The market rollercoaster ride dropped lower in April as the S&P 500 declined by -8.7%, the worst
monthly performance since March 2020. After reaching a year-to-date low on the last trading
day of the month, the S&P 500 is now down by -12.9% for the year. We will keep reminding our
clients that market declines are very common, as since 1928 the S&P 500 has averaged an
annual peak-to-trough decline of about -15%. This means that the 2022 decline is still below
average than what the market typically experiences on an annual basis. We will also continue to
point out that despite the selloff, recent market performance has been excellent as the S&P
500 has increased by +13.8% on an annualized basis over the last 3 years.
Market Cap: Mid (-7.1%) outperformed Large (-8.7%) and Small Caps (-9.9%).
Sector: Out of eleven sectors, only Consumer Staples (+2.6%) was positive for the month with Consumer Discretionary (-13.0%) and Communication Services (-15.6%) as the laggards.
The decline in the stock market this year is primarily driven by fears over the Fed tightening monetary policy, increased inflation expectations, Russia/Ukrainian war, and covid induced shutdowns in China. Only one or two of these issues on their own would be enough to cause some investor consternation, but each of them occurring simultaneously has created a very challenging short-term environment. In the near term, the markets would bounce on any sign of decreased Fed tightening expectations, inflation rates peaking, a cease fire, or China easing their severe covid restrictions.
We are sticking with our investment philosophy of maintaining a long-term viewpoint as the present environment is very challenging and fluid. Given all the uncertainty, we are maintaining defensive positioning while continuing to look for opportunities to tax loss harvest, reposition portfolios, and selectively put money to work for clients that have recently made contributions to their accounts. On the equity side, we remain tilted toward high quality US stocks (we allocate across regions, countries, market caps, factors, styles, sectors, and industries). On the fixed income side, we continue to focus on achieving ballast, stability, and income while accounting for short-term cash needs. We expect more opportunities to take advantage of volatility as we think it will persist for the next several months.
The markets have several major events over the next month, including, any update on the Russia/Ukrainian War and China lockdowns, the May FOMC decision (5/4, the Fed is likely to raise rates by 50 basis points and start their balance sheet runoff plan), OPEC+ Meeting (5/5), April Employment Report (5/6), CPI Inflation (5/11), and PCE Inflation (5/27).
At Winthrop Wealth, we believe the right mindset paired with a comprehensive financial plan and a thorough investment process can provide a sense of comfort and confidence in meeting your long-term financial goals, especially during times of heightened market volatility. We help our clients navigate challenging markets by ensuring their short-term cash flow needs are met while managing the rest of their investments in a globally diversified portfolio. By having two to three years of scheduled cash flows invested in ultra-short fixed income, we decrease the odds that we will need to sell out of risk assets after a market decline to fund distributions. Please see our recent Client Questions that can help put things into context:
The Bloomberg Barclays US Aggregate Bond index (Agg), which acts as a proxy for the investment-grade bond market, decreased by -3.8% in April, bringing the year-to-date decline to -9.5%. The decline in the bond market was driven by an increase in interest rates (bond prices move inversely to yields). The 10-Year Treasury has increased from 1.51% at the start of the year to 2.93%.
We hold fixed income to provide ballast, stability, and income to portfolios. Ballast means that ideally the fixed income holdings are increasing when equity markets are declining. Bonds have not provided ballast this year as interest rates have increased, but we expect the negative correlation between stocks and bonds to return in the future.
The increase in interest rates has also driven the yield to maturity of various bond indices to their highest levels in years. Yield to maturity is defined as the estimated rate of return an investor can expect on a bond if purchased today and held to maturity, assuming the issuer makes all of their interest and principal payments (no defaults). The yield to maturity on the US Aggregate Bond index increased to 3.5% at the end of the month. While 3.5% is not the double-digit yields we saw in the bond market in the early 1980s, it is still far more attractive than what we have seen over the past few years.
Monetary Policy
The Fed has now firmly admitted that inflation is a problem and that they will tighten monetary policy to attempt to bring it under control. The Fed will act primarily by raising interest rates and decreasing the size of their balance sheet.
Interest Rates: While the Fed has only raised rates once this year (0.25% on March 16th), they are just getting warmed up. The Fed will likely raise rates by 0.50% at the May 4th meeting, and the market has now priced in an additional 2.50% of rate increases in 2022. Our sense is that Chair Powell and the committee want to raise rates several times, start the balance sheet runoff process, and then reassess where the economy and inflation stand.
