The views expressed are those of Anchor Capital Advisors, LLC (“Anchor”) and are subject to change at any time. They are based on our proprietary research and general knowledge of said topic. The content and applicable data are in support of our views on said topic. Please see additional disclosures at the end of this publication.
In our opinion, we are, and will continue to be, in a new investment regime with higher levels of inflation and higher interest rates for the foreseeable future, signaling a rotation from growth to value in the market similar to what we saw in the early 2000’s. For the last several years we saw massive amounts of money flowing into venture capital, biotechnology, and cryptocurrencies, all of which are in the process of unwinding. In response, investors are moving money into more traditional sectors, such as energy and natural resources. While the transition period from growth to value in the early 2000’s was volatile, value outperformed expectations for the next several years.
Source: FactSet financial data and analytics
U.S. Equity Markets
Every sector of the U.S. equity market sold off during the second quarter with the S&P 500 and Nasdaq indices firmly in bear market territory (defined as a greater than 20% drawdown) for the year. The value indices are also down but have fared better than the core and growth indices. The primary reason, in our opinion, is the rotation from growth to value, with the expectation of benefiting from value’s defensive characteristics through a rising rate environment. Coming into this year, growth areas of the market were overvalued relative to history and have benefited from the low interest rate environment over the last decade. As interest rates increased significantly this year to combat high inflation, we have seen large stock price decreases and valuation re-ratings in the technology, consumer discretionary, and communication services sectors. Meanwhile energy, consumer staples, healthcare, and utilities sectors have been less negative and behaved defensively in the market sell off.
Even with the markets being down there are some major undercurrents across sectors. The Covid-19 pandemic and associated government policies distorted consumer spending. Consumers had extra money either from savings or stimulus and used those dollars to buy goods. Retailers responded by ordering more goods, which were delayed by supply chain issues and finally arrived this year. This led to a surplus of goods and increase in discounted items, increasing losses for this sector. We are now seeing a normalization back to pre-pandemic levels on the goods side and a shift in consumer spending. Furthermore, the cost of essentials like food, rent, and oil have gone up considerably, which impacts the consumer and their spending. The shift happened so fast that it caught many companies by surprise and has made it difficult to forecast spending patterns and costs. We expect the second quarter earnings season to be challenging given the rapid economic shifts. Currently, the expectations are for the S&P 500 earnings growth to be up 6% for 2022, but that prediction may be revised downward as the year progresses.
Source: FactSet financial data and analytics
The inflation picture has not eased as evidenced by the 8.6% annualized CPI growth in May. This has been a year of sustained high inflation numbers due to various factors, including higher oil, food, and rent prices, as well as increases in wages and supply chain issues. While some of the supply chain issues are getting better, we expect inflation to peak in the second half of 2022 and that it will remain elevated for some time.
Between government regulations and underinvestment in energy and natural resources, prices are likely to remain elevated. The forecast for inflation over the next three years is in the 3.5% to 4% range, which is much higher than we have seen in the last 20 years. The Federal Reserve is trying to tame inflation by raising interest rates. However, high inflation on its own can be enough to reduce demand and slow growth, which is what we are seeing now. The question remains whether the combination of high inflation and increased interest rates will push the economy into a recession.
Federal Reserve and Interest Rates
Since the beginning of the year, the bond market has been proactively increasing the interest rates on government bonds. In the second quarter, the yield on the 10-year Treasury bond moved from 2.3% to 3.1%, which is a significant move in a short period of time. The front end of the yield curve steepened, while the back end flattened, resulting in a slight inversion of the curve. We believe the bond market changes indicate that the Federal Reserve was late to act. Even Chairman Powell has acknowledged the need to be more aggressive in raising interest rates. The Fed started raising rates in March with more increases in May and June bringing the Fed fund rates to a 1.5%-1.75% range. The market expects the Fed to raise rates at least three more times in 2022 to bring the Fed funds rate closer to the current yields on the 10-year Treasury bond.
The energy markets have continued to rally with tight supplies and continued pressure from the Russia/Ukraine war. The price of oil has gone from $100/barrel at the beginning of the quarter up to over $120/barrel and back down now to $103/barrel. We expect that energy prices will remain somewhat elevated but are now seeing some demand destruction from the high oil prices. We are just starting to see consumers adjust their driving plans to reflect the higher oil prices.
Despite the inflation picture and broader macro concerns, the U.S. economy has been fairly resilient. Employment has been strong with unemployment levels continuing to stay at 3.6%. Manufacturing numbers as seen with the Purchasing Managers Index (PMI) has stayed above 50, in expansion territory. Many consumers continue to have a high level of savings relative to historic data. However, we are starting to see cracks in the economy. First quarter GDP growth decreased 1.5%. Additionally, 30-year mortgage rates have reached over 6% and high housing prices have caused the housing market and mortgage applications to cool. Retail sales for May declined by 0.3%. Finally, the University of Michigan Consumer Sentiment has reached extremely low levels.
Europe is facing more challenging conditions than the U.S. due to high levels of inflation coming from energy and food. Germany, in particular, one of the largest and most stable of the European countries, imports 30% of its energy needs from Russia and is facing severe shortages. German utilities that are unable to pass along higher energy prices are facing bankruptcy or potential government bailouts. Furthermore, Germany posted its first trade deficit since 1991. Inflation is running at 8.6% annualized and does not seem to be receding. The European Central Bank is preparing for its first interest rate increase in eleven years to help tame inflation, but even then many economists are forecasting a recession in 2023.
China has been operating under a strict zero Covid-19 policy and has been shutting down cities and restricting movement of people, which has hampered economic activity. Two investment banks recently cut their 2022 GDP forecasts to below 4% growth, while the official target has been closer to 5% growth. The effect of these shutdowns has been wide spread, affecting domestic Chinese consumption and manufacturing that is exported to the U.S. and Europe. Tesla reported that car deliveries were down 20% due to China’s Covid-19 restrictions. In order to counteract the weak Chinese economy, government officials have implemented a number of stimulus measures and are continuing to add more. Despite the weak economic environment and several quarters of market declines, the MSCI China Index was positive for the quarter, one of the few bright spots in the equity markets.
The rally in the U.S. dollar this year has pushed currencies around the world to their lowest levels in years. For example, the Euro is at a 20-year low compared to the dollar. The dollar has strengthened due to the Fed’s action to aggressively raise interest rates to tame inflation. This has resulted in an 11% increase in the U.S. dollar this year.
The U.S. equity portion of Anchor’s multi-asset portfolios is focused on value, which has helped protect the portfolios through these turbulent markets. We continue to remain diversified across asset classes with the focus on value and income producing assets that we feel will withstand higher inflation and a higher interest rate environment. While near term demand may be impacted by higher inflation, we believe that many undercurrents around energy and food will prevent inflation from surpassing levels that we have experienced over the last decade. We also believe that this environment continues to be conducive for value and Anchor’s strategies.