- Valuation – The sharp rally following the early days of the pandemic in March 2020 led to US stock and bond indices trading at above average valuations at the beginning of 2022 (higher than average price-to-earnings ratios for stocks, below average yields for bonds). A higher valuation starting point can leave market indices in a more precarious position should the outlook become cloudier (which it most certainly did).
- Pandemic – The COVID-19 pandemic is less of a concern for the average US citizen today, but it continues to create significant disruptions in other parts of the world, particularly China which introduced new lockdowns in April. These hangover effects from the pandemic continue to challenge global supply chains and are contributing to supply / demand imbalances and inflation.
- Monetary Policy – The US Federal Reserve has embarked on a path of normalizing monetary policy, which includes increases in short-term interest rates as well as a reduction in their holdings of fixed income securities. Both of these mechanisms serve to increase short and long-term interest rates, which is good for savers but bad for borrowers and tends to dampen demand for borrowing, spending, and investing.
- Russia / Ukraine – Beyond the horrific and shameful human toll of the war in Ukraine, the conflict has created additional supply gains in energy, materials, and agriculture that are contributing to higher costs for key inputs globally, in addition to the general anxiety around the potential for a larger conflict in Europe or beyond.
- Inflation – Supply chain disruptions, geopolitical conflicts, and aggressive stimulus during the pandemic have all led to supply / demand imbalances that are driving prices higher at a pace not seen in decades. Higher costs have already led to a steep decline in household sentiment, which could spill into a slowdown in spending.
Implications for Portfolio Management
These risks are obviously daunting, but they are just as ubiquitous and widely discussed in financial media and investor letters like this one. Both household and investor sentiment have become very negative relative to long-term averages, a phenomena which have often foreshadowed higher future returns in equity markets. We believe that these risks and resulting market volatility have created attractive opportunities in specific securities and asset classes, perhaps the most salient point that we could offer investors today is simply to focus on your long-term investing goals and attempt to look beyond shorter-term fluctuations.
- The US economy remains on solid footing despite inflation.
- The labor market is robust but running out of room for significant advancement from here.
- Higher food, energy, and housing prices have caused households to be more negative / cautious.
- The US Federal Reserve is seeking to normalize monetary policy at an aggressive pace in order to combat inflation, which may also slow economic growth.
- Broad equity and credit indices near long-term average valuation.
- Market technical signals remain mixed as multiple parts of the US equity market are near or in bearish trends, but investor sentiment is very bearish (historically a contrarian buying opportunity)
The declines in stocks in 2022 have brought most indices back into more normal valuation ranges relative to long-term averages. In addition to the risks facing equity markets (e.g., inflation, geopolitical), the pure movement higher in US Treasuries has likely been a very direct driver in the repricing lower of many stocks. The first chart below highlights the relationship between the earnings yield of the S&P 500 in green (earnings yield being the net profit earned by investors divided by the price of the index) and the yield on 7-10 year US Treasury notes (blue line). The black line represents the spread between these two, with a higher spread offering a more compelling relative value for equities compared to bonds.
S&P 500 Price-to-Expected Earnings
The confluence of risks facing investors today has led to the highest percentage of bears in the market since 2009. Historically, these periods of extreme pessimism have been attractive buying opportunities for long-term investors. However, we have yet to see confirming signs of a market bottoming process, and in fact, the overall trend of the S&P 500 continues to degrade. The various risks have led to 2022 being one of the most volatile years over the last two decades.
Prices & Interest Rates
|Representative Index||April 2022||Year-End 2021|
|Crude Oil (US WTI)||$104.69||$75.21|
|2 Year Treasury||2.70%||0.73%|
|10 Year Treasury||2.89%||1.52%|
|30 Year Treasury||2.96%||1.90%|
|Source: Morningstar, YCharts, and US Treasury as of April 30, 2022|
Asset Class Returns
|Category||Representative Index||April 2022||YTD 2022|
|Global Equity||MSCI All-Country World||-8.0%||-12.9%|
|Global Equity||MSCI All-Country World ESG Leaders||-7.9%||-13.7%|
|US Large Cap Equity||S&P 500||-8.7%||-12.9%|
|US Large Cap Equity||Dow Jones Industrial Average||-5.8%||-7.4%|
|US All Cap Equity||Russell 3000 Growth||-12.1%||-20.2%|
|US All Cap Equity||Russell 3000 Value||-5.8%||-6.6%|
|US Small Cap Equity||Russell 2000||-9.9%||-16.7%|
|Foreign Developed Equity||MSCI EAFE||-6.5%||-12.0%|
|Emerging Market Equity||MSCI Emerging Markets||-5.6%||-12.2%|
|US Fixed Income||Bloomberg Barclays Municipal Bond||-2.8%||-8.8%|
|US Fixed Income||Bloomberg Barclays US Agg Bond||-3.8%||-9.5%|
|Global Fixed Income||Bloomberg Barclays Global Agg. Bond||-5.5%||-11.3%|
|Source: YCharts as of April 30, 2022|