In our July market recap we cover the fixed income market, monetary policy, inflation, economic data and more. The equity market staged an impressive rebound in July as the S&P 500 increased by +9.2%, the strongest monthly return since November 2020 and the fifth best overall in the last twenty years. Despite the strong monthly return, the market is still down by -12.6% year-to-date. The S&P 500 is also still in the technical definition a bear market (a decline of -20% on a closing basis without a subsequent +20% increase) after the index fell by -23.0% from January 3rd through June 16th.Since the June 16th bottom, the market is higher by +12.8%.

Although volatility has been head spinning this year, we believe the environment is another example of why investors should maintain a long-term viewpoint. We constantly remind our clients that market volatility is quite common and it should not trigger emotional decision making that can be value destructive to long-term financial plans. From 1928 to 2021, the S&P produced a total annualized return of +9.7% with an average annual peak-to-trough decline of about -15%. While 2022 has been a difficult year thus far for financial markets, this kind of volatility is not unusual. Please see our Client Question titled Market Timing Does Not Work.

• Market Cap: Mid (+10.9%) outperformed Small (+10.4%) and Large (+9.2%) Caps.

• Style: Growth (Russell 1000 Growth: +12.0%) exceeded Value (Russell 1000 Value: +6.6%).

• Sector: All eleven sectors were positive in the month with Consumer Discretionary (+18.9%) and Technology (+13.5%) as the top performers and Health Care (+3.3%) and Consumer Staples (+3.3%) as the laggards.

While we are pleased with the market rebound over the last six weeks, we expect more volatility rather than a quick ascent to new all-time highs. The primary risks causing the market turmoil still remain, including, fears over the Fed tightening monetary policy, increased inflation expectations, the Russia/Ukrainian war, and covid induced shutdowns in China. While the short-term environment is unsteady, we believe that for the market to reach a sustainable bottom, Fed tightening expectations need to soften, ideally through signs of disinflation. Over the long-term, we continue to suspect this difficult economic environment has created a strong buying opportunity for investors willing to live with some short-term discomfort. We believe those who were able to either stay invested, rebalance, or add to their existing holdings will eventually be rewarded.

We are sticking with our investment philosophy of maintaining a long-term viewpoint as the present environment is very volatile and fluid. Given all the uncertainty, we are maintaining a disciplined approach while continuing to look for opportunities to tax loss harvest, reposition and rebalance portfolios, and selectively put money to work for clients that have recently made contributions to their accounts. We did take the opportunity to reposition many portfolios by increasing the equity percentage when the S&P 500 fell close to bear market territory. This was not an attempt to call the bottom, but rather to take advantage of a significant decline by rebalancing for long-term investors. We expect to have more opportunities to rebalance over the next several months as our base case is that volatility will continue.

The markets have several major events over the next month, including, any update on the Russia/Ukrainian War and China lockdowns, the July Employment Report (6/3), CPI Inflation (7/10), Federal Reserve Jackson Hole Economic Symposium (8/25 – 27), and PCE Inflation (8/26).

➡ Market Timing Does Not Work

➡  Sell in May and Go Away?

➡  Market Performance During Fed Tightening Cycles

➡  Market Reaction to Geopolitical Events

➡  Stagflation

Fixed Income Market

The Bloomberg Barclays US Aggregate Bond index (Agg), which acts as a proxy for the investment-grade bond market, also produced solid returns with an increase of +2.4% in July, the best monthly gain since August 2019. The bond market is still down by -8.2% year-to-date. The decline in the bond market this year 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 2.65% currently.

We hold fixed income with the goal of providing ballast, stability, and income to portfolios. Bonds have not provided ballast for most of the year as interest rates have increased, but we expect the negative correlation between stocks and bonds to return in the future once yields level out. We will also point out 10-Year Treasury yield peaked this year at 3.47% on June 14th before declining to the current level of 2.65%. Over that period the Agg index increased by +5.1%.

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 the interest and principal payments (no defaults). The yield to maturity on the US Aggregate Bond index increased to 3.4% at the end of the quarter.

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 tighten monetary policy and overall financial conditions by raising interest rates and shrinking the size of their balance sheet. The Fed’s actions are designed to remove liquidity from the financial system to decrease overall demand for goods and services. A simple definition of inflation is, “too much money chasing too few goods.” The Fed is about to shrink the amount of money available.