Balance Sheet: The Fed will likely start to reduce the size of their nearly $9 trillion balance sheet in May. Minutes from the March 16th meeting stated that FOMC participants agreed that the balance sheet runoff would have monthly caps of about $60 billion for Treasuries and $35 billion for agency mortgage-backed securities. The monthly reduction of about $95 billion will be larger than the $50 billion per month pace that was used during the 2017-2019 runoff plan. At the current runoff pace, it will take over 4 years for the Fed’s balance sheet to decrease to its pre-pandemic size.
Although the Fed is tightening monetary policy, they still believe they can achieve a “soft-landing” for the economy. A soft-landing means that the economy can avoid a recession despite the increase in interest rates. Chair Powell recently noted that the economy did achieve a soft landing in 1964, 1984, and 1994. We will keep highlighting that monetary policy is not on a preset course and the Fed will pivot if inflation starts to decelerate, the markets have a significant decline, and/or the economy starts to materially weaken. Fed Chair Powell has demonstrated that he is data dependent and will quickly change policy as the economy and markets evolve.
Inflation
Our comments on inflation sound like a broken record as the latest readings are still at nosebleed levels due to supply chain bottlenecks, surging energy prices, massive amounts of stimulus, and pent-up demand.
The Fed’s preferred inflation measure (Core PCE inflation) increased by +5.2% Y/Y in March, well above the target of about 2%. Now that the Fed has shifted to tightening monetary policy to decrease inflation, investors are anxious for the peak. While inflation may be near peak levels, the key will be how fast the growth rates start to decelerate to more digestible levels. We will need to wait at least a few months for this evidence. Current consensus is for Core PCE inflation at +4.7% in 2022 and +2.8% in 2023.
We are still trying to combat the current rise in inflation by holding little cash in portfolios, avoiding long-term bonds, and overweighting equities of companies that are able to grow their cash flows, earnings, and dividends. Please see our June Client Question on Inflation, where we detailed how the data is calculated, why the Fed cares about and targets inflation, and the impact it has on various asset classes (cash, fixed income, and equities). In our December Client Question – Revisiting Inflation, we thought it would be helpful to outline three potential scenarios for how inflation could impact the economy and stock market in 2022, provide an update on supply chain bottlenecks, and look at the latest readings of various inflation measures and forecasts.
Economic Data
First quarter real GDP came in a disappointing -1.4% seasonally adjusted annual rate. On a brighter note, the underlying components were not as weak as the headline number suggests. Consumer spending, which drives about 70% of GDP growth, came in at +2.7% and was up from +2.5% in Q4 (any significant consumer weakness would be concerning).The drop in GDP was mainly driven by declines in inventories and exports. Inventory build has been volatile as the measure added +5.3% to Q4 GDP before subtracting -0.8% from Q1. Net exports decreased Q1 GDP by -3.2% due to a stronger dollar, covid shutdowns in China, and a global slowdown caused by the Russia/Ukrainian war. The slowdown in Q1 is expected to be temporary as Real GDP is expected to increase by +3.0% in Q2, +3.2% in 2022, and +2.1% in 2023.
Given the weak first quarter GDP report, we’ve gotten a few questions from clients asking about the possibility of a recession. Our view is that the report confirms that the economy is slowing from the post-pandemic boom due to fading stimulus, rising inflation, Fed tightening, and surging commodity prices. We maintain that a recession over the next twelve months is still unlikely as the labor market is strong and the consumer is still in good shape. Although recession odds have increased over the past several weeks. A recession at some point is inevitable, the only open questions are whether one will hit within the next twelve months and how severe it could be. We will keep monitoring closely, but right now it is too early to sound the recession alarm bell.We also thought it would be helpful to answer a few common recession related questions:
What is a recession?
The National Bureau of Economic Research (NBER) Business Cycle Dating Committee is charged with maintaining official records of expansions and recessions. The NBER defines a recession as a significant decline in economic activity (this is slightly different than the traditional definition of a recession as two consecutive quarters of a decline in real GDP). An expansion is defined as a period where economic activity rises substantially. According to the NBER, since 1945 there have been 12 recessions in the United States lasting an average of 10 months each.
