Testing Our Resolve

Jul 1, 2022 | Newsletters

Testing Our Resolve

Dear Clients and Friends,

The first half of 2022 has tested the resolve of many long-term investors as economic surprises, stock performance, and even bond market returns all went in the wrong direction. While it may be tempting to sell risk assets during challenging periods such as these, we should remember that drawdowns and even recessions are a normal and recurrent part of the economic cycle. Successfully timing the market is difficult to impossible, and missing the upside impairs more portfolios than participating in the downside through a full cycle. Therefore, outside of near-term liquidity that is required for upcoming purchases or living expenses, continuing to hold the equity and debt of high-quality businesses is the most prudent  long-term strategy—one that we believe will yield long-term compounding returns that will outpace inflation.

Our base-case scenario for the remainder of the year is that the road ahead will present more bumps (and the likelihood for further market declines). Still, we have high conviction that companies will return to generating durable growth on the other side. We expect current economic challenges to gradually untangle, supporting an eventual recovery for both stocks and bonds.

In the coming quarters, we believe that inflation will begin to subside, allowing the Federal Reserve to slow its “tightening” policies. We see this fundamental improvement making room for growth in stock prices and steady bond coupon payments.

But before we get back to a long-term recovery, let’s review how we got here and what’s ahead for the economy and markets.

Inflation, the Fed, and Bonds

Inflation continues to be one of the greatest pressures on the economy. The Russia-Ukraine conflict tightened global energy supplies and boosted oil, gas, and other commodity and food prices, further adding to inflationary pressures sparked by COVID. Employment is another major market force creating pressure in our economy: Demand currently exceeds the supply of workers, which has placed additional pricing pressure on wages. These two inflationary forces have prompted the Fed to reverse the aggressive money-printing stimulus that began in the early days of the pandemic. Today, the Fed is restricting monetary policy in the other direction in an effort to depress demand across the economy and arrest inflationary pressures.

While the Fed can control short-term interest rates, market forces generally determine long-term rates. Higher inflation expectations have fueled a rise in long-term bond yields, as investors demand higher returns on bonds to offset rising inflation. Yields on the ten-year U.S. Treasury bond more than doubled to almost 3.5% in June (up from about 1.5% in January). Longer bonds are also seeing an impact, as higher 30-year mortgage costs weigh on housing demand.

Since bond prices move in the opposite direction as yields, bond returns have declined this year. One widely owned basket of high-quality government and corporate bonds, the Bloomberg US Aggregate Bond Index, fell -11% during the first half.

Recession Fears and Bear Markets

Stocks are also under pressure as investors try to understand where the economy is heading. While upcoming Fed actions may lower inflation and help consumers, investors are worried that monetary tightening could tip the economy into a recession. Current market prices reflect these rising investor concerns: Last week, the malaise of 2022 pushed stocks into a bear market, which is by definition a decline of 20% or more from recent highs. Stocks limped across the finish line at the end of the second quarter with a -20.5% performance year-to-date, the worst first half of a calendar year in decades.

Stock prices also reflect rising uncertainty surrounding inflation trends, looming Fed actions, the odds of a recession, and the next direction for corporate profits. While every financial cycle is unique, we can draw on history to frame investor sentiment in the current situation. In prior bear markets, stocks fell about 30% on average, suggesting we could see additional volatility ahead.

To be fair, some downturns coincide with deflation in “asset bubbles” such as Internet stocks in the late 90s and the housing sector in the early 2000s. Historically, when these types of asset bubbles burst, markets have declined roughly 60% on average. Some argue that some of the smaller, more speculative corners of markets such as cryptocurrency and special purpose acquisition companies (aka “SPACs”) have shown signs characteristic of asset bubbles. Indeed, many of these assets have declined 60% or more this year. Still, we do not currently believe that these speculative pockets of the market are large enough to, alone, lead to our economic demise.

Silver Linings?

Challenges seem to abound for many investors this year, but we see the glass half full in a few areas.  With a reversal in recent Chinese COVID lockdowns, global supply chains are showing signs of improvement. And although we are not finding that we have enough workers to fill open job vacancies, we are at full employment. That, coupled with generally steady consumption in the U.S. may reduce the downside of the next recession.

We also see silver linings in financial markets, as this year’s pain in the stock market has resulted in a return to discipline and a focus on fundamentals. Widespread market declines have made room for additions to portfolios as valuations have come down to more reasonable levels.

The Road Ahead

Typically, we strive to own quality companies with high barriers to entry, rising profitability, and the ability to take market share. We will be studying corporate earnings trends as they emerge in the coming weeks, as they may signal which companies have improving fundamentals and which ones are struggling to manage the challenges of this inflationary environment. Finally, within the fixed income market, rising short term rates are offering some of the most compelling opportunities we have seen in several years. In short, even amid the challenges that we face today, we intend to continue to deploy capital into the capital structure of high-quality businesses .

As many of us look forward to summer holidays and spending time with family and friends, we remain fully resolved in analyzing upside and downside scenarios for the economy, corporate profits, and stocks. We continue to monitor emerging trends and search for additional investment opportunities that meet our core investment principles, remaining ever mindful of your goals and objectives.

We wish you all the best this summer.

Michael Bailey, CFA
Director of Research

Michael Mussio, CFA, CFP®

Important Disclosures: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by FBB Capital Partners [“FBB]), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from FBB. FBB is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. A copy of the FBB’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request or at www.fbbcap.com. Please Remember: If you are a FBB client, please contact FBB, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. Unless, and until, you notify us, in writing, to the contrary, we shall continue to provide services as we do currently. Please Also Remember to advise us if you have not been receiving account statements (at least quarterly) from the account custodian. Historical performance results for investment indices, benchmarks, and/or categories have been provided for general informational/comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your FBB account holdings correspond directly to any comparative indices or categories. Please Also Note: (1) performance results do not reflect the impact of taxes; (2) comparative benchmarks/indices may be more or less volatile than your FBB accounts; and, (3) a description of each comparative benchmark/index is available upon request.

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