2022 | 2nd Quarter
Stocks and bonds accelerated their decline in the second quarter as not only did interest rates continue their upward trend, but also fears of recession forced investors to confront the possibility that the long trend of economic growth and positive corporate earnings was coming to an end. The S&P 500 had a negative return of 16% for the quarter and is down 20% for the year which marks its worst first half performance in nearly fifty years. The war in Ukraine and a Chinese economy that remains in a slowdown due to Covid-19 responses also weighed on markets. Markets continued to be volatile with large daily swings in both directions. It should be noted however, that even with the declines in the first half of this year the market has still produced annualized returns of 10.6% and 11.3% for the past three and five years respectively and roughly 13% annualized over the past ten years. To sum up, longer-term returns have been around historical averages, and this recent, horrible feeling of loss is simply a reduction of some of the excess gains and returns from 2021.
It may seem long ago given the current market dynamics, but just late last year markets were on a firm footing and many prognosticators were projecting continued gains despite rising inflation and money flowing into very speculative assets such as cryptocurrencies. What investors underestimated, including us to a certain extent, was the effect that easy money policies by the Fed and over $6 trillion in government spending programs had on first, inflating asset prices on everything from real estate, stocks, Bitcoin and other speculative assets, and second, on the general price level of everyday items such as food and energy. With the Fed now reversing policy and trying to tame inflation through higher rates and the recognition by some policy makers that excess government spending has helped fuel inflation, the question is whether inflation can be tamed without having a deep contraction in economic activity.
Simply put, besides cash and commodities, there was no asset class or sector that offered a safe haven in the second quarter. Large cap value stocks continued to outperform growth stocks but were still down over 12%. Investors continued to shun growth stocks, particularly those heavily dependent on future projected earnings, due to the sensitivity growth stocks have to higher interest rates. All sectors of the market showed negative returns with consumer discretionary, technology, and communications all having negative returns of over 20%. Healthcare, consumer staples, energy, and utilities were all down 4%-6%, less than the overall market due to the relative defensiveness of those sectors.
Small cap stocks still underperformed larger cap stocks but not as much as in the first quarter. Smaller companies are generally more vulnerable to higher interest rates and slowing economic conditions and have underperformed large caps mostly for this reason. Developed international stocks have performed generally in line with U.S. markets but have been more effected by the war in Ukraine and higher energy prices than the domestic market. Emerging markets performed relatively well (down 11.4%) as signs that China is relaxing Covid restrictions prompted hopes of improved growth in those regions.
Bonds also declined during the quarter as inflation remained at elevated levels not seen since the early 1980s and the Fed accelerated interest rate increases with a 0.75% increase in June, which was the largest increase since 1994. High yield bonds were the worst performing sector as investors worried that a slowing economy would cause defaults by highly indebted companies. Our emphasis on high quality bonds and issues with shorter durations softened the losses in our fixed income portfolios.
The fundamental unknown facing investors and policy makers is whether inflation can be cooled without tipping the economy into recession. For the first time since the early 1980’s we have a Fed actively trying to stamp out inflation that is, currently, running at levels that have material adverse effects on businesses and consumers. Economic data is tough to decipher at the moment. We are seeing some “demand destruction” as consumers cut back spending in some areas to pay for increased food and fuel costs. However, overall demand remains strong, because both consumers and businesses are in relatively sound financial condition and unemployment is at relatively low levels with businesses still clamoring for employees. We may technically already be in a mild recession as first quarter growth was down slightly, and the second quarter looked much the same. The Fed faces a delicate task in taming inflation without causing a recession and it seems unlikely there will be any meaningful helpful policy changes given the political division in government. We will continue to keep a close eye on the developing economic conditions.
We would like to conclude with some thoughts on how we view risk. Traditional measures of risk in the investment community center around the volatility of returns as measured by the standard deviation of returns of a portfolio or some other metric. While this is sound in the academic sense, we believe in some ways it is inadequate. Our primary purpose is to help clients reach their long-term financial goals and protect against permanent capital loss and not make decisions based on short-term measures of volatility. A very substantial part of our investment analysis involves finding investable securities that not just offer a reasonable return, but also protect against the permanent loss of capital. This means that we screen for companies, ETFs, mutual funds, and other instruments that no matter the current market conditions, we have confidence they will weather whatever storm we face and come out the other side when the storm abates. This has served us well through some of the most volatile markets. The tech crash of the early 2000’s, the financial crisis of 2008-2009, and most recently the Covid-19 pandemic all produced market losses that in the short run, were catastrophic. This may mean missing some return in strong up markets, but by investing in high quality securities we mitigate the risk of the worst-case scenario, permanent loss. The thoughtfully crafted portfolios that we create have always recovered and returned to positive returns. Many studies have shown that it is near impossible to reliably time the tops and bottoms of market cycles. Sometimes being out of the market is just as risky as remaining invested during market volatility. Missing relatively short periods of recovering markets after a downtown can have meaningful detrimental effects on long-term returns. This is why we deliberately avoid making knee jerk wholesale changes to portfolios in either wildly up or down markets. We will make changes to individual holdings as conditions merit and as opportunities arise, but we feel in most circumstances trying to guess “getting out” or “getting back in” decisions don’t serve our clients interests. This has been a very effective strategy and highlights an important fact that long term investors, like you, understand, time in the market is more important than timing the market.
We appreciate the faith that you show in us to manage your investment portfolios and we remain solely focused on your financial well-being. As always, please contact us with any questions.
Jonathan F. Kolle, CFA
President
Joseph K. Champness
Managing Director
Shawn R. Keane, CFP®
Vice-President
Rusty Giles
Director of Marketing
James V. Kelly, CFA
Director
The foregoing content reflects the opinions of Smithbridge Asset Management and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct.
Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns.
Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful or that markets will act as they have in the past.