What does the typical economic expansion-to-recession cycle look like?
An over-simplified business cycle typically follows a similar pattern: the economy expands rapidly – unemployment falls – inflation overheats – financial bubbles forms – the Fed responds by raising interest rates – credit tightens – good borrowers struggle to find loans – the economy stumbles – a recession occurs – the economy bottoms – repeat.
How will the markets and economy perform in a recession?
The following actions will probably occur during a recession: equity markets will decline by more than -20% from their peak, credit spreads will widen, yields on government debt will fall as investors flock to safety, consumer confidence and spending will decline, aggregate demand will decrease, the unemployment rate will increase, eventually inflation will decelerate, and the Fed will reverse course from tightening to easing monetary policy to attempt to stimulate the economy.
How will we manage portfolios during a recession?
At Winthrop Wealth our investment philosophy is based on maintaining a long-term viewpoint while our process is designed to provide well-diversified portfolios constructed with a methodology based on prudent risk management, asset allocation, and security selection. Our approach has helped our clients navigate through challenging financial markets and ultimately pursue their goals and objectives.
◦ For clients withdrawing money: Defining and accounting for upcoming cash flow needs is a critical component of our financial planning process. We will generally invest at least two years’ worth of estimated cash flows in short duration, high quality, liquid, fixed income securities. No matter what occurs in the markets, these holdings are readily available to fund cash flows as needed. This helps to ensure that clients will not need to sell equities to fund cash flows after a significant market decline. Please see our Client Question on Withdrawing Money.
◦ For taxable investors: We can dynamically tax-loss harvest by selling an investment with a loss and immediately purchasing a different security with similar (but not identical) exposure. The loss on the sold security can be used to offset taxable gains. Please see our Client Question on Tax Loss Harvesting.
◦ For all investors: Repositioning portfolios means that we can increase the overall equity allocation and/or we can reallocate among various asset classes. Keep in mind, some of the best buying opportunities occur during periods of market turmoil.
Our framework for navigating current conditions:
During periods of market volatility, we follow the same playbook and convey the same messages. At Winthrop Wealth, we believe the right mindset paired with a comprehensive financial plan and a thorough investment process can provide a sense of comfort and confidence in meeting your long-term financial goals, especially during times of heightened market volatility.
The Right Mindset – Take a long-term viewpoint and avoid the impulse to market time
“Don’t try to buy at the bottom and sell at the top. It can’t be done – except by liars.”
Bernard Baruch
Market volatility is stressful and controlling your emotions during these periods is critical. Market timing decisions are often emotional rather than rational and data based. Making sudden large adjustments to portfolios is value destructive over time and a major reason for poor investor performance. Our investment philosophy is, never time the market. Please see our Client Question titled Market Timing Does Not Work, where we demonstrate that: the stock market goes up over time despite frequent drawdowns, the average investor underperforms due to market timing mistakes, and the benefit of a diversified portfolio and a long time horizon.
Financial Plan
“The Best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and behavioral discipline that are likely to get you where you want to go.”
Benjamin Graham
Financial planning drives the investment strategy and provides a roadmap to each client’s unique goals and objectives. The comprehensive financial plan defines cash flow needs, optimizes account structures, considers tax minimization strategies, and continuously evaluates financial risks as circumstances and/or goals change.
We also stress test the financial plan for many different environments including extreme volatility and market declines. The financial plan does not assume perpetually strong markets and linear returns. Rather it assumes that your portfolio will go through periods of weakness throughout your investment time horizon. We often update financial plans during and after volatility to quantify the impact that the market decline had on the probability that the client will reach their long-term goals and objectives. Since we account for market volatility and declines, the financial plan is less likely to be damaged when these periods inevitably occur.
Investment Process
“Good times teach only bad lessons: that investing is easy, that you know its secrets, and that you needn’t worry about risk. The most valuable lessons are learned in tough times.”
Howard Marks
Our investment management process is designed to provide well-diversified portfolios constructed with a methodology based on prudent risk management, asset allocation, and security selection. We help our clients navigate challenging markets by ensuring their short-term cash flow needs are met while managing the rest of their investments in a globally diversified portfolio.
