Mid-Year Report Card and Outlook for 2022

It’s fair to give the markets D or maybe an F for the first half of 2022. Watch the video below for our outlook for the remainder of the year. We cover our views on stocks, bonds, the economy, unemployment, and inflation. Most importantly, we provide practical ideas that you should consider for your own portfolio.

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Transcript:

Welcome to our 2022 midyear report card. My name is Brian C and I'm the founding partner of capital stewards. We are professional investors who help professionals from other fields make smart, long term investing in financial planning decisions.

Today I'm gonna share our view on the markets performance so far in 2022. And most importantly, what investors should be focused on as we head into the second half of the year. So let's dive in. So let's second look at what's happened so far this year, as most of you are probably aware stocks and bonds are down significantly since January the S and P 500, which is the measure of large companies in the United States is down almost 18%. The same is true in Europe and emerging markets.

And yields which is the return on treasury securities are up. They doubled in, in a lot of cases in the first part of this year. And so that means bond prices have fallen really from an asset perspective. The only thing that's really risen significantly so far this year is oil.

And we'll talk about that a little bit more as we get into the presentation, but instead of getting to myopically focused on what's happened just in the last three or four months I think it's really important that we zoom out because there's always the best investors make really long term investment decisions.

And so it's important to zoom out and if you've seen any of our other stuff, you'll see this frequently and kinda understand where we are in the arc of history and markets. As we go forward. So looking at the long term, the S and P 500 is earning close to 9% on average every year since the mid nineties.

I think during downturns it's especially important that we look at prior peak to trough declines and help and use that to help us inform where we are today. For example, even if you had invested in stocks, which are the red line on the chart or bonds for that matter, the green line at the height of the tech bubble or right before the great financial crisis or even right before COVID you would still be a really happy investor.

You have long term investment goals and therefore it's important to look long term have long term perspective and a long term investment plan in place to accomplish those things. If we zoom in just slightly over the last decade you've likely, still experienced really significant stock market returns.

Even after this year's market downturn, the S and P 500 has returned north of 13% over the last 10. You see it followed by real estate which is compounded significantly as well. Bonds and gold have slightly underperformed inflation but risk assets overall have, have done really well.

We saw a really historic rise in stock markets particularly coming out of the COVID pandemic. And so now some of that is reverting back towards Long term averages, but as a long term investor, your portfolio benefited from the upside of the last couple of years. So your long term investment goals if they were really well planned and you had a well constructed portfolio, should still be on track. Even with a challenging start to 2022, if you aren't sure. About your goals, we'd recommend that you talk to a professional, like us or another one that you trust to build a solid long term investment plan as you go forward.

As we expected in our 2022 forecast titled rising rates will impact everything rates have risen this year. And so why are markets down in 2022? Rising rates are the answer to that. The 10 year treasury bond yield, which is a good measure of the return that investors expect on sort of risk free assets of the us treasury. It's more than doubled. Since the beginning of the year, we moved from one and a half percent to just below three and a half percent. And that's caused that prices of many assets, including stocks and bonds to fall

what's causing rates to rise inflation. Food and energy prices are responsible for some of the move. Certainly that's been in the news, however, core CPI or core inflation which is the green line. And that measures inflation, excluding food and energy is up more than 6% for the year. And as you can see, that's historically a very high number prices on all fronts were trending higher before the Russian invasion of Ukraine.

So that was likely the cherry on top of an already challenging situation where global demand was growing faster than supply can catch. That's especially true in energy. Where years of under investment in sort of old school energy sources like coal and oil have caused shortages in supply. Now that COVID is over and the economy is normalizing.

So we'll discuss that a little bit more as we dive deeper, but inflation clearly has been the, the core cause of rising rates. And I think there's still some question as to the core source of inflation out. And, and I wanted to take some time to dive into that and clarify, what's really driving the inflation numbers because it's important as we think about the impact to the economy and future invest.

It's clear that while shortages exist in a limited number of supply chains, the real issue is that demand has outstrip production. If you look at manufacturer shipments, which are on the left side of this page we've compared pre COVID levels to where we were coming into this year, actually 12 30, 1 of, of 2021.

