Q2 2022 Market Commentary & Outlook

Where We Are

Happy 246th Birthday to the United States of America! Paraphrasing the incomparable Erma Louise Bombeck (1927-1996):

“You have to love a Nation that celebrates its Independence every July 4…with family picnics where kids throw Frisbees, the potato salad gets iffy, and the flies die from happiness. You may think you have overeaten, but it is patriotism.”

And especially in the U.S. equity markets, June has generated considerable fireworks. Declining -8.4% in price in June and -20.6% for the first half of 2022, the S&P 500 index finished its worst first half performance in 52 years (in 1970; and it is worth keeping in mind that in the second half of that year, the S&P 500 generated a price gain of +27%). For the 12 S&P 500 bear markets since World War II — excluding this year’s — the price decline has averaged -34% and the bear market length has averaged 10 months. If the current bear market adheres to this average performance, approximately 61% of the total damage has occurred, and approximately 70% of the bear market’s time duration has transpired.

The S&P 500‘s decline represents its fourth-worst first-half performance ever, only behind the price losses in 1932 (-45.4%), 1962 (-23.5%), and 1970 (-21.0%), with the following June storyline playing out in financial markets (data are from The Wall Street Journal):

1. Two-year U.S. Treasury yields ranged between a low of 2.66% on June 1st and a high of 3.40% on June 13th before closing at 2.92% on June 30th;
   
2. Ten-year U.S. Treasury yields ranged between a low of 2.92% on June 2 and a high of 3.49% on June 14th before closing at 2.98% on June 30th;
   
3. Thirty-year U.S. Treasury yields ranged between a low of 3.09% on June 1st (and June 2nd) and a high of 3.45% on June 14th before closing at 3.14% on June 30th;
   
4. The DXY U.S. dollar index versus the six major currencies rose +2.6% over the month (up +9.1% year-to- date) and ranged from a low of 101.82 on June 2nd to a high of 105.52 on June 14th, before closing at 104.70 on June 30th;
   
5. The VIX equity volatility index exceeded 30 on six out of 22 trading days in June and ranged between a low of 23.96 on June 8th and a high of 34.02 on June 13th;
   
6. Investors reacted to still elevated inflation readings; softening retail sales; slowing PMI services and manufacturing data; the Federal Reserve’s 75-basis point policy rate increase on June 15th; very gradual reopening signs in the pandemic lockdown in China; and back-and-forth news in the Ukraine conflict;
   
7. The technology-heavy Nasdaq Composite Index fell -8.7% in June, has only managed to generate a gain in one month of the year (+3.4% in March), and is down -29.5% year to date; and
   
8. In descending order, the June price performance of the 11 S&P 500 industry sectors was: Healthcare -2.5%; Consumer Staples -2.8%; Communication Services -6.2%; Utilities -6.2%; Real Estate -7.5%; Industrials -7.8%; Information Technology -8.2%; Consumer Discretionary -9.5%; Financials -10.3%; Materials-13.0%; and Energy -15.3%.

As investors enter the seventh month of 2022, it can be seen in the nearby chart that on average over the 94 years from 1928 through 2021 inclusive, the month of July – with its historical +1.6% price gain for the S&P 500 – ranks first among the best price-performing months among the twelve months in more than nine decades of monthly performance ranking. It is worth repeating that these nine-decade results are averages, with a given month’s outcome having the potential to vary above or below the long-term average.

And as highlighted in the nearby price performance table, after a volatile trading month in June, the S&P 500 finished down -8.4% (3785.38 on June 30th versus 4132.95 on May 31st). The Nasdaq Composite registered an –8.7% decline in June, and the Russell 2000 index of small- and mid-cap companies fell -8.4% over the month.