Market volatility can be used to our advantage by tax-loss harvesting or reallocating to more attractive securities:
◦ Tax-loss Harvesting: Tax-loss harvesting is achieved by selling an investment with a loss and immediately purchasing a different security with similar (but not identical) exposure. The loss on the sold security can be used to offset taxable gains. Since we simultaneously sell a security to capture a loss and purchase a different holding with similar exposure, the client is never out of the market. We can capture losses during declines, and as the market recovers the new position also recovers PLUS the client has a tax-loss to offset future gains. Please see our Client Question on Tax Loss Harvesting.
◦ Repositioning Portfolios: Repositioning portfolios means that we can increase the overall equity allocation and/or we can reallocate among various asset classes. During a market selloff, portfolio equity allocations often fall below their target levels. For example, assume a portfolio is invested to its target allocation of 60% equities and then the stock market declines -10%. The new allocation would be about 54% or -6% below the target level. We can use the market decline as an opportunity to buy stocks at lower prices to bring the allocation back to the 60% target level. Furthermore, we can rotate to the equity asset classes that have become more attractive (for equities, we allocate across regions, countries, market caps, factors, styles, sectors, and industries). Keep in mind, some of the best buying opportunities occur during periods of market turmoil.
April 2022 Market Returns
DISCLOSURES
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
Financial planning is a tool intended to review your current financial situation, investment objectives and goals, and suggest potential planning ideas and concepts that may be of benefit. There is no guarantee that financial planning will help you reach your goals.
Rebalancing a portfolio may cause you to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.
Likewise, it is important to remember that no investment strategy assures success or protects against loss. Past performance is no guarantee of future results. Asset allocation does not ensure a profit or protect against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. All investing involves risk which you should be prepared to bear.
This information is not intended to be a substitute for individualized tax advice. We suggest that you discuss your specific tax situation with a qualified tax advisor.
All indexes mentioned are unmanaged indexes which cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The Russell 3000 Index is a market-capitalization-weighted equity index maintained by FTSE Russell that provides exposure to the entire U.S. stock market. The index tracks the performance of the 3,000 largest U.S.-traded stocks which represent about 98% of all U.S incorporated equity securities.
The NASDAQ Composite Index measures all NASDAQ domestic and non-U.S. based common stocks listed on The NASDAQ Stock Market. The market value, the last sale price multiplied by total shares outstanding, is calculated throughout the trading day, and is related to the total value of the Index.
The S&P Midcap 400 Stock Index is an unmanaged index generally representative of the market for the stocks of mid-sized US companies.
The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.
The Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.
Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.
The prices of small cap stocks and mid cap stocks are generally more volatile than large cap stocks.
The MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI EAFE Index consists of the following developed country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the UK.
The MSCI Europe Index captures large and mid cap representation across 15 Developed Markets (DM) countries in Europe. With 445 constituents, the index covers approximately 85% of the free float-adjusted market capitalization across the European Developed Markets equity universe.
The MSCI Japan Index is designed to measure the performance of the large and mid cap segments of the Japanese market. With 322 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Japan.
The MSCI China Index captures large and mid cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs). With 709 constituents, the index covers about 85% of this China equity universe. Currently, the index includes Large Cap A and Mid Cap A shares represented at 20% of their free float adjusted market capitalization.
The MSCI EM (Emerging Markets) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the emerging market countries of the Americas, Europe, the Middle East, Africa and Asia. The MSCI EM Index consists of the following emerging market country indices: Brazil, Chile, Colombia, Mexico, Peru, Czech Republic, Egypt, Greece, Hungary, Poland, Qatar, Russia, South Africa. Turkey, United Arab Emirates, China, India, Indonesia, Korea, Malaysia, Philippines, Taiwan, and Thailand.
The MSCI ACWI ex USA Index captures large and mid cap representation across 22 of 23 Developed Markets (DM) countries (excluding the US) and 27 Emerging Markets (EM) countries. With 2,354 constituents, the index covers approximately 85% of the global equity opportunity set outside the US.
The Bloomberg Barclays U.S. Aggregate Bond Index is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds.
The Bloomberg Barclays Capital U.S. Credit Bond Index measures the performance of investment grade corporate debt and agency bonds that are dollar denominated and have a remaining maturity of greater than one year.
The Bloomberg Bloomberg Barclays Capital US Corporate High Yield Bond index is an index representative of the universe of fixed-rate, non-investment grade debt.
