To be sure, 2022 has been one of the most difficult years for investors since the financial crisis. As of the time of this writing, the S&P 500 stock index has lowered by about 20%, and the Barclay’s Aggregate Bond Index (AGG) is lower by about 15% from the beginning of the year. We at Atlas came into the year with a defensive tilt to our portfolios, but as the year has progressed, we’ve been compelled to take further actions to reduce the level of credit exposure in our bond holdings as well as to reduce our international exposure on the equity side. More on this later…
Many of our clients have expressed serious concerns about the direction of things, which is entirely understandable. The exhortation “I can’t take another 2008” is one we’re hearing frequently. We point out that the circumstances today are different than those we faced 15 years ago, however, we understand that the fears are very similar. So, let’s examine the current dynamics affecting the markets and look to provide some perspective on where we may be going in the future.
The current (time of writing) level of the S&P 500 places us approximately where we stood at the start of last year. 2021 provided us with a S&P return of 28.71% positive (including dividends),1 therefore, a decline of 20% from the higher, ending level returns us to approximately where we were over 18 months ago. Until August, much of this decline was registered in the sentiment category, as earnings and estimated forward earnings continued to hold up. The Price to Earnings multiple of the market came down as investors observed Central Bank policies tightening. To a considerable extent, and as we indicated in one of our publications this spring, 2022 has become the Year of The Fed. But on top of this, the Geo-Political situation, particularly in eastern Europe, has become increasingly volatile. These two factors have led us to a current situation where profitability expectations are coming down for 2023.
As for bonds, the rise in both short-term rates by the Fed, and the rate of inflation have provided considerable headwinds to income-oriented investors… unfortunately, the price deterioration has occurred concurrently across the yield curve, leaving few places to find shelter. In fact, never in the history of the AGG index have we seen the deterioration that we have experienced to this point in 2022.
As we look forward, several issues are at the top of our list for consideration.
First is the question of whether or not the entirety of expected Fed rate hikes and the impact of inflation have been reflected in current bond prices. Recently, the expected terminal rate for overnight lending by banks was raised from 3.4% to 4.4% in 2022, and to 4.6% in 2023.2 So, given the current target range of 3.0% – 3.25%, we can expect further (but perhaps smaller) rate hikes as the Fed meets in November and December. For our part, we think that as higher rates have a more direct effect on Investment Grade bond values, the impact is largely priced in. However, for riskier credit sensitive bonds, the impact may continue, causing further pain for holders of those securities. Accordingly, we have taken steps through the last year to reduce credit exposures in our strategies that present this risk. Recently, with new investments into Investment-Grade bonds we’ve been able to take advantage of higher rates that have become accessible. Investors have been lamenting low interest rates for two decades. To get to higher yields, prices needed to adjust downward. While we have seen deterioration of bond prices, bonds have the feature of returning to their face value at maturity. The silver lining is that higher rates will finally produce higher yields for those same investors.
We would not be surprised to see worrying headlines regarding bonds as we go forward, but at this point we are comfortable with the quality of the holdings we have and look forward to a recovery. We think that the intermediate-term outlook for Investment Grade debt is currently attractive from this level.
Next, we are concerned about the outlook for corporate profitability as we move toward and into 2023. We know that in the intermediate to long-term, stock prices are driven mainly by profitability and expectations for future earnings. Since June, we have seen the consensus estimate for S&P 500 aggregate earnings for the coming 12 months decline. As Fed actions to combat inflation through raising the cost of borrowing have become more of a concern to investors, the prospect of a more broadly felt recession has caused investors to trim their hopes.
Third, inflation continues to be a major topic of concern. While the other two issues discussed can be characterized as cyclical events that, while concerning, are part of the economic cycle, the current level of inflation is not. To the extent that the Fed is unable to thwart inflation, the prospect of stagflation raises its ugly head. Thus far, the rate hikes implemented by the Fed have had little effect on inflation. In fact, they have yet to have much real impact on the U.S. economy itself. While we have seen the economy enter the textbook definition of recession, we have yet to see the economy show the telltale signs of a traditional recession; higher unemployment, shrinking availability of credit and negative growth in the manufacturing and service sectors of the economy3. We hold the belief that as we move toward 2023, we’ll see a decline in reported inflation, but will fail to reach the Fed target of 2.5% in the foreseeable future. We think that by some point in 2023 inflation will get to a run rate in the 4.0% range, give or take a bit, for some time.
Considering all of this, what is an investor to do? As is always mentioned in these pieces, we continue to believe that maintaining a proper risk-based allocation, adjusting to conditions as necessary, and maintaining a long-term view is essential to investment success. As was seen in 2020, when in the wake of the onset of Covid-19 investors were unnerved, stocks and bonds staged one of the sharpest selloffs and subsequent recoveries in the history of the markets. We would suggest that in late March of that year, few, if any investors were anticipating a rally to begin. For investors that lost their perspective in March, succumbed to fear, and sold holdings, the opportunity to participate in the recovery was lost. Again, the markets showed us that patience, calm in the face of uncertainty, and commitment to an investment strategy can lead to positive results. Destructive activity on the other hand, can lead to lost opportunity.
As always, if you have any questions or concerns, please feel free to contact your Atlas Wealth Management Advisor. They will be happy to discuss your specific situation with you.
1 – S&P 500 Annual Total Return (ycharts.com)
2 – US Fed lowers economic growth forecast, raises terminal rate above 4% (aa.com.tr)
3 – The Institute for Supply Management continues to indicate expansion in both manufacturing and services as of September 2022 ISM Report On Business® (ismworld.org)