Over the course of June, West Texas Intermediate crude oil prices declined -7.8%, from $114.67 per barrel on May 31st to $105.76 per barrel on June 30th. The global oil demand side continues to reflect signs of China’s Covid-19 lockdowns easing; slowing momentum in the global economy; fuel shortages; low levels of inventories and spare capacity limited to a few countries; and precautionary buying, while on the supply side: (i) the four-month Russia-Ukraine conflict continues to create significant demand and supply disruptions; (ii) several nations, especially the U.S. and including certain allies, have launched the release of crude oil from their respective Strategic Petroleum Reserves; (iii) Iran continues with the nuclear talks begun on November 29th, which could in theory increase the supply of Iranian oil officially entering global oil markets if economic sanctions on Iran are relaxed; (iv) facing pressure from investors to moderate growth and address their emissions amid concerns about increasing regulations and climate change, large U.S. and European oil companies have continued to spend sparingly to boost production, even as certain major oil companies have halted and/or completely exited their Russian activity; (v) consolidating U.S. shale producers have not excessively increased output in reaction to higher crude prices (as shown in the nearby chart) and have followed production discipline and exerted capital spending restraint; and vi) following the 30th OPEC and non-OPEC ministerial meeting on Thursday, June 30th, the group (which includes Saudi Arabia, Russia, the United Arab Emirates, Kuwait, Iraq, and other countries) agreed to keep the rate of their monthly output increases at an agreed pace of 648,000 barrels per day in August of this year, with Saudi Arabia and the United Arab Emirates likely to account for most of the supply increases. The 31st OPEC+ Ministerial Meeting is scheduled for Wednesday, August 3rd, when the organization is expected to decide on production quotas for September.

During June, the U.S. dollar rose +2.9% versus the DXY index, comprised of six major currencies (the Euro, Japanese yen, British pound, Canadian dollar, Swiss franc, and Swedish krona). On June 30th, the DXY index closed at 104.69, +9.1% versus its level of 95.97 on December 31st, 2021.

Reflecting varying degrees of competition from short-term interest rates over the course of the past month, the daily spot gold price (as logged by USA Gold) closed at $1,804.10 per troy ounce on June 30th, down -2.1% during June and down -1.3% from its close of $1,829.05 per troy ounce on December 31, 2021.

In the accompanying table, June month-end closing yield levels are shown for 2-year, 10-year, and 30-year U.S. Treasury securities, and these monthly data are used to compute the year-to-date 2022 yield level changes (expressed in basis points), also highlighted nearby.

For 2-year U.S. Treasury securities, yields rose 39 basis points in June to 2.92% at month-end where they are up 219 basis points (2.19%) since their closing level of 0.73% on December 31st, 2021.

For 10-year U.S. Treasury securities, yields rose 13 basis points in June and closed at 2.98% at the end of the month, where they are up 146 basis points (1.46%) since their closing level of 1.52% on December 31 , 2021.

For 30-year U.S. Treasury securities, yields rose 7 basis points in June and reached 3.14% at the end of the month, where they are up 124 basis points (1.24%) since their closing level of 1.90% on December 31 , 2021.

The following paragraphs review several of the key factors we consider at this time likely to exert meaningful influence on financial asset prices in the interval ahead.

Factors Likely to Exert Significant Influence on Financial Asset Prices

Inflation

As a widely used input in the construction industry and in many manufacturing processes, so-called “Dr. Copper” is reputed to have a “Ph. D. in economics” because of the red metal’s perceived ability to foretell turning points in the global economy. The nearby chart shows that copper prices have exhibited a declining trend of late, perhaps reflecting lessening shortages, bottlenecks, and other supply-driven inflationary forces.

And copper is not the only commodity to have exhibited recent price weakness. As depicted in the nearby chart, versus their 52-week highs, numerous other commodities have declined to a considerable degree versus their 52-week highs in the energy, precious metals, base metals, and agricultural sectors.

These declines notwithstanding, their still-high absolute levels and especially, rising labor and occupancy costs have contributed to businesses’ and consumers’ elevated inflation expectations. These future price beliefs are monitored closely by the Federal Reserve to ascertain whether high inflation expectations are getting anchored in: (i) wage and salary expectations; (ii) consumers’ spending patterns, and (iii) corporate pricing behavior.

On June 28, the Conference Board Consumer Confidence Index declined to a new 16-month low of 98.8, down from a downwardly revised 103.2 in May (the initial reading was 106.4). As part of the release, one- year consumer inflation rate expectations rose to +8.0%, versus an upwardly revised +7.5% in May. This reading appeared to somewhat offset or even contradict the previous bullishly-interpreted results of the preliminary (June 10th) and final (June 24th) University of Michigan Consumer Sentiment surveys, the latter of which had reported one-year consumer inflation expectations unchanged at +5.3%, with June’s final long-run (5 to 10 years) inflation expectations at +3.1%, up from +3.0% in May’s final report and down from +3.3% in mid-June.