The Bloomberg Barclays Insured Municipal Bond Index is a total return performance benchmark for municipal bonds that are backed by insurers with Aaa/AAA ratings and have maturities of at least one year.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
< COMMENTARY
Market Commentary | May 04, 2022
April 2022 Market Recap
By Andrew Murphy, CFA
Co-Chief Investment Officer
The market rollercoaster ride dropped lower in April as the S&P 500 declined by -8.7%, the worst monthly performance since March 2020. After reaching a year-to-date low on the last trading day of the month, the S&P 500 is now down by -12.9% for the year. We will keep reminding our clients that market declines are very common, as since 1928 the S&P 500 has averaged an annual peak-to-trough decline of about -15%. This means that the 2022 decline is still below average than what the market typically experiences on an annual basis. We will also continue to point out that despite the selloff, recent market performance has been excellent as the S&P 500 has increased by +13.8% on an annualized basis over the last 3 years.
The decline in the stock market this year is primarily driven by fears over the Fed tightening monetary policy, increased inflation expectations, Russia/Ukrainian war, and covid induced shutdowns in China. Only one or two of these issues on their own would be enough to cause some investor consternation, but each of them occurring simultaneously has created a very challenging short-term environment. In the near term, the markets would bounce on any sign of decreased Fed tightening expectations, inflation rates peaking, a cease fire, or China easing their severe covid restrictions.
We are sticking with our investment philosophy of maintaining a long-term viewpoint as the present environment is very challenging and fluid. Given all the uncertainty, we are maintaining defensive positioning while continuing to look for opportunities to tax loss harvest, reposition portfolios, and selectively put money to work for clients that have recently made contributions to their accounts. On the equity side, we remain tilted toward high quality US stocks (we allocate across regions, countries, market caps, factors, styles, sectors, and industries). On the fixed income side, we continue to focus on achieving ballast, stability, and income while accounting for short-term cash needs. We expect more opportunities to take advantage of volatility as we think it will persist for the next several months.
The markets have several major events over the next month, including, any update on the Russia/Ukrainian War and China lockdowns, the May FOMC decision (5/4, the Fed is likely to raise rates by 50 basis points and start their balance sheet runoff plan), OPEC+ Meeting (5/5), April Employment Report (5/6), CPI Inflation (5/11), and PCE Inflation (5/27).
At Winthrop Wealth, we believe the right mindset paired with a comprehensive financial plan and a thorough investment process can provide a sense of comfort and confidence in meeting your long-term financial goals, especially during times of heightened market volatility. We help our clients navigate challenging markets by ensuring their short-term cash flow needs are met while managing the rest of their investments in a globally diversified portfolio. By having two to three years of scheduled cash flows invested in ultra-short fixed income, we decrease the odds that we will need to sell out of risk assets after a market decline to fund distributions. Please see our recent Client Questions that can help put things into context:
➡️ Market Timing Does Not Work
➡️ Sell in May and Go Away?
➡️ Market Performance During Fed Tightening Cycles
➡️ Market Reaction to Geopolitical Events
Fixed Income Markets
The Bloomberg Barclays US Aggregate Bond index (Agg), which acts as a proxy for the investment-grade bond market, decreased by -3.8% in April, bringing the year-to-date decline to -9.5%. The decline in the bond market was driven by an increase in interest rates (bond prices move inversely to yields). The 10-Year Treasury has increased from 1.51% at the start of the year to 2.93%.
We hold fixed income to provide ballast, stability, and income to portfolios. Ballast means that ideally the fixed income holdings are increasing when equity markets are declining. Bonds have not provided ballast this year as interest rates have increased, but we expect the negative correlation between stocks and bonds to return in the future.
The increase in interest rates has also driven the yield to maturity of various bond indices to their highest levels in years. Yield to maturity is defined as the estimated rate of return an investor can expect on a bond if purchased today and held to maturity, assuming the issuer makes all of their interest and principal payments (no defaults). The yield to maturity on the US Aggregate Bond index increased to 3.5% at the end of the month. While 3.5% is not the double-digit yields we saw in the bond market in the early 1980s, it is still far more attractive than what we have seen over the past few years.
Monetary Policy
The Fed has now firmly admitted that inflation is a problem and that they will tighten monetary policy to attempt to bring it under control. The Fed will act primarily by raising interest rates and decreasing the size of their balance sheet.