So. The end of last year and except for a few areas like textiles and vehicles the supply chains have largely sorted themselves out and manufacturers are shipping more goods , than they did before the COVID crisis started. So we can't really blame supply chains for everything that has transpired

on the other side of the page, you see the balance sheets of global central banks, which is a good proxy of the money. As you can see almost all central banks expanded their money supply significantly during the COVID recession to try to prevent a greater financial contraction.

And if you look at the expansion that occurred during the COVID crisis and compare it to what happened during the global financial crisis, it makes the global financial crisis in 2007, 2008, look like a hiccup on the chart. So from a policy perspective, whether. Government representatives in a country spend or whether the central bank itself stimulates the economy by, by printing money and, and sending it in through the banking system.

It shows up on the central bank's balance sheet. So all of that money needed a place to go and it showed up in assets like stocks and crypto over the last couple of years. And in every day goods purchases. It says many businesses were running lean due to COVID. They weren't able to expand and keep up with all the demand that was caused by the stimulus that was put into the economy.

So we have demand driven inflation. so now the federal reserve and other central banks are attempting to reverse course and tighten conditions to slow down that demand and to dampen inflation. You can see the federal reserve has raised rates already this year, one and a half percent. And markets expect that to continue.

You see recessions on the chart often following rate hikes. But that's not always the case. And we're gonna talk about this some more as well. If you look at Heights in the mid 1990s, it took more than five years. For a recession to actually happen. And that happened after the tech bubble burst.

And so was probably not completely due to the interest rate environment. So it's not a foregone conclusion that rising rates will cause a recession the feds move, however will absolutely slow the economy. And so it's a difficult question to know whether or not we're gonna get a recession market forecasters, see the odds of somewhere between 30 to 50%.

So that's about as helpful as slipping a coin. But our own view is we don't really need to know. The absolute endpoint of rates and GDP growth, which is the demarcation of a recession or non recession. We just need to know whether or not the Fed's medicine for inflation is working, whether the economy is slowing down.

And you can see from core labor demand that rate hikes and expected future rate hikes have started to flatten out the demand between job openings and available workers. Job openings , are the red line. And the available workers are unemployed.

Workers are the yellow line and you can see for the first time in modern history those two things inverted on the backside of COVID. And so we have more job openings than we have available workers. That gap has stopped increasing, but it remains really, really large. The technology sector is just maybe the most invisible tip of the employment iceberg.

There were 17,000 startup layoffs in may, another 11,000 so far in June. So there's evidence that tightening is slowing business investment. And some expansions and business fundings that happened in the past two years are not going to continue going forward. But clearly there's a lot more work that's gonna have to be done on this front before we have true balance back in the labor market.

The other thing we can look at is leading indicators of economic activity. And these are things like new manufacturing orders for consumer goods, building permits. Along with investment markets, they've started to move down, but they have further to go to, to signal that there's a true contraction happening in the economy.

So the, so the fed interest rate rises making an impact. But we're not really all the way there yet. So the economy is showing signs of slowing. It's not in a recession today and we think lower growth is gonna be needed to offset the pandemic stimulus and get things back in balance.

So the next logical question is how much will the fed have to raise rates? When we think back to the core CPI number that we were talking about a couple of minutes ago which was 6% year over year vehicle inflation, which is one area that is challenged by lingering supply chain issues is responsible for a little bit more than 1% of that.

So if we back that out, then that means the true core economy that the fed can control. Through interest rate raising is, is about 5%. The fed can't fix the supply chain issues. It can't make more cars, it can't make more oil, but it can slow down the core demand issue that it created by flooding the economy with money during the COVID pandemic.

So if core demand is running at 5% annually, history shows us. And if you look here at CPI which is the. Red line and the green line is the effective funds rate. If you look at those things historically, in order for CPI to slow down, when it has gotten to peaks, you see that the effective funds rate has had to get to levels that were at or above the CPI for that to happen.

And so it seems like the federal funds rate would need to go higher materially in order to slow down inflation. And in fact, the fed and market participants. The fed and market, the fed and market participants still don't believe that rates need to go higher. At least not much higher than three or 4%, just like they were at the beginning of the year.