In the past, as shown in the nearby chart, the U.S. economy usually falls into recession after the headline rate of consumer price inflation increases to above +5.0%.

Another nearby chart shows headline and core (excluding energy and food prices) comparative month-over- month and year-over-year inflation data for the CPI (consumer prices), the PPI (producer prices), and PCE (personal consumption expenditures), as well as a data release schedule for these metrics through the end of 2022.

At this point, barring any public health, monetary/fiscal/currency policy, political, or geopolitical shocks, we are of the belief that inflation is likely to decline, yet slowly, to an elevated plateau level above the approximate +2.0% level of the immediate pre-Covid years, perhaps to the +3.0-4.0% range in late 2023 and into 2024.

Monetary Policy and Interest Rates

As shown in the nearby charts, following a significant interval of very low nominal yields throughout most of the 2020-2021 Covid-pandemic experience, short- and intermediate-term U.S. Treasury interest rates have risen significantly in 2022. These increased yields have been in response to: (i) quickening U.S. economic activity; (ii) rising expectations of inflation; and (iii) increasingly restrictive monetary policy.

At the end of June, three-month nominal U.S. Treasury bill yields had risen to 1.69%, versus 0.06% on December 31, 2021, and 10-year U.S. Treasury yields had increased to nearly 3.50% by mid-June, up from 1.52% on December 31, 2021.

In the last week of June, two-year U.S. Treasury yields were quoted at 3.18% (up from 0.73% on December 31, 2021), before declining 26 basis points (0.26%) to close the month at 2.92%.

Through year-end 2023, meetings of the monetary policy-making Federal Open Market Committee (FOMC) are scheduled as follows:

Following a 75-basis point increase on June 14-15 in the FOMC’s fed funds target monetary policy rate, to a 1.50%-1.75% range, a number of FOMC voting members have been advocating for a second 75-basis point hike in the target fed funds rate at the upcoming July 26-27 meeting. If enacted, that would lift the target monetary policy rate to a 2.25–2.50% range by the end of July.

As shown in the nearby chart, market participants in fed funds futures trading have recently been expecting the fed funds policy rate to continue rising through the course of this year to reach a midpoint above 3.50% in early 2023. Then, based on their assessment of: (i) the evolution of an already declining demand picture in the U.S. economy, perhaps encompassing a full-blown recession; and (ii) further stages of monetary policy tightening by the Fed adding contractionary downward force to interest-sensitive sectors of the economy (including housing, automobiles, and other big-ticket consumer outlays), fed funds futures market participants at the end of June were pricing in 40 basis points of interest rate cuts in 2023.

In addition to declining expectations for the level of fed funds futures in the second half of 2023: (i) several other fixed-income derived inflation expectations over the next 5–10 years have been falling; (ii) industrial commodities prices have been easing; and (iii) many sectors in the Value style category (such as industrials, metals, and energy stocks) have been exhibiting varying degrees of price weakness. In some ways, such market behavior has fostered expectations that inflation could peak sooner than expected and thus allow the Fed to hike monetary policy rates at a slower pace than anticipated.

At this point, we are of the opinion that the Fed is likely inclined to continue monetary tightening in order: (i) to slow inflation through (a) the direct effect of higher interest rates on the real economy, as well as through (b) asset price declines in the highly financialized U.S. economy; (ii) to buttress the central bank’s inflation fighting credentials; and (iii) to “store up” higher levels of policy interest rates in order to be able to stimulate the economy through interest rate cuts as recessionary episodes appear.

As we expect the economy to continue slowing in response to: (i) elevated rates of inflation crimping overall demand; (ii) continued increases in monetary policy interest rates; and (iii) Quantitative Tightening (monthly reductions in the Federal Reserve’s balance sheet, increasing from a $47.5 billion rate in June, July, and August to a monthly rate of $95.0 billion commencing September 1), our stance at this point is to remain flexible and data dependent, before beginning in the coming year to modestly add funds to longer duration fixed-income securities and to other beneficiaries of declining interest rates.

