8 Charts Summarizing Our 2022 Q2 Investment Update

By Brian Tall | Jul 25, 2022 |

For our Q2 2022 Investment Update, Brian Tall, our Chief Investment Officer, reviewed the performance of our portfolios and core market segments, took an in depth look at what has driven negative performance of fixed income markets this year, and provided an update on the relative performance of value vs. growth stocks.

This article summarizes the key points addressed in this update.  You can find the original recorded webcast of this investment update here. Alternatively, you can download Brian Tall’s presentation deck with his corresponding commentary here.

1. Historical Expansions/Contractions

This chart shows the growth of a moderate risk portfolio—with a 60% weighting to stocks—since the peak of the market before the global financial crisis.  The bottom half of the page shows the length and magnitude of expansionary and contractionary periods during the 15-years shown.[1]

Expansions and Contractions
Key Takeaway:

We’ve heard some scary headlines throughout the first half of the year.  For example, the aggregate bond market suffered its largest drawdown in more than 40 years, and the US Stock Market suffered its worst first half since 1970.  These type of headlines make it sound like we haven’t seen this type of volatility before.  But this is the 6th time in the past 15 years a diversified portfolio has experienced a drawdown of 10% or more.

If there’s one thing that’s always important to remember, it’s that volatility is a normal part of investing.  And despite these temporary setbacks, capital markets have a long history of rewarding investors for the capital they supply. It’s also important to remember that events that only happen once every 30, 50, or 100 years happen all the time.  And the financial media has a way of slicing and dicing data to make everything sound more scary than it needs to sound because that’s what gets us to click on articles, and that’s how they get paid.  This isn’t to say we shouldn’t read the news, because it is important to be aware of issues that are taking place…but don’t let headlines hijack your emotions.  It’s moments like this where attractive investment opportunities start to show up.

2. Portfolio Component Performance

This chart illustrates year-to-date performance for the core market segments within our portfolios.[2]

Key Takeaway(s):

  • In the first quarter, equity markets suffered a 10% correction but recovered sharply in the last two weeks of the quarter—despite Russia invading Ukraine and the Fed’s first interest rate hike in March.
  • But the relief was short-lived and both equity and fixed income markets trended lower in Q2, with stocks falling into a bear market (defined as a decline of 20% or more).
  • One thing that’s different this year relative to other periods with a meaningful drawdown in equity markets is that we’re also seeing negative performance in high-quality bonds.
  • If we divide the return of the moderate risk portfolio into the return of the Russell 3000 Index, we’re experiencing a very typical “down capture ratio” relative to other periods with equity market declines.
  • The reason for that is our global equity holdings in aggregate are outperforming the US market by about 3-4%, owing to our structural overweight to value stocks and better relative performance of our international holdings.
  • Stated differently, the outperformance of some of our managers is offsetting the fact that high-quality bonds haven’t offered positive performance.
  • Note: the foregoing information does not reflect the potential impact of client-specific personalization e.g. the exclusion of certain sectors or companies.

3. US Treasury Yield Curve Evolution

The chart below visualizes the treasury yield curve as of 12/31/ 2021 (gray), 3/31/2022 (blue), and 6/30/2022 (yellow).[3]

Key Takeaways:

  • The primary driver of fixed income returns has been a sharp re-rating of forward-looking interest rate expectations.
  • As we entered the year, consensus expectations were calling for three interest rate hikes of 25 basis points in 2022 followed by another three hikes of 25 basis points in 2023.
  • At the end of the 1st quarter, the market was anticipating seven hikes this year and two hikes next year, along with the possibility of one or two 50 basis point increases.
  • At the end of the 2nd quarter, consensus expectations believe the fed funds rate will likely end the year between 3.25% and 4%–up from its current target range of 1.5-1.75%.
  • Some members of the Federal Reserve Open Market Committee also suggested opening the door to a 1% hike at the end of July—although the most likely scenario is another 75 basis point hike.
  • Important Note: Expecting that interest rates will go higher is not a reason in and of itself to sell bonds in advance of that happening.
    • In order to earn excess profit from a view that you have, your view must be different from consensus expectations.
    • It isn’t enough to say “I think interest rates are going higher so I’ll sell my bonds.” You’d have to say “I think interest rates are going to go up faster and by a larger magnitude than what the consensus expects.”
    • And, the profit potential available is always going to be proportional to the degree to which your view differs from the consensus. In order to make a lot of money, your view has to be so different from the market consensus that pretty much everyone is going to call you crazy unless you’re eventually proven right.
    • Looking ahead, the prevailing consensus view is that the Fed Funds rate is going to be more than double what it is currently. Unless you think the Fed will increase rates materially higher than that, you shouldn’t sell out of bonds.

