Q2 2022 Capital Market Highlights

Q2 Review

As challenging as Q1 was, the second quarter was among the worst for investors. After suffering (rare) losses in Q1, a typical “balanced” portfolio suffered double-digit losses in Q2 alone, seen only in the Great Depression and the Global Financial Crisis. The Russian invasion has faded a bit in media coverage, but its devastating impact on food and energy prices remains.

With inflation as the primary enemy of our Federal Reserve, short-term lending rates have finally started rising with market rates. As you’ve likely seen, mortgage rates have increased to the highest in years, reaching the 6% range and freezing the real estate market after an ultra-hot period in which bidding wars were prevalent.

Interest rates remain a hot topic, but markets have now entered a “soft or hard landing” debate. Q1 Gross Domestic Product (GDP) ran at a pace below 0%, and Q2 is tracking similarly. The technical definition of a recession is consecutive quarters of negative GDP growth. So, will high gas prices induce our consumer-driven economy into a more profound slowdown? Or will the underlying strength in employment get us through a soft patch and into a resumption of growth?

Portfolio Changes

In Q2, the Investment Committee continued our renovation of the defensive sleeves in portfolios to better capture income in an inflationary environment. We also tweaked the growth sleeves, resulting in the following allocation changes:

In the defensive sleeve: We sold three intermediate-term “core” bond funds and two “unconstrained” bond funds to reduce the interest rate and credit risk. In their place, we bought the Aptus Defined Risk ETF and Schwab Short-Term Treasury ETF. With those changes, we reduced average duration (interest-rate sensitivity), eliminated mortgage bond exposure, improved credit quality, and improved tax efficiency by moving from mutual funds to exchange-traded funds (ETFs).

In the growth sleeve: We sold Vanguard All-World Equity ETF and trimmed Vanguard Total Stock Market ETF. We were able to replace these holdings with lower beta ETFs JP Morgan Equity Premium Income and Aptus Collared Income Opportunity. Both funds add additional return streams with less pure reliance (and thus, risk) on the performance of equity markets.

In summary, we think the totality of our moves has positioned portfolios for more stable long-term performance and even less reliance on predicting future economic outcomes. Moreover, after the changes of the past two years, portfolios have less exposure to interest rates and credit quality. They have spread the portfolio burden across more unique streams of returns.

Contributors and Detractors

The market drawdown highlighted that while bonds provided diversification benefits in recent decades, that relationship is not guaranteed. In an inflationary period like the one we’re in now, bonds can not only fall with stocks but, in some periods, fall faster. With better long-term upside potential, owning stocks with built-in protection (hedged equities) can provide both lower downside in the short-term and higher upside in the long-term.

Contributors were few, with their role limited to softening the downside. In addition, no major categories delivered positive returns in Q2. The result was that diversification offered little help to investors in the first half of this year:

Risks and Outlook

As summer approached, the market’s view shifted from “The Fed can’t stop inflation” to “The Fed is going to trigger a recession.” As seen in the most fluid economy-tracking tools available, Q2 GDP data drifted lower and then abruptly plunged into negative territory:

When the final Q1 GDP tally showed a negative actual number, it was generally accepted as an anomaly driven by a surge in imports that cut the official number. But now, given the technical definition of a recession as two consecutive quarters of negative GDP growth, it appears we may get an official “recession” call.

This does not mean widespread layoffs and plunging consumer spending. On the contrary, U.S. corporations remain in great shape financially, labor markets remain tight, and with “typical” Consumer Price Index (CPI) figures, the GDP figures are easily in positive territory, meaning nominal GDP remains positive despite the headlines.

If the Fed has its way, this economic slowdown will put a lid on this surging inflation. They can then back off their rate hikes and return to a more neutral stance. Equity investors would likely welcome this, as the current state of Fed policy is the tightest we’ve seen in recent decades:

The primary risk is that the economy slows AND inflation remains high, a condition known as stagflation, which is the worst of all environments. The Fed has said it will remain vigilant against inflation and would seemingly have little choice but to continue lifting rates – even in a recession.

We will closely monitor this balancing act and adjust accordingly if the evidence dictates a strong stance one way or another. In the meantime, we’re confident that our current positioning is the one most appropriate for a wide range of conditions.

We also take comfort in the ingenuity of capitalism and the history of markets, which have ultimately rewarded long-term investors throughout a range of unique bear market environments:

As always, we remain grateful for your continued trust in all we do related to planning and investments.