The Economy and Corporate Profits

In conjunction with the Federal Open Market Committee (FOMC) meeting held on June 14–15, 2022, Fed Governors and Federal Reserve Bank Regional presidents submitted their projections of the most likely outcomes for U.S. real gross domestic product (GDP) growth, the unemployment rate, and inflation for 2022, 2023, and 2024 (as well as over the longer run). Each participant’s projections have been based on information available at the time of the meeting, together with her or his assessment of appropriate monetary policy — including a path for the federal funds rate and its longer-run value — and assumptions about other factors likely to affect economic outcomes. The longer-run projections represent each participant’s assessment of the value to which each variable would be expected to converge, over time, under appropriate monetary policy and in the absence of further shocks to the economy. “Appropriate monetary policy” is defined as the future path of policy that each participant deems most likely to foster outcomes for economic activity and inflation that best satisfy his or her individual interpretation of the statutory mandate to promote maximum employment and price stability.

For each time frame, the median represents the middle projection when the participants’ projections are arranged from lowest to highest (when the number of projections is even, the median represents the average of the two middle projections). The nearby chart displays the June (and March) median economic projections of the FOMC.

As displayed in the nearby chart, June FOMC median GDP projections call for U.S. real GDP growth of +1.7% in 2022, +1.7% in 2023, and +1.9% in 2024, down from the March projections of +2.8% in 2022, +2.2% in 2023, and +2.0% in 2024. The June FOMC median projections call for 3.7% unemployment at the end of 2022, 3.9% at the end of 2023, and 4.1% at the end of 2024, up from 3.5% unemployment at the end of 2022, 3.5% at the end of 2023, and 3.6% at the end of 2024. The June FOMC median Personal Consumption Expenditures inflation forecasts call for +5.2% in 2022, +2.6% in 2023, and +2.2% in 2024, up from March PCE inflation forecasts of +4.3% in 2022, +2.7% in 2023, and +2.3% in 2024. And the June Core (ex food and energy) FOMC median Personal Consumption Expenditures inflation forecasts call for +4.3% in 2022, +2.7% in 2023, and +2.3% in 2024, up from March Core PCE inflation forecasts of +4.1% in 2022, +2.6% in 2023, and +2.3% in 2024.

Recognizing the fallibility of all human forecasting efforts, including those of the Federal Reserve, we can observe that the Fed Governors and Regional Bank presidents have significantly downshifted their outlook for U.S. 2022 GDP growth, even as they have meaningfully increased their projection of 2022 headline Personal Consumption Expenditures inflation. Some international perspective is contained in the nearby chart (published in mid-June) containing 2022 and 2023 GDP projections of the International Monetary Fund (IMF).

From the chart, it can be seen that the IMF projects +3.7% real GDP growth for the U.S. in 2022 and +2.3% in 2023 (versus the FOMC’s median projection of +1.7% real GDP growth for the U.S. in 2022 and +1.7% in 2023). Also worth noting in the chart are significant slowdowns in World Output (+3.6% in 2022, versus +6.1% in 2021), as well as in the GDP of the Euro Area (+2.8%, down from +5.3% in 2021), China (+4.4%, down from +8.1% in 2021), Brazil (+0.8%, down from + 4.6% in 2021), Mexico (+2.0%, down from +4.8% in 2021), and South Africa (+1.9%, down from +4.9% in 2021).

Our view envisions a recessionary phase in the U.S. economy in coming quarters. After -1.6% annualized real GDP growth in 1Q2022, as of July 1, the Atlanta Fed GDPNow forecasting tool was predicting a -2.1% GDP contraction for 2Q2022, with the nearby chart depicting an unexact trajectory of how we expect slowing economic growth to fall short of the U.S. economy’s 2015–2019 real GDP trendline growth path.

Against a backdrop of slowing Purchasing Managers Indices (Manufacturing, as well as Services), and possibly a recessionary GDP path unfolding, we are concerned about the possibly detrimental implications for corporate earnings per share results. According to analysts’ estimates collected by I/B/E/S Refinitiv and tabulated by Yardeni Research, S&P 500 earnings per share are projected to grow +11.6% in 1Q22, +5.1% in 2Q22, +10.7% in 3Q22, and +10.0% in 4Q22, with full-year earnings growth projected to be +9.9% in 2022 and +9.7% in 2023. The nearby chart shows the possibility of downward revisions to earnings per share growth in the coming quarters, and call for vigilant attention to be paid to Chief Executive Officers’ and Chief Financial Officers’ comments about the forward outlook on their companies’ earnings calls which will begin in the middle of July.

