After three consecutive calendar years of above average performance, global risk assets finally stumbled in the first half of 2022. Tightening monetary policy, fading fiscal stimulus, China’s zero-COVID strategy and the Russia-Ukraine conflict, combined with rapidly rising interest rates and surging inflation, roiled markets and rattled investor sentiment. The growing threat of a global recession has raised serious concerns about the future sustainability of corporate profits.
60/40 Portfolios Disappoint
The expected diversification benefits from combining stocks and bonds in portfolios has failed investors miserably throughout the first five months of the year. According to Strategas Research Partners, US stocks are off to their fourth-worst start to a year (January 1 – May 15) in the past 90 years.1 And, more specifically, the S&P 500 Index is off to its worst midterm election year start in history.2 Meanwhile, 98% of all fixed income funds are trading at a year-to-date loss, with an average return of -8%.3
For investors desperately searching for silver linings, stocks typically recover soundly for the remainder of the year (May 16 – December 31) after suffering such a poor start.4 And the Bloomberg US Aggregate Bond Index has never produced back-to-back calendar years of negative returns.5
Fed Focuses on Taming Inflation
Perhaps the single biggest question in the second half of 2022 is whether the Federal Reserve (Fed) can successfully engineer a softish landing. Continued global shocks from the pandemic, the Russia-Ukraine conflict and China’s zero-COVID strategy have made balancing supply and demand very difficult this year. The result has been rampant global inflation. Despite economic data indicating a potential cyclical slowdown, the Fed and other global central banks are likely to keep raising interest rates until they are confident that longer-term inflation expectations are stable.
Monetary policy tightening is seeking to cool economic growth just enough to address supply-demand imbalances and tame inflation. But the risks remain skewed to the downside. The US economy recorded a surprise negative GDP in the first quarter of 2022. Inflation has remained high for so long that it risks becoming entrenched. The Fed may need to tighten further and faster than expected as inflation data remains red hot. If the Fed wants to aggressively defeat inflation, short-term interest rates have to move above the inflation rate. Given today’s lofty inflation figures, that’s a scary proposition for investors and suggests that the Fed has a long way to go in raising rates.
In addition, global supply shocks show little signs of abating. Regrettably, if supply cannot rise to meet demand, then demand has to fall. As a result, corporate profits are likely to come under additional downward pressure.
Three Strategies for Current Challenges
Today’s investment environment is more complex than it has been in recent years. But despite the challenges, all is not lost for investors. A lot of bad news is already reflected in the first half performance of global risks assets. Unexpected good news from the Fed, China or the Russia-Ukraine conflict — or data that suggests inflation has peaked — could spark a relief rally in risk assets later in the year.
Consider these three strategies when constructing portfolios for the second half of 2022:
1 Strategas Research Partners, May 20, 2022. 2 Strategas Research Partners, May 20, 2022. 3 Bloomberg Finance, L.P., as of May 27, 2022. 4 Strategas Research Partners, May 20, 2022. 5 Bloomberg Finance, L.P., as of May 27, 2022.
Bloomberg US Aggregate Bond Index A benchmark that provides a measure of the performance of the U.S. dollar-denominated investment-grade bond market. The “Agg” includes investment-grade government bonds, investment-grade corporate bonds, mortgage pass-through securities, commercial mortgage-backed securities and asset-backed securities that are publicly for sale in the US.
A commonly used measure, expressed in years, that measures the sensitivity of the price of a bond or a fixed-income portfolio to changes in interest rates or interest-rate expectations. The greater the duration, the greater the sensitivity to interest rates changes, and vice versa. Specifically, the specific duration figure indicates, on a percentage basis, by how much a portfolio of bonds will rise or fall when interest rates shift by 1 percentage point.
Inflation The decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.
S&P 500® Index A popular benchmark for U.S. large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
The views expressed in this material are the views of Michael Arone through the period ended May 27, 2022, and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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