What an interesting quarter to say the least. The unpredictable last three months significantly aided in completing the third worst start to a year for the markets in the last century. Increased worry around inflation and a recession were the primary catalysts to what we just experienced. Regardless of persistent inflation or officially entering a recession, a meaningful level of those concerns was reflected in year-to-date declines. While there is a myriad of additional macro factors at play, the focus for this quarterly letter will be specifically on inflation and the intertwined topic of a recession.
Inflation is running at the highest level in the last 40 years. The FOMC was using low rates as an accelerant to economic growth coming out of the financial crisis and doubled down on this strategy through Covid. With no other considerations to account for, this tactic can work with the counterweight being rate increases to temper that growth over time. Combining supply chain reconciliation with record fiscal stimulation and an energy shock, results in the historically high period of inflation (~8.5% year over year) we see currently. Now the FOMC is forced to try and get ahead of runaway inflation by aggressively raising rates in the hope of avoiding a recession.
The simple measure of a recession is defined by subsequent quarters of negative growth in GDP. Note that the largest component of domestic GDP is consumption at around 70%. Government spending and business investment make up the majority remaining elements. Since consumption is the largest component of GDP, understanding the strength of the consumer is imperative. With unemployment low, wages beginning to rise, and debt service ratios at historic lows, a case can be made that the US economy is slowing but a deep, destructive recession is avoidable. The most volatile portion of GDP spending is Business Investment, and when companies cut capital expenditures and pause new productive projects out of fear, the business cycle sours. It remains to be seen how businesses will respond in the near term.
The equity and bond markets struggled in the first half of the year in the ambiguity around all of this. When the Federal Reserve raised the overnight interest rate in March (fighting inflation), and broadcasted loudly that more rate increases totaling 3% would follow rapidly, interest rates across all maturities rose dramatically. Understandably, a repricing of all investable assets adjusts when underlying discount rates and capital costs cause growth rates to change. This is very normal through economic cycles and works in both directions. The debate is the degree of downward adjustments, to account for a deceleration.
This brings me back to the level of foreshadowing that has occurred to date. Any asset that had growth characteristics was penalized because the sustainability of that growth is now in question. Significant multiple contraction occurred for equities and now reflect a more historical average. The next phase is understanding the adjustments to profitability in which the multiples are applied. The back half of 2022 is where this component will play out and the beginning of a bottoming process can occur. It is not to say the bottom is in, but the magnitude of the declines does reflect a forward expectation of high inflation and relevant slowing in the economy. Said differently, the fears around inflation and a recession are somewhat baked into what we see today.
As it pertains to the fixed income markets, the unprecedented pace of rate increases caused bonds to act in high correlation to equity declines like no period in history. Stabilization in the bond market is happening and creating more attractive yield forecasting for re-entry into what should be a more normalized relationship between fixed income and equities.
During the quarter we were able to do some tax-loss harvesting in taxable accounts and strengthen positioning towards global value where quality dividend payments are a focus. We hold this posture and feel it is too early to chase growth simply because of how poorly performance has been year-to-date.
In our fixed income portfolios, yields are getting slightly better in investment grade products. Rates remain relatively low but are improving, which sets the stage for strategic additions in portfolios where bond diversification makes sense.
Since all portfolio strategies are unique to your personal planning objectives, we look forward to discussing specific allocation changes in our next one-on-one meeting.
As always, our Team is available for any questions you might have. We remain humble for the trust you have placed in us to assist in your planning needs.