As a precursor of possible earnings weakness, the nearby chart shows analysts’ securities rating upgrades versus downgrades.

Even as S&P 500 price-earnings ratios have already contracted significantly thus far this year (as shown in the nearby chart), in our opinion, further equity price weakness (and further P/E ratio contraction, despite the P/E-boosting effects that may occur when earnings are lowered and prices are not lowered to the same degree) could lie ahead if S&P 500 forward earnings per share estimates are revised downward and the results fall short of current constructive earnings prospects.

Portfolio Positioning

Portfolio Positioning Strategies:

Following the S&P 500’s well above-average total return performance of +31.5% in 2019, +18.4% in 2020, and +28.7% in 2021, and in the current environment of: (i) monetary policy abridgement via interest rate increases and Quantitative Tightening; (ii) slowing economic outcomes; and (iii) elevated inflation, we believe that careful thought, planning, and attention need to be devoted to the investor’s most appropriate forms and vehicles for implementing the fundamental elements of Asset Allocation and Investment Strategy, which include:

1. Diversification: while it does not by any means guarantee a profit or ensure against a loss, diversification means including low- and negatively-correlated investment exposures that truly counterbalance price movements in other assets, particularly during times of significant financial stress and/or rising financial asset volatility;
   
2. Rebalancing: which encompasses consideration of when to use concepts of reversion to the mean and market price dislocations to trim exposures to assets that have grown to represent too large a portion of the overall portfolio, while at the same time, adding exposures to high-quality assets that have fallen out of investor favor and suffered significant, though deemed not permanent, price declines versus intrinsic value;
   
3. Risk Management: which involves recognizing when markets have become consumed by unrealistic expectations, meme securities, excessive speculation, momentum plays, “story stocks,” and information overload — a situation that has pertained at various times last year and earlier this year to a number of companies in certain parts of the cryptocurrency realm and the technology spectrum — and understanding the degree of liquidity, the true pricing realism, and the appropriate roles of short- term liquid securities, real assets, financial assets, and alternative assets during intervals of geopolitical disturbance and especially, in years-long or even in decades-long regimes of inflation, stagflation, deflation, monetary disruptions, and currency resets;
   
4. Reinvestment: which encompasses knowing when to emphasize and trade off income return versus capital growth, all the while keeping in mind the critical importance of discipline, equanimity, patience, perspective, cost consciousness, tax awareness, and longevity in capturing and compounding dividend, coupon, rental, maturing securities, and other forms of incoming capital flows; and
   
5. Asset Protection and Husbandry: which encompass considerations of current and likely future income, wealth, and capital gains taxation at the state, local, federal, and possibly international level; estate planning; relevant insurance design and structuring; cybersecurity shielding; portfolio monitoring and reporting; administrative expenses; forms, frequency, and means of asset access; and asset custody.

Portfolio Positioning Principles:

With roughly equal weightings to Growth, to Value, and to Defensive-style rubrics, we continue to allocate a meaningful exposure to equities (leavened by judicious apportionments to short-term, high-quality income- generating instruments), with prudent shifts between styles, sectors, geographies, and — where appropriate from a cost, timing, tax, liquidity, and size standpoint — public versus private markets. Given the equity and fixed-income price swings of the past three years, expressed below are a number of themes that we believe should be taken into consideration over the next few quarters and years in selecting asset categories, asset classes, asset managers, sectors, companies, and security types:

1. Paying Attention to the Value of Money: Taking advantage of (rather than being taken advantage by) the consequences of money printing, internal and external currency debasement, government debt monetization, and the ‘Modern Monetary Theory’ approach that to some degree in the pandemic- response era has at times been pursued by the Authorities — within shifting money and credit cycles — to service America’s massive explicit government and corporate indebtedness and the enormous implicit obligations of pension and healthcare benefit promises;
   
2. Concentrating on “All-Weather” Sectors and Companies: Seeking investments with balance and flexibility, that are able to thrive regardless of: which political persuasion informs the thinking and policies of the White House, Congress, the judiciary, the state legislatures, and relevant domestic and international regulatory authorities; evolving Environmental, Social, and Governance (ESG) priorities and values; wealth distribution initiatives and public health conditions; episodes of geopolitical tension (such as have especially pertained in recent months), entente, and detente; and wider socioeconomic trends;
   