Interest Rates: While the Fed has only raised rates once this year (0.25% on March 16th), they are just getting warmed up. The Fed will likely raise rates by 0.50% at the May 4th meeting, and the market has now priced in an additional 2.50% of rate increases in 2022. Our sense is that Chair Powell and the committee want to raise rates several times, start the balance sheet runoff process, and then reassess where the economy and inflation stand.
Balance Sheet: The Fed will likely start to reduce the size of their nearly $9 trillion balance sheet in May. Minutes from the March 16th meeting stated that FOMC participants agreed that the balance sheet runoff would have monthly caps of about $60 billion for Treasuries and $35 billion for agency mortgage-backed securities. The monthly reduction of about $95 billion will be larger than the $50 billion per month pace that was used during the 2017-2019 runoff plan. At the current runoff pace, it will take over 4 years for the Fed’s balance sheet to decrease to its pre-pandemic size.
Although the Fed is tightening monetary policy, they still believe they can achieve a “soft-landing” for the economy. A soft-landing means that the economy can avoid a recession despite the increase in interest rates. Chair Powell recently noted that the economy did achieve a soft landing in 1964, 1984, and 1994. We will keep highlighting that monetary policy is not on a preset course and the Fed will pivot if inflation starts to decelerate, the markets have a significant decline, and/or the economy starts to materially weaken. Fed Chair Powell has demonstrated that he is data dependent and will quickly change policy as the economy and markets evolve.
Inflation
Our comments on inflation sound like a broken record as the latest readings are still at nosebleed levels due to supply chain bottlenecks, surging energy prices, massive amounts of stimulus, and pent-up demand.
The Fed’s preferred inflation measure (Core PCE inflation) increased by +5.2% Y/Y in March, well above the target of about 2%. Now that the Fed has shifted to tightening monetary policy to decrease inflation, investors are anxious for the peak. While inflation may be near peak levels, the key will be how fast the growth rates start to decelerate to more digestible levels. We will need to wait at least a few months for this evidence. Current consensus is for Core PCE inflation at +4.7% in 2022 and +2.8% in 2023.
We are still trying to combat the current rise in inflation by holding little cash in portfolios, avoiding long-term bonds, and overweighting equities of companies that are able to grow their cash flows, earnings, and dividends. Please see our June Client Question on Inflation, where we detailed how the data is calculated, why the Fed cares about and targets inflation, and the impact it has on various asset classes (cash, fixed income, and equities). In our December Client Question – Revisiting Inflation, we thought it would be helpful to outline three potential scenarios for how inflation could impact the economy and stock market in 2022, provide an update on supply chain bottlenecks, and look at the latest readings of various inflation measures and forecasts.
Economic Data
First quarter real GDP came in a disappointing -1.4% seasonally adjusted annual rate. On a brighter note, the underlying components were not as weak as the headline number suggests. Consumer spending, which drives about 70% of GDP growth, came in at +2.7% and was up from +2.5% in Q4 (any significant consumer weakness would be concerning).The drop in GDP was mainly driven by declines in inventories and exports. Inventory build has been volatile as the measure added +5.3% to Q4 GDP before subtracting -0.8% from Q1. Net exports decreased Q1 GDP by -3.2% due to a stronger dollar, covid shutdowns in China, and a global slowdown caused by the Russia/Ukrainian war. The slowdown in Q1 is expected to be temporary as Real GDP is expected to increase by +3.0% in Q2, +3.2% in 2022, and +2.1% in 2023.
Given the weak first quarter GDP report, we’ve gotten a few questions from clients asking about the possibility of a recession. Our view is that the report confirms that the economy is slowing from the post-pandemic boom due to fading stimulus, rising inflation, Fed tightening, and surging commodity prices. We maintain that a recession over the next twelve months is still unlikely as the labor market is strong and the consumer is still in good shape. Although recession odds have increased over the past several weeks. A recession at some point is inevitable, the only open questions are whether one will hit within the next twelve months and how severe it could be. We will keep monitoring closely, but right now it is too early to sound the recession alarm bell. We also thought it would be helpful to answer a few common recession related questions:
What is a recession?