4. Market Expectations for Future Rate Hikes

This chart is a probability distribution table showing where the market believes the Fed Funds rate will be following upcoming Federal Reserve Interest Rate Policy Meetings, the dates of which are listed in the column on the far left.[4]  The probabilities listed in the table are all derived from the prices of Fed Funds Futures Contracts that trade throughout the day.  The logic behind the calculations is that the current prices of various Fed Funds Futures Contracts only makes sense if these probabilities correctly reflect investor expectations.

Key Takeaway(s):

  • The market is pricing in about a 70% probability the fed will again raise interest rates by 75 basis points at the end of July. Following the June Inflation Report, the market also started discounting the possibility of a 1% hike, but that is less likely at this point.
  • The consensus believes the Fed Funds target rate will be between 325-400 basis points at the end of 2022, with the most likely scenario being 350-375 basis points.
  • Unless an investor thinks the Fed will increase rates materially higher than what these probabilities suggest, they shouldn’t sell out of bonds.

5. US Equity Style Performance

This chart displays the Year to Date performance of Morningstar Style Box Indexes.[5]

Key Takeaway(s):

  • In a reversal of fortune from previous years, value stock are outperforming growth stocks significantly in 2022.
  • Our core equity strategies are outperforming owing to a structural overweight to value stocks.

6. Valuations by Equity Style

These charts illustrate the different measures of valuation for US large Growth, US Small Value, and International stocks since 2000.[5]


Key Takeaway:

  • Whether you gauge valuation by price-to-earnings, price-to-sales, or price-to-book, growth stocks increasingly looked expensive while value stocks and international markets were priced more in line with their historical norm.
  • Despite the ~40% decline in large growth stocks, value stocks continue to be priced attractively.
  • The larger sell off in growth stocks is not causing us to rethink—even temporarily—our structural bias towards value stocks.

7. Brighton Jones Equity Exposure Comparison

These charts illustrates how our exposure to equity style boxes (right) compares to popular indexes.[5]

Key Takeaway(s):

  • Certain indexes like the NASDAQ 100 and S&P 500 have heavy exposure to large cap growth stocks.
  • Looking under the hood, these indexes also have high exposure to just a small handful of companies. For example, about 40% of the NASDAQ was concentrated in Apple, Amazon, Microsoft, Google, Facebook, and Tesla at the start of the year.
  • The equity exposure in a Brighton Jones portfolio is more broadly distributed among the style boxes, with a material underweight to Large Cap Growth Stocks relative to the S&P 500.
  • The last two years have been favorable as we’ve seen value stocks come back in favor.

8. Performance of Selected Themes

This final chart compares the YTD performance of popular themes that we have been asked about to the Total Stock Market Index.[5]

Key Takeaway(s):

  • In late 2020 and early 2021, some investors felt like they were missing out on exception returns in baskets of stocks that try to take advantage of certain trends, like working from home, and everything related to FinTech, Blockchain, and Disruptive Technologies.
  • Like clockwork, many of these once popular themes have imploded (as bad as some of these numbers look, they don’t even capture the full peak-to-trough decline because a lot of these categories reached their highs outside of the year-to-date window shown).
  • The investment community often equates discipline with not selling during market corrections or bear markets. But not chasing returns and piling into potential bubbles during strong markets is what sets us up for success in down markets

 

Data Disclosures

[1] Moderate Risk Portfolio: 5% Short-Term Bonds, 5% Intermediate-Term Bonds, 4% Inflation-Protected Bonds, 4% Multisector Bonds, 4% Floating Rate Bonds, 4% High Yield Bonds, 4% Preferred Securities, 34.5% US Stocks, 18% International Stocks, 4.5% Global Real Estate, 3% Master Limited Partnerships.  The foregoing information is provided for discussion purposes only and should not be relied upon as indicating any expected or projected returns. Hypothetical back-tested performance does not represent actual performance, trading costs or the impact of taxes and should not be interpreted as an indication of such performance.  Data source: Morningstar Direct.
[2] Taxable Bond Portfolio: 50% Vanguard Short-Term Bond Index + 50% Vanguard Total Bond Market. Tax-Exempt Bond Portfolio: 50% Vanguard Limited-Term Tax-Exempt + 50% Vanguard Intermediate-Term Tax Exempt. Inflation-Protected Bonds: Vanguard Inflation-Protected Securities. Multisector Bond Strategy: PIMCO Income. Floating Rate Bonds: Fidelity Floating Rate. High Yield Bonds: PIMCO High Yield. Preferred Securities: Nuveen Preferred Securities. US Equity: DFA Core Equity I. International Equity: DFA World ex US Core Equity. Global Real Estate: DFA Global Real Estate. Data source: Morningstar Direct.
[3] Source: US Treasury, CME FedWatch Tool
[4] Source: CME FedWatch Tool
[5] Source: Morningstar Direct

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