Interest Rates: After raising interest rates by an uncommonly large 0.75% each at the June 15th and July 27th meetings, the top-end of the federal funds rate now stands at 2.50%. Thus far in 2022, the FOMC has raised interest rates by 2.25%, including by 1.50% over the last six weeks. At the latest press conference, Fed Chair Powell stated that going forward, “it likely will become appropriate to slow the pace of increases while we assess how our cumulative policy adjustments are affecting the economy and inflation. ”The takeaway is that while the Fed will likely raise rates further, future increases will either be 0.50% or 0.25%.

Balance Sheet: The Fed is also beginning to reduce the size of their nearly $9 trillion balance sheet. The runoff plan started in June and will ramp up to 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 rate, it will take over 4 years for the Fed’s balance sheet to decrease to its pre-pandemic size.

A key question facing the markets and economy is: how high does the Fed need to raise interest rates before there are definite signs of disinflation? If inflation moderates quickly, the FOMC will not have to raise rates much further than current levels, and the greater the chance the economy can achieve the “soft-ish” landing (only a mild slowdown or recession) that the Fed is aiming for .If inflation remains persistent, the FOMC will be forced to raise rates much further than current levels, and the economy faces a higher risk of a “hard landing” (severe recession). The Fed’s latest Summary of Economic Projections signal a peak federal funds rate of 3.8% by December 2023 while the market has priced in a top rate of 3.3% by December 2022. The situation is dynamic, but we will receive more clarity on where inflation, interest rates, and the economy are headed over the next several weeks as more data is available.

Inflation

The increase in inflation is driven primarily by supply chain bottlenecks, surging energy prices, strong consumer demand caused by a solid labor market, and massive amounts of stimulus.

The Fed’s preferred inflation measure (Core PCE inflation) increased by +4.8% Y/Y in June, well above the target of about 2%, but below the recent peak of +5.3% in February. While inflation may be near peak levels, the key will be how long it takes for disinflation to set in and the growth rate to move back toward 2%.The Fed would very much appreciate a strong period of disinflation, allowing them to slowdown the pace of tightening. We will need to wait at least a few months for this evidence. The latest FOMC projections show inflation ending the year at +4.3% before falling to +2.7% in 2023 and +2.3% in 2024.

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.

Economic Data

Our view is that the that the economy is slowing from the post-pandemic boom due to fading stimulus, rising inflation, Fed tightening, and surging commodity prices. The current period is best characterized by high inflation and a lot of uncertainty caused by Fed tightening expectations, the Russia/Ukraine War, and China’s covid lockdowns.

After increasing by +5.7% in 2021, Real GDP Growth is estimated at +2.0% in 2022 and +1.3% in 2023. Economic growth estimates have been decreasing over the past several weeks as economic indicators, consumer spending, and the housing market have all weakened while inflation has stayed elevated. The labor market continues to show signs of strength, but we do expect the unemployment rate to tick up over the next few months as several major firms have begun to announce hiring freezes or layoffs. The open question is whether the economy is headed for a slowdown/mild recession or a more severe contraction. Right now, we see a slowdown/mild recession as the most probable outcome.

Another open debate is whether the economy has already fallen into a recession. Real GDP increased by +6.9% in Q4 2021 before falling to -1.6% in Q1 2022 and -0.9% in Q2 2022. Many people define as a recession as two consecutive quarters of negative GDP. However, in the United States, 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, while an expansion is defined as a period where economic activity rises substantially. According to the NBER, since 1929 there have been 15 recessions in the US lasting an average of 13 months each.

In our opinion, the current environment likely achieves the NBER’s definition of a recession, albeit a mild one for now. While the NBER does not view two consecutive negative quarters of GDP growth as a recession, the current period probably meets the test of a significant decline in economic activity. The NBER usually waits several months after the fact to announce the official start and end dates for recessions. Therefore, it is possible the United States is already in a recession that started in early 2022. Of course, not all recessions are created equal. The current period looks far better than past severe recessions like the Great Depression or Financial Crisis.

The bottom line is that whether the United States has reached the official definition of a recession is mostly just semantics, while there is no debate that the economy has slowed considerably.

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 help provide confidence in working towards 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 can be value destructive over time and can be 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 discuss that: the stock market has historically gone up over time despite frequent drawdowns, the average investor underperforms due to market timing mistakes, and our belief in 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

We believe 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 mitigation strategies, and 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 client’s long-term goals and objectives. Since we account for market volatility and declines, the financial plan can be modified 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 seeking to ensure 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 if 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 have historically occurred during periods of market turmoil.

July 2022 Returns