Portfolio Commentary—2nd Quarter 2022

SUMMARY and TAKEAWAYS

  1. High inflation and Federal Reserve tightening have historically led to bear markets.
  2. Bear markets and recessions are typically related.
  3. Stocks typically bottom before the end of recessions.
  4. Today’s Inflation is part pandemic related, baby-boom retirement related, and part green energy policy driven
  5. Consumer confidence is at lows and indicates a consumer recession
  6. Low consumer confidence typically precedes post recessionary recoveries
  7. Mid-Term election years historically start weak, then rally to a post mid-term year high

Portfolio Commentary

Written by Allen Gillespie, CFA®, Chief Investment Officer

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Inflation, Recessions, Corrections & Bear Markets

At this point, it is no secret that inflation has boldly made its reappearance on the investment scene. The most recent year-over-year measures of the consumer price index have been over 8%, a level last reached in 1981. The price increases in many goods, mainly crude oil, food, and fuel, have been a shock to many consumers, businesses, and government officials.  The eye-popping inflation has forced the Federal Reserve to raise short-term interest rates and to reverse its quantitative easing policy.  Quantitative easing has been the policy of the Federal Reserve since the global financial crisis of 2008 and the U.S. credit downgrade of 2011.  The new policy of the Federal Reserve is quantitative tightening.

Short-term interest rates compete for investor dollars, so as short-term interest rates have begun racing higher, both stocks and bonds both have been trading lower to start the year in 2022. The weakness in stocks and bonds, in turn, has caused an increased in recessionary and bear market fears and chatter. The inflationary and recessionary fears are warranted, as the United States economy is dominated by the consumer.

Consumer spending accounts for roughly 70% of U.S. GDP, and higher interest rates and higher fuel prices directly reduce consumer purchasing power.  The combination of higher energy prices and higher interest rates has historically preceded U.S. recessions as detailed in numerous reports, including one written by former Fed Chairman Ben Bernanke. Most recently Standard & Poor’s research detailed the following:

Y/Y % Changes in Headline CPI Since 1948

Source: CFRA, S&P DJ Indices, Bureau of Labor Statistics, NBER. Past performance is no guarantee of future results. Data: 12/31/47-5/20/22.

“There have been 12 bear markets since 1948, and an equal number of recessions. While most bear markets were triggered by impending recessions, not all bear markets were paired with recessions. Three bears (1961, 1966, and 1987) occurred independently of recessions, while three U.S. recessions were not preceded by bear markets (1953, 1960, and 1980). When the stock market did anticipate a recession by slipping into a bear market, the peak in prices occurred an average of seven months prior to the recession’s start. Only once did a recession start simultaneously with a top in prices (1990). Encouragingly, while recessions lasted an average of 10 months, bear markets bottomed an average of four months prior to the end of recession.

The unnerving historical implication is that every time the Y/Y change in Headline CPI exceeded one standard deviation above the mean, the U.S. fell into recession and the S&P 500 suffered through a bear market. In addition, these bear markets ended up being deeper than those not associated with recessions, falling an average of 38% versus 28%, respectively. Moreover, bears with recessions lasted longer (an average of 15 months) than bears not associated with recessions (average of six months).

Should history repeat by accurately predicting that the current correction (-10.0 to -19.9%) will become a bear market (-20%+), target prices based upon 50.0% and 61.8% retracement levels indicate possible declines to 3,517 (-26.7%) and 3,215 (-33.0%). Encouragingly, both decline levels are less than the average for all bear markets since WWII.”

At this point, FinTrust believes it is important to take a clearer look at the inflationary and recessionary signals. Some of the inflationary forces impacting the economy are secular in nature, some are policy driven, and others are hangover effects from the Covid pandemic shutdowns. As a result, we do not believe the inflation picture is as permanently negative as the market anticipates. The pandemic related inflation effects should begin to ease this year, the policy forces can be changed with elections and by consumer choices over time, but the secular inflationary forces will remain. Meanwhile, today’s economy lacks many classic recessionary indicators like excess business inventories and inverted yield curves. As a result, we believe inflation will moderate but remain higher than pre-pandemic levels.

Examples to illustrate the three different types of inflationary effects.

Pandemic related inflation. Suppose we look at the automobile market, new car production shutdown during the pandemic. Meanwhile, the demand side of cars experienced a huge jump, as consumers were helped by stimulus checks, low interest rates, and the desire to move out of major metropolitan areas. As consumers competed to buy the only cars that were available, prices for used cars increased dramatically. We believe this type of inflationary pressure should ease as production returns, stimulus checks are removed, and interest rates rise. 