Markets are also still only expecting the fed to move rates, maybe up to three and a half percent, three and three quarters of a percent by next year. So the federal reserve board expects about the same. You can see on the dot plot, which is where they survey the members and say, Hey, where do you think we need to raise rates to.

They're about 3.75% at the peak in 2023, nowhere near the 5% level that it seems history would show us that we need to be at to start to cool inflation. Given where the economy is today the fed also watches inflation expectations, and those have moved up significantly since January consumers now expect one year inflation to be 5.3%.

And so whether you believe the Michigan consumer surveys or the sort of informal survey of your friends, your family, and your neighbors, most people believe that inflation's really hot. And it's gonna be above 5%. And so we need to see rates above that level in order for inflation to go down,

if that move higher. So another question that comes up is whether the move higher end rates will cause a recession. And again, it's not so important for us to know from an investment standpoint, whether we're gonna get a recession or whether we're gonna have a slowing economy, we just need to know that the direction is slower.

It is important to have a good grounding on what recession really means. We did a podcast episode on this. I think it's sometimes it's sort of a, you know, the R word, a dirty word recession. And I think for many mid-career professionals, that's for good reason because the recessions that we have experienced recently have been really bad by historical standards.

They were caused by significant abnormalities in the economy. That was the overinvestment. In housing stocks or housing prices in , in the United States in 2007, 2008, a lot of the financing that was geared around that in Mor in the mortgage market mortgage backed securities. That led to a significant deflationary shock in in 2007, 2008 in the beginning of oh nine.

And then we had a government imposed, immediate shutdown of the economy for COVID in 2020. , normally when the fed causes a recession due to an overheating economy which you can see several examples of on the chart. If you go back in history through the seventies, eighties, and nineties, the recession is both short and milder than what has occurred in recent memory.

So a recession, especially by a historical standard, should not be a, a reason to abandon your long term investment plan. And I would not immediately equate the recession that we could see here to something like the financial crisis or the COVID recession. It's likely to be shorter. And more mild. . Let's focus on oil for a moment.

Since gas prices are a concern for everyone across the economy oil consumption is back at pre COVID levels. And us refining capacity is not. And so that clearly creates a, a mismatch a supply demand I balance, and that's gonna result in higher prices. Refineries were underinvested in during the last decade, following 2010, because oil was cheap.

And so integrated oil companies were losing. Investors wanted to focus on new energy, renewables, ESG, all those sorts of things. And that results in an underlying loss in refining capacity in the United States as with most areas of the economy, trying to force uneconomical activities Usually results in a snap back to reality.

Eventually a lot of those new energy sources will likely be profitable and scalable, and we will move in that direction of sort of more green energy. There's something wrong with that. But they're not there today. They're not scalable, they're not profitable. And so rising demand for energy. And limiting refining capacity to invest in other things results in really record low oil stocks.

And you see that in the upper right hand chart on this page. So we're actually making more oil in the United States than we made last year. But just not enough to keep up with demand. Again, we have a demand problem in the economy. A lot of folks wonder if OPEC will be able to sort of bail us out.

If you look at the chart on the bottom, right of this page, You'll see that the excess inventory that OPEC has is more akin to where it was in the 2000 8, 9, 10 time period, not the last couple of years where they had a lot of oil that they could put on the market to try to influence the price.

So the solution really to oil prices is a long term one hydrocarbon energy, coal oil, gas the production needs to increase in the us. We need an increase in refinery capacity in order to bring prices back down. That's a long term solution that takes months and years not weeks. It's, so it's not a short term solution.

The resolution of the Ukraine invasion probably will reduce some short term pressure. But that still probably leaves oil above $70 of barrel long term. And that's conservative. It could well be 80 or $90. It's not going to be in the forties or fifties. A barrel that we grew accustomed to seeing in 2016 through 2020.

So longer term, we expect oil prices to remain more elevated. So what does all of that mean for stocks and investment markets? There's two key inputs, to stocks. We've talked about this before, right? Profits and valuation valuation, simply the price that we paid to own a piece of those profits over the long term.

