June 17, 2022
Dear Clients and Friends,
The latest inflation reading of 8.6% from the May consumer price index (CPI) coincided with another leg down in stocks, triggering an official bear market. For many investors, it has probably felt like a bear market for a while now, but the S&P 500 Index didn’t close more than 20% below its January 3 record high until this past Monday, June 13th.
It’s hard to find a silver lining in inflation over 8%, but here’s the good news. Goods inflation came down quite a bit, which is likely to continue. Also keep in mind that the Federal Reserve’s (Fed) preferred inflation measure, the core personal consumption expenditure index (PCE) is just under 5%. The PCE inflation reading factors in product substitutions, making it a better reflection of how consumers are coping in this tough environment.
The Federal Reserve lifted the fed funds rate by 0.75% on Wednesday, the largest hike since 1994. Chairman Powell’s comments following the decision were focused on acting quickly to quell inflation. For those concerned the Fed may be overly aggressive, consider how the market has done a lot of this work already. Home price appreciation has slowed from higher mortgage rates. Lower stock values will likely slow spending. Margin balances have fallen. Wage increases have leveled off as layoff announcements and pulled job openings have started to hit the newswires. The cost of credit has increased based on investment-grade and high-yield corporate bond spreads. Financial conditions are already tightening early in the Fed’s campaign. This is good news since these factors suggest the Fed may pause its rate hiking campaign in the fall.
While recession risk has risen, most of the economic indicators we track point towards continued expansion, albeit at a slower pace due to the tighter financial conditions mentioned above. In particular, we see continued strength in consumer spending from the robust job market, which in turn should help support corporate earnings. Stocks at current levels are near their average decline in a bear market without a recession, potentially introducing an attractive risk-reward trade-off for stock buyers here. After the S&P 500 enters a bear market, the median 12-month gain has been 24% with advances in seven of the past 10 instances back to 1957 (only 1973 and 2008 saw big declines). Even better, the average historical 12-month gain off a midterm election year low is over 30%.
Though the decline in stocks and bonds has been painful to start the year, we have been active in managing portfolios to both mitigate the downside and take advantage of opportunities. Our proprietary stock strategies have outperformed their benchmarks thanks to our equal weight approach which has minimized exposure to mega cap technology names that dominate the broad indexes. In addition, we have an overall value tilt to these strategies which has allowed us to benefit from the outperformance of value relative to growth. On a model basis, a diversified portfolio of our stock strategies has outperformed the broader market by 4-5% YTD. In taxable accounts, we have been active in tax-loss harvesting – a process where we sell positions at a loss to help offset future capital gains, thereby alleviating tax burden. Lastly, over the past few years, we have been active in adding alternative investments such as private real estate and private credit to portfolios. These alternative investments have not been subject to the same volatility experienced in public markets this year, and many have delivered positive returns YTD.
As always, we encourage you to reach out should you like to discuss our outlook in more detail and/or review your current portfolio allocations.
Gallacher Investment Committee