The National Bureau of Economic Research (NBER) Business Cycle Dating Committee is charged with maintaining official records of expansions and recessions. The NBER defines a recession as a significant decline in economic activity (this is slightly different than the traditional definition of a recession as two consecutive quarters of a decline in real GDP). An expansion is defined as a period where economic activity rises substantially. According to the NBER, since 1945 there have been 12 recessions in the United States lasting an average of 10 months each.
What does the typical economic expansion-to-recession cycle look like?
An over-simplified business cycle typically follows a similar pattern: the economy expands rapidly – unemployment falls – inflation overheats – financial bubbles forms – the Fed responds by raising interest rates – credit tightens – good borrowers struggle to find loans – the economy stumbles – a recession occurs – the economy bottoms – repeat.
How will the markets and economy perform in a recession?
The following actions will probably occur during a recession: equity markets will decline by more than -20% from their peak, credit spreads will widen, yields on government debt will fall as investors flock to safety, consumer confidence and spending will decline, aggregate demand will decrease, the unemployment rate will increase, eventually inflation will decelerate, and the Fed will reverse course from tightening to easing monetary policy to attempt to stimulate the economy.
How will we manage portfolios during a recession?
At Winthrop Wealth our investment philosophy is based on maintaining a long-term viewpoint while our process is designed to provide well-diversified portfolios constructed with a methodology based on prudent risk management, asset allocation, and security selection. Our approach has helped our clients navigate through challenging financial markets and ultimately pursue their goals and objectives.
◦ For clients withdrawing money: Defining and accounting for upcoming cash flow needs is a critical component of our financial planning process. We will generally invest at least two years’ worth of estimated cash flows in short duration, high quality, liquid, fixed income securities. No matter what occurs in the markets, these holdings are readily available to fund cash flows as needed. This helps to ensure that clients will not need to sell equities to fund cash flows after a significant market decline. Please see our Client Question on Withdrawing Money.
◦ For taxable investors: We can dynamically tax-loss harvest by selling an investment with a loss and immediately purchasing a different security with similar (but not identical) exposure. The loss on the sold security can be used to offset taxable gains. Please see our Client Question on Tax Loss Harvesting.
◦ For all investors: Repositioning portfolios means that we can increase the overall equity allocation and/or we can reallocate among various asset classes. Keep in mind, some of the best buying opportunities occur during periods of market turmoil.
Our framework for navigating current conditions:
During periods of market volatility, we follow the same playbook and convey the same messages. At Winthrop Wealth, we believe the right mindset paired with a comprehensive financial plan and a thorough investment process can provide a sense of comfort and confidence in meeting your long-term financial goals, especially during times of heightened market volatility.
The Right Mindset – Take a long-term viewpoint and avoid the impulse to market time
Market volatility is stressful and controlling your emotions during these periods is critical. Market timing decisions are often emotional rather than rational and data based. Making sudden large adjustments to portfolios is value destructive over time and a major reason for poor investor performance. Our investment philosophy is, never time the market. Please see our Client Question titled Market Timing Does Not Work, where we demonstrate that: the stock market goes up over time despite frequent drawdowns, the average investor underperforms due to market timing mistakes, and the benefit of a diversified portfolio and a long time horizon.
Financial Plan
Financial planning drives the investment strategy and provides a roadmap to each client’s unique goals and objectives. The comprehensive financial plan defines cash flow needs, optimizes account structures, considers tax minimization strategies, and continuously evaluates financial risks as circumstances and/or goals change.
We also stress test the financial plan for many different environments including extreme volatility and market declines. The financial plan does not assume perpetually strong markets and linear returns. Rather it assumes that your portfolio will go through periods of weakness throughout your investment time horizon. We often update financial plans during and after volatility to quantify the impact that the market decline had on the probability that the client will reach their long-term goals and objectives. Since we account for market volatility and declines, the financial plan is less likely to be damaged when these periods inevitably occur.
Investment Process
Our investment management process is designed to provide well-diversified portfolios constructed with a methodology based on prudent risk management, asset allocation, and security selection. We help our clients navigate challenging markets by ensuring their short-term cash flow needs are met while managing the rest of their investments in a globally diversified portfolio.
Market volatility can be used to our advantage by tax-loss harvesting or reallocating to more attractive securities:
◦ Tax-loss Harvesting: Tax-loss harvesting is achieved by selling an investment with a loss and immediately purchasing a different security with similar (but not identical) exposure. The loss on the sold security can be used to offset taxable gains. Since we simultaneously sell a security to capture a loss and purchase a different holding with similar exposure, the client is never out of the market. We can capture losses during declines, and as the market recovers the new position also recovers PLUS the client has a tax-loss to offset future gains. Please see our Client Question on Tax Loss Harvesting.
