2Q22 Letter: "Rules to Invest By"
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Rules to Invest By
It’s been nearly twenty years since I first started managing money professionally. I actively traded through the Global Financial Crisis of 2008-09, the European sovereign debt crisis in 2009-2010, and during the significant selloff in the corporate bond markets in 2015. As I sit down to write this quarter’s letter and reflect on my experiences as an investor, I’ve landed on three core beliefs regarding financial markets:
1) I believe that financial markets are forward looking. Investors are generally focused on the future, rather than the past or present. Individual stocks are valued based on future earnings and cash flow, and markets tend to “price in” economic expansions or contractions well before they occur.
2) I believe that changes in investors’ collective expectations drive market movements. To understand how and when to add or reduce risk, an investor must first determine what the market is “pricing in.” As “good” or “bad” news is released, the variations in reality relative to expectations are what drives prices higher or lower, as opposed to whether that news is generally “good” or “bad”.
3) I believe that investor sentiment is the primary driver of short-term market cycles. While markets generally go up over time, shorter-term market cycles are created by shifts in investor psychology and sentiment.
Economic and Market Update
At the time of my last quarterly letter, inflation fears dominated the headlines and recession concerns were mounting. In early April I estimated that financial markets were pricing in a 35% probability of recession, based on the slope of the yield curve. Today, strategists at Citigroup place the odds of a global recession at 50% over the next 18 months, while Morgan Stanley economists now expect a recession in Europe by 4Q22.
Main Street has also shifted its focus from being worried about inflation to being worried about a recession. As shown in the graph below, Google searches for the term “recession” have increased throughout 2022, whereas searches for the term “inflation” have been relatively consistent during the same timeframe.
Google Search Interest in the Term “Recession” and “Inflation”
As economist and consumer concerns have mounted, so have those of investors. The close of the second quarter marked the end of the most challenging first half of the year for stocks since 1970. As of June 30th, the S&P 500 benchmark index was down 20.6% year-to-date, and the Nasdaq Composite index was down 29.5%.
S&P 500 & Nasdaq Year-to-Date Through June 2022
So what is priced into markets today? Following last week’s inversion of the yield curve, “there has been a better than two-thirds chance of a recession at some point in the next year and a greater than 98% chance of a recession at some point in the next two years,” according to Bespoke Investment Group. My sense is that the question today is not whether we are going to see an economic slowdown; instead, we consider the severity and duration of the imminent contraction.
Echoing my sentiments in past letters, I continue to anticipate a modest slowdown in economic growth or a mild recession over the next 1-2 years. I expect this contraction to be far less painful than the Global Financial Crisis of 2008-09 and the downturns experienced following periods of stagflation in the 1970s and 1980s for two major reasons:
1) The labor market in the U.S. remains very strong. Last week’s jobs report came in well ahead of expectations, with employers having added 372,000 jobs in June vs. economist’s estimates for roughly 100,000 jobs. The unemployment rate remains at 3.6%, near a 50-year low.
2) The U.S. consumer is much better positioned. Household balance sheets in the U.S. are healthier than they were prior to the economic contractions in the 1970’s and late 2000’s. As a percentage of overall Disposable Personal Income (DPI), household debt obligations came in at 9.5% of disposable personal income in 1Q22, well below the 13.2% seen in late 2007.
How I’m Positioning
As noted in previous letters, earlier this year I added exposure to diversified commodities for certain portfolios as an inflation hedge. These hedges tracked futures contracts on oil and natural gas, precious and base metals, and agricultural products.
In June, as investors’ attention turned away from fear of inflation and toward fear of recession, I removed the commodity hedges across all of my clients’ portfolios. My rationale was simple: as economic activity slows meaningfully, so would demand for various commodities, particularly energy-related commodities. Accordingly, last week Citigroup analysts noted they see oil falling to $65 in the event of a global recession.
Bloomberg Commodity Index, Year-to Date Performance
Evolve Investing’s strategies remain generally defensive, with (1) lower technology sector exposure relative to the overall market, (2) virtually zero exposure to European stocks and bonds, (3) larger companies that have solid balance sheets and proven access to capital, and (4) a generally higher percentage of bonds and cash.
In my last State of the Markets call I pointed out the generally bearish sentiment we’re seeing in the markets based on hedge fund positioning, market technicals, and fund flows. For patient, long-term investors, I believe today’s environment offers an opportunity to add risk and - as Warren Buffet has said - “be greedy when others are fearful.”
As always, if you’d like to discuss any of the above themes and how your portfolio is positioned, you’re welcome to reach out any time. Thank you for your continued support and confidence in Evolve Investing.
Best,
Peter Hughes, CFA