Market insights and analysis

How dynamic, risk-managed investment solutions are performing in the current market environment

2nd Quarter | 2022

Market insights and analysis

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Updates on how dynamic, risk-managed investment solutions are performing in the current market environment.

By Jason Teed

The major U.S. stock market indexes fell sharply last week, with the S&P 500 hitting bear market territory as of Monday’s close. The Russell 2000 was the worst performer for the week, down 7.48%. The Dow Jones Industrial Average was the best performer, falling 4.78% for the week. The 10-year Treasury bond yield rose 7 basis points to 3.23% as rates edged upward, peaking on June 14 at 3.47%. Spot gold closed the week at $1,839.39, down 1.72%.

All 11 sectors were down last week. Energy was the worst performer, down an astonishing 17.16%. Consumer Staples and Health Care were the best-performing sectors, falling 4.39% and 4.51%, respectively.

Stocks

Stocks resumed their downward volatility last week after inflation readings came in higher than expected for the prior month. Inflation in May was at 8.6% year over year, a reversal of April’s decline from the previous high of 8.5% in March.

The market expected higher interest rates to cause inflation to continue to slow. When that did not happen, concerns that the Federal Reserve would need to be even more aggressive in raising rates increased.

These concerns were well-founded. The Fed increased the federal funds rate by 75 basis points, the highest one-time increase since 1994. It is expected to do so again for July’s meeting. This would put the rate at its highest level since 2019.

As the rate increases beyond the July meeting, we’re likely to enter territory that we’ve not seen since before the 2008 financial crisis. Consensus currently puts the rate around 3.4% by the end of 2022, though that estimate has been revised upward in recent months.

Rising interest rates hurt many asset classes. Bond prices are most directly affected, having an inverse relationship with yields. However, stocks also tend to be negatively affected by rising rates for many reasons. First, rising rates make it more expensive for companies to grow through debt, creating a drag on earnings growth. Second, rising rates discourage consumers from purchasing products, potentially depressing growth even further. Third, as rates rise, equity investors begin demanding more earnings from companies to justify a given price level, which lowers the PE (price-to-earnings) ratio that is acceptable to investors. All three factors create a drag on stock prices.

When economic slowing is caused by rising rates, the typical bond-equity diversification that passive investors use tends not to work very well. This has proven to be the case so far this year. Currently, the six-month return of a typical 60/40 portfolio is the lowest it’s been in decades, except during the 2008 financial crisis, which was more driven by equity losses than we’re seeing so far this year. Given the current economic situation, the performance of this portfolio could exceed the losses experienced then.

Indeed, dollar for dollar, we’ve experienced the largest destruction of wealth in history—though, that number is not adjusted for inflation.

When investors experience such a loss of wealth, typically they respond by hunkering down and spending less overall, which is one of the overall goals of the Fed. But can investors do so without causing a recession?

As we get further into the year, it seems more likely that a recession will occur. Market forecasters continue to increase their estimates. The question is whether the market is currently pricing in a recession. Goldman Sachs and Morgan Stanley recently stated that it is not. They believe the markets are adjusting price multiples rather than expecting an actual slowdown in earnings. Should a recession be priced in, both are predicting additional market slides 15%–20% lower than current levels.

The risk of a recession will remain until either one materializes or inflation begins to cool, allowing the Fed to be less aggressive than it currently plans to be. Regardless of what occurs, investors should pay close attention to inflation readings in the coming months.

Bonds

Treasury yields were up for the week. Shorter-term yields rose faster than longer maturities.

The term yield fell 4.6 basis points, and credit spreads rose by about 23 basis points. Both movements indicate expected economic weakness going forward. Overall, long-term Treasurys outperformed high-yield bonds, and longer-term bonds underperformed shorter-term bonds.

The yield curve remained inverted last week, with the two-year remaining above the 10-year yield for the week. An inversion often signals a coming recession within the next year or so. The market expects that rates will continue to rise, with potentially another 75-basis-point increase in July, as the Fed continues to combat high inflation. Economic messaging from the bond market seems pessimistic this week.

Gold

Spot gold was down last week after bottoming out on Tuesday’s close. Year to date, the metal is up about 0.37% after having experienced significant volatility.

Gold has faced recent headwinds. The Federal Reserve has increased rates significantly over the past few months and is expected to continue to do so. Rising rates make the U.S. dollar more valuable when compared to other currencies. Being priced in dollars, the value of gold appears to have downward pressure for a U.S. investor. An unexpectedly high inflation reading last month has renewed concerns that the Fed will have to continue to aggressively raise rates, which is increasing downward pressure on the metal.

Non-currency safe-haven assets, such as long-term Treasurys, were also down for the week as rates rose—despite a clearly risk-off environment. The rate increase led to the rising stock market. Given the nature of the pullbacks in stocks and bonds, it’s unreasonable to expect a higher correlation between these two asset classes in the near term.

Flexible Plan Investments is the subadvisor to the only U.S. gold mutual fund, The Gold Bullion Strategy Fund (QGLDX), designed at its introduction more than nine years ago to track the daily price changes in the precious metal.

The indicators

Our Political Seasonality Index began the week fully invested. It exited on Tuesday’s close and remained there to begin this week. (Our QFC Political Seasonality Index is available post-login in our Weekly Performance Report section under the Quantified Fund Credit category.) The very short-term-oriented QFC S&P Pattern Recognition strategy’s equity exposure began the week 1.6X long, changed to 2X long on Monday’s close, and exited the market on Tuesday’s close to begin this week.

Our intermediate-term tactical strategies have mixed exposure. The Volatility Adjusted NASDAQ (VAN) began the week with a 40% inverse exposure to the markets and changed to 60% inverse on Thursday’s close. The Systematic Advantage (SA) strategy began the week completely out of the market. It changed to 30% exposed on Wednesday, 90% exposed on Thursday, and 30% exposed on Friday’s close to begin this week. Our QFC Self-adjusting Trend Following (QSTF) strategy was 1X inverse to the market for the week. VAN, SA, and QSTF can all employ leverage—hence the investment positions may at times be more than 100%.

Our Classic strategy was fully invested last week. On Wednesday’s (June 22) close, Classic went to defensive mode. The strategy can trade as frequently as weekly.

Our strategies mostly remain relatively underexposed to the market, having exited several weeks ago. Volatility remains high and overall market direction has been trending downward year to date. Market professionals expect further downside volatility.

Flexible Plan’s Growth and Inflation measure, one of our Market Regime Indicators, shows that we remain in the Stagflation economic environment stage (meaning a positive monthly change in the inflation rate and negative quarterly GDP reading). This environment has occurred only 9% of the time since 2003 and has been a positive regime state for gold and bonds, while equities tend to fall. Gold tends to significantly outpace both stocks and bonds on an annualized return basis in this environment, with a lower risk of drawdown than equities. From a risk-adjusted perspective, Stagflation is one of the best stages for gold.

Our S&P volatility regime is registering a High and Falling reading, which favors gold over bonds and then equities from an annualized return standpoint. The combination has occurred 13% of the time since 2000. It is a stage of higher returns and higher volatility for all three major asset classes.



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