2022 2nd Quarter Investment Bulletin
Executive Summary
U.S. Stocks fell -5% during the quarter after being down more than -13%. A late-quarter rally beginning on March 14th helped to stem a decline.
Bonds came under increasing pressure resulting in a -6% loss. The 10-year Treasury rate increased from 1.68% to 2.32%.
The impact of inflation continued to negatively impact consumers during the 1st quarter of 2022 with the cost for food, energy, and core goods rising sharply.
Markets could continue to experience increased volatility owing to several factors including higher interest rates, slowing earnings growth, and a focus on geopolitical risks.
Looking Back at Q1 2022: Few Places to Hide
The first three months of 2022 were not hospitable for long-term investors. Broadly speaking, U.S. stocks, international stocks and bonds all declined during the quarter. A diversified and fully invested portfolio was challenged to find any respite from losses. However, as you can see from the table below, emphasizing certain parts of markets helped at the margins. U.S. Value stocks fared much better than U.S. Growth stocks, so overweighting the value side of the market helped ease losses. Additionally, with interest rates on the rise, emphasizing shorter-term bonds over longer-term bonds helped to mitigate losses in the bond market.
Factors Influencing Markets: Inflation and Rising Interest Rates
The stock and bond markets have been under pressure because inflation has soared as the pandemic has receded. The economy roared back to life over the last year and a half which has resulted in supply chain shocks that has helped to push inflation much higher. The cost of food, energy and consumer goods has risen sharply. The high level of inflation in the U.S. has created a heightened sense of urgency for the Federal Reserve to push rates higher to slow some of the excess that exists in the economy. Inflation and rising interest rates can produce a headwind for assets including stocks, bonds, and real estate. The Federal Reserve is attempting to thread a needle that allows them to get control of inflation without negatively impacting the economy and earnings growth.
The outbreak of war in Europe also had the potential to challenge the market. However, as is often the case with external geopolitical events, the opposite happened. Initially the outbreak of war caused a selloff in stocks that was sharply reversed a week or so later. We are disciplined in our approach and will not be influenced by events that lead to increased short-term volatility.
Changing Market may Require Different Tactics
The bull market in stocks that has persisted since 2009 has been primarily characterized by two themes: (1) the domination of growth stocks relative to value stocks and (2) the domination of domestic stocks over international stocks.
We firmly believe that markets rotate and revert towards a mean. It is a big reason why we have maintained an allocation to international stocks despite the persistent underperformance relative to U.S. stocks. Additionally, it is the reason for our continued emphasis on value stocks that we've incorporated into portfolios for the last couple of years. As you can see from the chart below, the divergence between these different styles has been significant for a long time (over the last decade), so a reversal of that trend is likely to persist for a lengthy period of time.
Bond Market Pose a Challenge
The bond market is proving to be a challenge as interest rates have started to move higher. The combination of very low starting rates and rising rates provide a very difficult setup for long-term investors in the bond market. For the last forty years, interest rates have trended downward, which has created a favorable environment for bond prices. That long-term trend appears to be reversing. While we believe that even with rising rates, bond investments can still offer a meaningful counterbalance to the risk of declining stocks, there is no question that the upside on bond investments is less than it has historically been.
We have increasingly been positioning assets that were in bond investments into the option-based strategy that we refer to as "hedged equity." The Allianz option-based strategy provides a 20% downside buffer that we feel is a meaningful counterbalance to stock market declines with a more favorable upside profile than bonds. We will not eliminate bond allocations in most portfolios but anticipate greater allocations to the option-based strategies.
The chart below shows the performance during the 1st quarter of the 20% Allianz buffered investment compared to bond market performance across different maturities.
Outlook
As we move through 2022 and beyond, we envision an environment that can still produce healthy investment returns, but anticipate that the return environment is likely to be less lofty than it has been the last few years. A changing investment landscape will likely mean emphasizing different parts of the stock market - being willing and able to increase stock allocations in the face of falling values in anticipation of a turnaround and utilizing investments such as the option-based ETF's to complement traditional stock and bond investments.
For our clients, we are always taking portfolio risk into account at the individual household level. What is acceptable to some, may not be to others and that is why we strive to create an individualized approach for each client and business we serve.