As you can see from the left hand side of the. Profits rose materially coming out of the COVID pandemic. That trend continued earlier this year. However, valuations on the right hand side of the page have fallen substantially. Given the rise in rates that we covered earlier the rising rates impact everything like we said, at the beginning of the year, not just bonds.

So going forward, earnings estimates have been moving lower since the end of the first quarter. It's the largest decline in estimate since the COVID pandemic, but we've had this really unusual, rapid increase in estimates. So analysts are expecting company profit growth to slow down, which it makes sense because they've been unseasonably high.

Profits are more likely to grow slowly over the next couple of years, year over year earnings growth maybe looks something more like 4%, which is what we've seen histor. Not 10, 11, 12%, something like that. Low PE ratios are the most important metric that investors use when they do quantitative investing and, and in qu screens.

And there's good reason for that. It's because valuation is the most. Correlated with stock market returns over time. So if I'm looking for something to predict the stock market valuations you know, there is no perfect predictor of the stock market, but valuations have statistically been one of the better ways to do that over time.

So said differently, average valuations. Have led to those average returns that we talk to and anchor around in our portfolios, low valuations tend to lead to above average returns and high valuations lead to below average returns. So we wanna buy at low valuations and sell at relatively high valuations, natural rebalancing that we talk a lot about helps ensure this process over long periods of time.

As assets appreciate, we seldom as assets depre. We buy more that helps ensure that we're buying when things are at low valuations and selling when things are at high valuations. So given that valuations are hovering around historical averages investors should be considering rebalancing portfolios back into neutral stock positions.

If you're underweight and you likely are, if you haven't done anything since the beginning of the year, because stock prices are down so much compared to where we were in January. I think this is also an opportunity for us to look at conventional wisdom and make sure we're thinking about facts and not just relying on sort of rules of thumb as we invest as earnings in the economy, downshift into low growth mode

Growth

typically outperforms value. In those, in those situations growth is outperformed value in recessions, going back to the 1980s the same is true in slowing economy. So whether we actually get a recession or we don't have a recession, if the economy is slowing down, growth tends to outperform value.

And the reason for that is. Is fairly straightforward. So traditional value stocks like banks and energy utilities, old school stuff, they need the overall economy to grow in order for their business to grow. Which makes sense., they're not innovating. They're generally moving fairly slowly. They need the economy to grow in order to take market share and to make more profits.

On the other hand, growth companies, they're building new business. They're acquiring new customers. And so their businesses are going to grow regardless of what happens in the economy. And so it's key to let history be your guide as we go through potentially a slower growth period or a recession and let that guide how you position your stock portfolio, not sort of rules of thumb that would say, Hey, we need to, be conservative going into a recession and, you know, sort of by maybe S dodgy old companies because history shows that they actually underperform during slower growth environments.

It's also important to think carefully about what's in your portfolio during a rising rate environments, and we've hammered this point home in our forecast earlier this year. We're talking about it again today, but this is a really, really important concept. Many individual portfolios still look like something on the left hand side of this page, which is like 60% in stocks and 40% in bonds.

Institutions have been way more diversified than. For years and years and years, for more than a decade a truly diversified portfolio, especially when rates are rising and likely higher, long term is more like what you see on the right hand side of the chart. Investors should own assets that do better when inflation and rates are higher.

And that includes things like commodities. Real estate infrastructure more diversification into assets beyond stocks and bonds is key to building a solid well diversified portfolio. If you portfolios a couple of target date funds and simply stocks and bonds, it's time to move past that to a new, more modern era type portfolio.

And to further emphasize the point. I, I just pulled a couple of examples. Commodities are up materially this year, so I didn't include that because I think everybody sort of has a sense for that. But infrastructure and credit, they're less well known examples in that diversified portfolio infrastructure investments are flat up early to up slightly so far in 2022, which is what we expect in inflationary environments.

Stocks and bonds are both materially lower. So on the left hand side of the page infrastructure is, is the blue lines, a couple of different types of, infrastructure investments there. And on the, right hand side of the page, you'll see private credit has produced positive returns so far this year. And that's really because private credit, unlike a lot of core bonds tend to invest in adjustable rate type structures. And so as rates. The, the rates on the, on the underlying debt payments from the company's increase.