3. Distinguishing Between Temporary and Permanent Change: Focusing on the commercial and financial implications of new social and political power structures, alliances, and global associations; new energy sources and resources; new trade channels; new on- and offshoring structures; new cost, logistical, supply-chain, and transportation modalities, hybrid “WFH” and “WFA” (Work From Home and Work From Anywhere) employment patterns; and new business models, pathways, digitalizations, and forms of person-to-person and business-to-business work, leisure, learning, and wellness activity;
   
4. Taking Advantage of Demographic Tailwinds: Through U.S. and select non-U.S. companies, recognizing current economic and financial challenges facing several emerging markets and using significant asset price and valuation discontinuities, shifts in currency exchange rates, and shifts in consumer and business preferences to gain exposure to, and benefit from the rising needs, aspirations, and appropriate spending power of, the expanding global middle class (Please see the nearby chart for data on the past and projected growth of the middle class as a percent of the total inhabitants in five large population countries – India, Indonesia, China, Brazil, and Mexico)

5. Comprehending and Verifying Past Success: Emphasizing companies and sectors that have demonstrated successful track records and past experience in: competitive preeminence; abundant free cash flow generation; capital allocation skill; balance sheet strength; risk management; sustainably defendable business models; and the ability to maintain high multiyear returns on equity (derived from revenue growth and favorable margin preservation, rather than through disproportionately high levels of leverage) meaningfully above the companies’ and sectors’ weighted average cost of capital; and
   
6. Identifying Innovative and Disruptive Technology Hegemons: Recognizing when, at various points in economic and financial market cycles, to focus on technology enablers, disrupters, and dominators in such fields as diagnostics, biotechnology, and therapeutics based on CRISPR (Clustered Regularly Interspaced Short Palindromic Repeats), weight management and wellbeing, public health, medical nutrition, regenerative medicine, artificial intelligence, data analytics, machine learning, 5G cellular network technology, the Internet of Things, infrastructure, robotics, retraining, quantum computing, battery inventions, alternative energy, virtual reality and augmented reality devices, hypersonic aviation, electric vehicles, and cybersecurity, while not least, also taking account of the Environmental, Social, and Governance (ESG) risks, aspirations, and initiatives of companies in these and other fields.

Portfolio Positioning Tactics:

1. Keeping Things in Perspective: Many of the overarching themes and conditions that influence our intermediate- and long-term asset allocation and investment strategy emphasize the need to recognize that the concepts and implementation methods intended to achieve safety, balance, purchasing power protection, diversification, and liquidity are likely to face evolving (and sometimes, rapidly shifting) internal financial market dynamics, taxation regimes, regulatory emphases, social priorities, geopolitical power relationships, price level changes, demographic trends, indebtedness levels, technological penetration and usages, financial structures, currency systems, and importantly, perceptions of the definition, role, degree of physicality, embodiment, and value of money itself.
   
2. Flexibility versus Conviction in Formulating Investment Thinking: In seeking to determine when to adhere to, and when to lean against, prevailing consensus views (such views may be sometimes pejoratively referred to as “groupthink”), it is important to critically question the soundness and durability of the reasoning and assumptions underlying a given investment framework and positioning at any point in time. While it at intervals may not make sense to hold out-of-consensus views — often expressed as “fighting the tape,” — at other times — especially at major cyclical or secular turning points (at a significant asset top, when reality is finally found to fall short of prevailing overly optimistic expectations, or a major asset bottom, when reality is shown to be worth considerably more than prevailing overly pessimistic expectations), the rewards of implementing a contrarian stance can be quite meaningful.
   
3. Enhancing and Preserving: Even with some of the speculative fervor having materially diminished thus far this year in more than a few areas of the financial realm, we still confess to a degree of unease over several lingering manifestations of investor exuberance, and the popularity of certain securities and sectors considered to be “forever holdings” — our preference at this juncture remains to take note of the Federal Reserve’s explicit policy measures to rein in inflation, while taking advantage of episodes of asset price strength to continue the course of upgrading positions — offloading lower-quality, higher- risk assets and with timing and price discipline, gradually adding to attractively-priced, higher-quality assets on equity market pullbacks.
   