Policy related inflation. The Biden Administration, the UN 2030 agenda, and environmental lobby want to accelerate a global transition away from hydrocarbon to “cleaner” energy resources. As a result, current policies are designed to raise energy prices to encourage both substitution and conversation. The war in the Ukraine has added additional pressure to these policies, as Europe is attempting to free itself from Russian oil and gas supplies.  While substitution and conservation effects, like an increase in solar, are happening at many levels, they are not happening fast enough to keep this transition from being highly disruptive, particularly to global food supplies. Higher energy prices have historically not been a great policy platform for elections in the United States, and Germany will face a much more challenging situation come winter. As a result, we expect that while the underlying goals of an energy transition will remain, more realism about timelines and what is possible will enter the discussion come fall and winter.

 Secular inflation. It has been said that demographics are destiny, and the peak year in the baby boom was 1957, so the average baby boomer will turn 65 in 2022. Over 40% of the baby boomers have retired, and the next four years will see a historic increase in retirement age eligibility. When combined with a Generation X labor force that is by our estimates 19% smaller, you have the conditions for a tight labor market until companies can recruit and train up the larger Millennial and upcoming Gen-Z workforce.

Poor Consumer Confidence Indicates Recession but Precedes Recessionary Recoveries

1. Consumer confidence is at lows and indicates a consumer recession
2. Low consumer confidence typically precedes post recessionary recoveries

Year-to-date, there have been very few places to hide and market inflationary concerns and higher interest rates are leading to a contraction in earnings multiples. The first five months of 2022 have been the worst start for the S&P 500 since 1970 and the sixth worst back to 1928. While caution is warranted, we believe the equity risk premium (the return of equities above cash and inflation) continues to make a case for equities. Stock valuations have come down, and the market has declined more than the average earnings decline associated with recessions. Moreover, the consumer knows its bad out there, as consumer confidence recently hit 40-year lows. In the chart below, however, you will also see that such poor consumer sentiment usually precedes large equity market recoveries as markets recover from recessionary conditions.

Mid-Term election years historically start weak, then rally to a post mid-term year high

Since 1950, the average decline during mid-term election years has been 16.3% and the subsequent returns have averaged 37.2%.

Key Index Performance

Index QTD YTD
S&P 500 (Large Capitalization Equity) -16.10 -19.96
S&P 400 (Midcap Equity) -15.42 -19.54
S&P 600 (Small Cap Equity -14.11 -18.94
S&P 500 Growth Stocks -20.81 -27.62
S&P 500 Value Stocks -11.27 -11.41
S&P GSCI (Commodities) 2.01 35.80
S&P U.S. Aggregate Bond Index -4.70 -10.01
Balanced Weighting (60/40) -11.54 -15.98
S&P 500 Sectors QTD YTD
Energy -5.17 31.84
Utilities -5.09 -0.55
Consumer Staples -4.62 -5.58
Health Care -5.91 -8.33
Industrials -14.78 -16.79
Materials -15.90 -17.89
Financials -17.50 -18.73
Real Estate -14.72 -20.02
Information Technology -20.24 -26.91
Communication Services -20.71 -30.16
Consumer Discretionary -26.16 -32.82

*Source: S&P Dow Jones Indices

Thank you for the trust you have placed in us, particularly during this difficult market environment. As always, if you have further questions, please do not hesitate to contact your FinTrust investment advisor.

Sincerely,
Your FinTrust Investment Team.

Important Disclaimer

Securities offered through FinTrust Brokerage Services, LLC (Member FINRA/ SIPC) and Investment Advisory Services offered through FinTrust Capital Advisors, LLC. Insurance services offered through FinTrust Capital Benefit Group, LLC. This material does not constitute an offer to sell, solicitation of an offer to buy, recommendation to buy or representation as the suitability or appropriateness of any security, financial product or instrument, unless explicitly stated as such. Past performance is not necessarily indicative of future returns. This information should not be construed as legal, regulatory, tax, or accounting advice. This material is provided for your general information. It does not take into account particular investment objectives, financial situations, or needs of individual clients. This material has been prepared based on information that FinTrust Capital Advisors believes to be reliable, but FinTrust makes no representation or warranty with respect to the accuracy or completeness of such information. Investors should carefully consider the investment objectives, risks, charges, and expenses for each fund or portfolio before investing. Views expressed are current only as of the date indicated, and are subject to change without notice. Forecasts may not be realized due to a variety of factors, including changes in economic growth, corporate profitability, geopolitical conditions, and inflation. The mention of a particular security is not intended to represent a stock-specific or other investment recommendation, and our view of these holdings may change at any time based on stock price movements, new research conclusions, or changes in risk preference. Index information is included to show the general trend in the securities markets during the periods indicated and is not intended to imply that any referenced portfolio is similar to the indexes in either composition or volatility. Index returns are not an exact representation of any particular investment, as you cannot invest directly in an index.

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