denominated, investment-grade, fixed-rate, taxable bond market consisting of SEC-registered securities. Includes U.S. Treasuries, U.S. agency bonds, U.S. corporates, mortgage-based securities (MBS, CMBS) and asset-backed securities (ABS).
TIPS (Treasury Inflation-Protected Securities) = Barclays U.S. Treasury Tips Index
Measures the performance of TIPS of various maturities issued by U.S. Treasury.
INTERNATIONAL FIXED INCOME
International Developed Bonds = BofA Merrill Lynch Global Government Bond II ex U.S.
Measures the performance of non-U.S. developed-market government bonds on an unhedged currency basis.
Emerging Market Bonds = BofA Merrill Lynch Emerging Markets Sovereign
Bond Index Measures the performance of emerging markets government bonds on an unhedged currency basis.
U.S. FIXED INCOME, TAX-EXEMPT
Intermediate Municipal Bonds = Merrill Lynch Municipals, 3-7 Yrs Index
A subset of The Merrill Lynch U.S. Municipal Securities Index, including all securities with a remaining term to final maturity of between 3 and 7 years.
Municipals, Broad Market = Merrill Lynch Municipal Master Index
Tracks the performance of U.S. dollar denominated investment-grade tax-exempt debt publicly issued by U.S. states and territories, and their political subdivisions.
Absolute Return Funds = HFRX Absolute Return Index
Tracks the performance of hedge funds aiming to provide stable performance regardless of market conditions. Such funds tend to be less volatile and less correlated to market benchmarks. Data is based on estimates for the most recent months, may not include performance for the last business day of the indicated month and is subject to revision.
Market Directional Funds = HFRX Market Directional Index
Tracks the performance of hedge funds that add value by participating in the direction of various financial markets. Such funds characteristically have higher expected volatility than Absolute Return strategies (see above). Performance data is based on estimates for the most recent months, may not include performance for the last business day of the indicated month, and is subject to revision.
Equity Volatility = CBOE VIX Index
Aims to measure investor expectations for near-term stock-market volatility as conveyed by the pricing of stock options on the S&P 500 index that mature within 30 days.
Implied Inflation = 10-Yr TIPS Implied Inflation
Gauges investor expectations for future U.S. inflation based on the difference between the yield on a 10-year TIPS (Treasury Inflation Protected Security) and the yield on a nominal 10-year Treasury.
Gold Spot $/oz.
An index intended to measure the current price of gold, based on futures contracts deliverable in the following month priced in U.S. dollars per Troy ounce.
Oil = Brent Crude Oil Spot Price $/bbl
Brent Crude Oil refers to a particular grade of crude oil often quoted in financial reports as the global benchmark for the price of oil. It typically trades at a premium to the West Texas Intermediate price.
U.S. Dollar = Trade-Weighted U.S. Dollar Index
Value of the U.S. dollar relative to a composite of 26 currencies of major U.S. trade partners, weighted based on trade data.