   With monetary policy interest rate increases and Quantitative Tightening (Federal Reserve balance sheet reduction) under way; slow growth in China and slowing growth in Europe; and in view of our expectation of continued asset price volatility in the months ahead, prudence counsels remaining aware of the narrowed market breadth, along with the meaningful first half of 2022 headline and below-the-surface deterioration in the Russell 2000, the Nasdaq Composite, and the S&P 500 indices, while formulating specific game plans to take advantage of such retrenchments as a key element determining the timing and amount of new capital commitments.
   

4. Equity Emphases and De-emphases: In the current conditions of higher U.S. Treasury interest rates, particularly at the short end of the maturity spectrum, to us it appears likely that cash-generating, financially-stable companies with robust growth prospects, which are able to operate and thrive against a distinctly unsettled geopolitical backdrop and in the digital sphere as they continue to enhance their business models, deserve to retain some degree of a valuation affirmation. Within equities: (i) we recommend continuing to gradually shift emphasis from Growth sectors, companies, and managers towards the inclusion of select Value and Defensive sectors, companies, and managers (with a focus on energy, industrials, select financials, materials, Covid-recovery, reopening, and consumer staples sectors, and a concomitant de-emphasis on companies and sectors dependent on access to low-cost energy); (ii) we continue to counsel very selectively adding small- and mid-cap companies (or investment managers specializing in and with good track records in this space) to our primary emphasis on large-capitalization enterprises; and (iii) for the time being, while we continue to prefer a tactical overweighting to U.S. domestic equities — with pullbacks such as those encountered in January, April, and June viewed as an opportunity to only carefully and highly selectively add equities, particularly those sectors and companies likely to thrive in a less-predictable economic environment — we also espouse holding (or gradually building) relatively defined allocations to global leaders listed in international markets.
   
5. Focus on Strength and Quality: Our long-term equity portfolio weightings continue to emphasize asset managers, sectors, and specific companies that can benefit from the major identifiably sustained trends of the 2020-2030 decade, including: (i) incremental growth in a wide range of economic circumstances; (ii) a focus on economic and infrastructure repair, digitalization, e-commerce, personal wellness, safety, domesticity, home improvement, and sustainable consumer demand; and (iii) advantageous capture of benefits from onshoring, supply chain redesign, and deglobalization as important drivers of capital spending and disruptive innovation. At the company level in equities, as mentioned above in “Comprehending and Verifying Past Success,” we emphasize identifying and building long-term exposure to firms possessing fortress-like, cash-rich balance sheets, prudence in balance sheet utilization, limited debt, consistency and durability of positive free cash flow generation, dividend strength, and competitive business models with abiding competitive advantages (high barriers to entry, low threat of substitute products, and enduring pricing power vis-à-vis suppliers and/or customers) that over a long time frame can generate high returns on equity through revenue growth and sustainable profit margins, rather than through unhealthily high levels of leverage. At the current time, we recommend that consideration be given to top-quality companies in the healthcare and consumer staples sectors, as well as firms exceptionally-positioned to benefit from inflationary forces in the real assets sectors that have demonstrated an ability to take advantage of shifting price level changes.

6. Balancing Growth and Value Sectors: At its closing level of 2202.06 on Thursday, June 30th, the price return of the Russell 1000 Growth index (symbol RLG, and including companies in sectors such as technology, healthcare, and communication services) was (according to The Wall Street Journal) down -28.4% from its December 31,2021 closing level of 3074.99, while the price return of the Russell 1000 Value index (symbol RLV, and including companies in sectors such as financial, real estate, energy, utility, and industrial businesses) was, at its closing level of 1427.46 on Thursday, June 30th (according to The Wall Street Journal), down -13.8% from its December 31,2021 closing level of 1655.73. This 14.6 percentage point (14.6) Value minus Growth returns differential appears to argue for continuing a degree of balanced exposure in selected Value sectors, companies, and managers as well as in selected Growth sectors, companies, and managers. As this process continues, it is worth keeping in mind that true value investing represents identifying and owning assets that are trading for less than they are actually worth, not assets that are merely inexpensive. Many superficially inexpensive assets may be inexpensive for a reason, and can very well remain so or deteriorate further.
   