And so the returns are more steady. So diversification, isn't just a nice euphemism. And it's not just a pie chart. It really helps drive risk adjusted returns over the long term. And it's something that we are working with our clients on and you need to be thinking about in your portfolio.

So lastly, my favorite asset class cryptocurrency, because stocks are boring now. Right. What about crypto? And I think many of the former darlings have moved on because everybody loves crypto when it's up a ton and then they hate it when it goes down. Our position doesn't change and it hasn't changed on cryptocurrency.

Since last year. We viewed crypto last year in all of its underlying sort of web three infrastructure as akin to a venture capital investment, lots of volatility, and a lot of risk, perhaps it pays off big in 10 years. Perhaps it's flat or worthless. Either way the volatility demonstrates that it's not a long term store of value and you shouldn't own it as a core part of your portfolio.

You should own it sparingly if at all. Blockchain's real, the associated sort of technology transformation is real. But the assets have not demonstrated, there are anything other than sort of a long term be on new technology, which is again like venture capital. So again, we own things like that sparingly in your portfolio, if at all, And it shouldn't be a core part of what you're doing from an investment perspective.

Okay. So what do we do in light of all of this? We always try to boil it down to a couple of things that are practical, that you can walk away with and implement yourself or work with your team to implement in your portfolio. And the first is to diversify into a modern portfolio. , we talked a little bit about what that is and it's getting beyond stocks and bonds. Commodities infrastructure private credit, there are lots of other asset classes that you need to be thinking about as you construct a portfolio. Tax loss. Harvesting also is really important right now. This is another area where the rules of thumb can sort of get you in trouble.

If you're investing in a taxable account and you sort of have this rule of thumb that, you know, it's only a paper loss if I don't sell it. So I just won't sell anything. You should be selling to capture the loss for tax purposes and then replacing that asset with something that's similar, but not identical.

And the rules there can be complex. And you wanna make sure you're working in a taxable account, not in an IRA so I would, I would definitely talk to a professional before you start doing this, but it's important to be taking those losses, realizing them so that you can use them to offset future investment gains and potential income as well.

And then the third thing is rebalancing. Calling market bottoms is really hard. A lot of professionals these days will tell you there's a 50% chance of a recession. I've heard sort of, as rates go up, we're gonna have a hard landing, a soft landing, a kind of bumpy, landing, a landing without the landing gear, all kinds of landings that might happen.

And, and all of that is. Really no more helpful than sort of flipping a coin or listening to the weather name what you can do. That's more proven over time is to buy depreciated assets and sell appreciated assets. So rebalancing and that discipline even in this market is the best chance you have to buy low sort of sell high systematically over the long term and through market cycle.

So take a look at your asset allocation check to see if it matches where your objectives are and where your investment plan is and take action if it doesn't. And if you don't have a really good, solid long term investment plan. And that's where you need to talk to your professionals so that you have something that you're comfortable with rebalancing into over the long.

We do each of these activities on behalf of our clients every day. If you're not sure how to proceed, it's super easy to schedule a call with us to get real professional and guidance. There's a link in the video notes that you can use. There's no sales pitch. We won't even let you sign up to work with us.

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So no pressure. But if you, if you want professional help, if you want professional guidance implementing into this schedule an intro call, it's really easy. . Why do our clients love working with us? It's really simple.

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You should be able to work digitally with professionals, but you should have a person that you can build a relationship with. And expert personal guidance should be combined with intuitive digital tools to make it really easy. Advice needs to come from a fiduciary.

That's solely concerned about your interest. If you're working with somebody who has a series, something licensed to sell you things, they're probably doing that and advisors shouldn't be compensated for selling products to you. They shouldn't be compensated for selling insurance or. Other securities, they should be compensated for giving you advice.

That's gonna help you get where you want to go. And that's what we try to do for our clients. And we also believe that you should understand how your portfolio works. You're in the driver's seat, it's your money. We're your professional advisors to help you get where you're trying to go. So those are the things that we implement and that's why our clients love working with us every day.

Thanks for listening . Feel free to reach out. If you have questions we help fix broken portfolios every day. We'd love to help you. If you have questions, have a great day.