◦ Repositioning Portfolios: Repositioning portfolios means that we can increase the overall equity allocation and/or we can reallocate among various asset classes. During a market selloff, portfolio equity allocations often fall below their target levels. For example, assume a portfolio is invested to its target allocation of 60% equities and then the stock market declines -10%. The new allocation would be about 54% or -6% below the target level. We can use the market decline as an opportunity to buy stocks at lower prices to bring the allocation back to the 60% target level. Furthermore, we can rotate to the equity asset classes that have become more attractive (for equities, we allocate across regions, countries, market caps, factors, styles, sectors, and industries). Keep in mind, some of the best buying opportunities occur during periods of market turmoil.
April 2022 Market Returns
DISCLOSURES
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
Financial planning is a tool intended to review your current financial situation, investment objectives and goals, and suggest potential planning ideas and concepts that may be of benefit. There is no guarantee that financial planning will help you reach your goals.
Rebalancing a portfolio may cause you to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.
Likewise, it is important to remember that no investment strategy assures success or protects against loss. Past performance is no guarantee of future results. Asset allocation does not ensure a profit or protect against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. All investing involves risk which you should be prepared to bear.
This information is not intended to be a substitute for individualized tax advice. We suggest that you discuss your specific tax situation with a qualified tax advisor.
All indexes mentioned are unmanaged indexes which cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The Russell 3000 Index is a market-capitalization-weighted equity index maintained by FTSE Russell that provides exposure to the entire U.S. stock market. The index tracks the performance of the 3,000 largest U.S.-traded stocks which represent about 98% of all U.S incorporated equity securities.
The NASDAQ Composite Index measures all NASDAQ domestic and non-U.S. based common stocks listed on The NASDAQ Stock Market. The market value, the last sale price multiplied by total shares outstanding, is calculated throughout the trading day, and is related to the total value of the Index.
The S&P Midcap 400 Stock Index is an unmanaged index generally representative of the market for the stocks of mid-sized US companies.
The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.
The Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.
Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.
The prices of small cap stocks and mid cap stocks are generally more volatile than large cap stocks.
The MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI EAFE Index consists of the following developed country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the UK.
The MSCI Europe Index captures large and mid cap representation across 15 Developed Markets (DM) countries in Europe. With 445 constituents, the index covers approximately 85% of the free float-adjusted market capitalization across the European Developed Markets equity universe.
The MSCI Japan Index is designed to measure the performance of the large and mid cap segments of the Japanese market. With 322 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Japan.
The MSCI China Index captures large and mid cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs). With 709 constituents, the index covers about 85% of this China equity universe. Currently, the index includes Large Cap A and Mid Cap A shares represented at 20% of their free float adjusted market capitalization.
The MSCI EM (Emerging Markets) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the emerging market countries of the Americas, Europe, the Middle East, Africa and Asia. The MSCI EM Index consists of the following emerging market country indices: Brazil, Chile, Colombia, Mexico, Peru, Czech Republic, Egypt, Greece, Hungary, Poland, Qatar, Russia, South Africa. Turkey, United Arab Emirates, China, India, Indonesia, Korea, Malaysia, Philippines, Taiwan, and Thailand.
The MSCI ACWI ex USA Index captures large and mid cap representation across 22 of 23 Developed Markets (DM) countries (excluding the US) and 27 Emerging Markets (EM) countries. With 2,354 constituents, the index covers approximately 85% of the global equity opportunity set outside the US.
The Bloomberg Barclays U.S. Aggregate Bond Index is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds.
The Bloomberg Barclays Capital U.S. Credit Bond Index measures the performance of investment grade corporate debt and agency bonds that are dollar denominated and have a remaining maturity of greater than one year.
The Bloomberg Bloomberg Barclays Capital US Corporate High Yield Bond index is an index representative of the universe of fixed-rate, non-investment grade debt.
The Bloomberg Barclays Insured Municipal Bond Index is a total return performance benchmark for municipal bonds that are backed by insurers with Aaa/AAA ratings and have maturities of at least one year.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.