7. Fixed Income Securities: Reflecting some of their largest quarterly price declines in more than three decades, U.S. Treasury bond prices year-to-date through June 30th have declined -3.2% in the 1-3 year maturity range, -11.0% in the 7-10 year maturity range, and -22.5% in the above 20-year maturity range. Even though yields have continued to move upward in the past month, to us they appear likely to be subject to conflicting forces, with higher yields coming from monetary tightening, perhaps counterbalanced by lower yields coming from the economic retrenchment brought about in the monetary tightening. And outside the United States, as shown in the nearby chart, according to Bloomberg in late-June, a dramatically lower total of $1.7 trillion (down from $18 trillion in early 2021) was outstanding in global negative-yielding sovereign — and some corporate — debt outstanding). We continue a preference for issuers at the high-quality end of the rating spectrum, both in taxable investment grade and high-yield bonds and in tax-exempt bonds (where we see some pockets of value on a taxable equivalent basis). We view fixed income securities as continuing to be subject to Federal Reserve policy-induced price risk due to our current expectation of higher yields as 2022 progresses, and thus we prefer maturities and durations along the short-to-intermediate portion of the yield curve spectrum.

8. U.S. Dollar Outlook: After declining -9.9% in 2017, appreciating +4.4% in 2018, marginally gaining +0.4% in 2019, and declining -3.4% in 2020, the DXY U.S. dollar index measured versus a basket of six major currencies — the euro, Japanese yen, Swedish krona, British pound, Canadian dollar, and Swiss franc — had as of its market close of 95.97 on December 31st, appreciated +6.7% in 2021. On Thursday, June 30th, the DXY U.S. dollar index had appreciated +9.1% year-to-date, closing at 104.70. Over the next few quarters, given our expectations of the Federal Reserve: (i) continuing its policy interest rate increases; and (ii) commencing the process of reducing the size of its portfolio of U.S. Treasury and mortgage- backed securities, we believe the U.S. dollar may rise relative to major currencies including the euro and Japanese yen.
   
9. Alternative Investments and Real Assets: In alternative investments, we continue our multi-quarter focus that has for some time emphasized exposure to: (i) commodities and real-asset sectors of the economy including industrial metals, agriculture, and materials, (ii) gold and/or gold mining ETFs/shares (particularly those miners with reserves in stable geographic locations, capital discipline, and cash flow growth); (iii) high-quality master limited partnerships with strong business models and sustainable dividend-paying capacity; (iv) select investments in private credit and private real estate; (v) and opportunistic strategies that are positioned to selectively derive meaningful value from dislocations created by geopolitical developments and/or potentially injurious mutations of the coronavirus, as well as the economic and profits recuperation therefrom.

— David Martin Darst, CFA Dynasty Financial Partners

Investment Strategy Themes for 2022

To continue our Investment Strategy Themes for 2022, we are including them below, surrounded by the 27 flags flown by the United States of America in the 246 years since our nation’s founding. In preparing Portfolio Positioning Strategies, Portfolio Positioning Principles, and Portfolio Positioning Tactics for 2022, we again pay tribute to the oft-quoted observation of the 34th U.S. President (and Five-Star General) Dwight David Eisenhower (1890- 1969) that “plans are useless, but planning is indispensable.” With this wisdom in mind, our 2022 Investment Planning approach reflects and encompasses the following themes:

1. Growing but Slowing GDP as forecast by the FOMC median projection (approximately +1.7% in 2022) and 2022 corporate profits as estimated by FactSet (approximately +9.9%), with downside risk to both projections
   
2. Implementing a restrictive monetary and fiscal policy backdrop
   
3. Fluctuating financial asset prices in conditions featuring shifting performance leadership and increased equity (VIX), bond (MOVE), and currency (VXY) volatility
   
4. Differentiating with emphasis on greater discernment and selectivity in asset classes, managers, sectors, and companies
   
5. Challenging — in an environment of elevated valuations, the easy money has been made, with the recent significant sharp upward and downward swings in individual securities prices not a usual characteristic of bull markets

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In addition, we have included content from some of our asset management and research partners:

•  Envestnet PMC Economic & Market Overview Q2 2022
•  J.P. Morgan: Guide to the Markets 3Q 2022
• Widsom Tree: Economic & Investments Chart Book Q3 2022
• Callan: Unprecedented Territory – And the Inherent Limits of Diversification 

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If you are interested in any other market commentaries, or have further questions, please contact us.