Market Recap

It’s been a rough year, with equity markets down more than 20% and “low-risk” bond markets registering low double-digit losses. The S&P 500 dropped 16.1% for the quarter and is now down 20% for the year, after being down as much as 24% through mid-June. Foreign stocks fared slightly better with Developed international markets (MSCI EAFE Index) down 14.5% for the quarter and 19.6% YTD. Emerging Market (MSCI Emerging Markets Index) stocks held up a bit better, dropping 11.4% for the quarter, and down 17.6% YTD.

Core investment-grade bonds were pummeled again in the second quarter, with the benchmark Bloomberg U.S. Aggregate Bond Index (the “Agg”) dropping 4.7%. This puts the “safe-haven” AGG down an incredible 10.3% for the year to date — its worst first-half ever. In other segments of the fixed-income market, high-yield bonds (ICE BofA Merrill Lynch U.S. High Yield Cash Pay Index) fell 9.9% and floating rate loans (S&P/LSTA Leveraged Loan index) dropped 4.5% for the quarter.

As we have long pointed out, core bonds are not low-risk or defensive assets in an inflationary (rising interest rate) environment. Taken together with the equity bear market, this is by far the worst first-half performance for a traditional “60/40” balanced portfolio (60% S&P 500/40% Aggregate Bond Index) in modern history, down 16.1%. The previous worst first half was 1962, down 12%.

Portfolio Update

While absolute returns were disappointing this quarter, our balanced portfolios performed in-line with, or slightly outperformed their benchmarks.

Our tactical overweight to emerging-market stocks was a relative bright spot this quarter with emerging-market stocks declining 11% versus a 16% loss for US stocks. EM’s relative outperformance occurred despite a continued rally in the US dollar, which finished higher by 6% in the quarter (a strong US dollar is a headwind to foreign equity returns for US-based investors).

A headwind to performance this quarter included our meaningful exposure to credit-oriented, flexible bond funds in place of core investment grade bonds. While we’re confident that our line-up of bond funds can outperform in flat and rising interest rate environments, they are more sensitive to credit risk and generally won’t hold up as well when stocks decline.

Investment Outlook and Portfolio Positioning

Over the past few months, the economic backdrop has worsened with sustained high inflation and slowing growth, as the Federal Reserve and other global central banks aggressively tighten monetary policy. A sharp economic growth slowdown in the U.S. (and abroad) is all but certain this year and the risk of recession over the next 12 months continues to rise.

The ideal outcome would be the elusive “soft landing,” in which inflation is subdued without causing a recession. But the simple economic cause-and-effect influenced by the Fed’s toolkit assumes the supply side of the economy remains steady. However, this has not been the case due to (1) the Russia/Ukraine war’s impact on energy and agricultural commodities, and (2) COVID-related supply chain disruptions. We expect (hope) these shocks will recede with time. But the Fed can’t do anything about them. BCA’s U.S. investment strategist, Doug Peta put it well: “Soft landings are extremely elusive. It is fiendishly difficult to fine-tune a complex multi-faceted economy with central bankers’ blunt tools.”

Our best guess at this point is that if the U.S. economy does fall into a recession, it is likely to be a more “normal” type of cyclical recession rather than like the 2008-09 financial crisis, the 2000-2002 dotcom bubble bust, or the 2020 COVID recession.

Given the sharp stock and bond market declines we’ve already experienced this year, this leads us to a relatively positive medium-term (five-year) outlook for financial markets and asset class returns. And if U.S. stocks drop further this year – for example, due to increasing recession fears – we will start adding incrementally more to our portfolio allocations.

Meanwhile, our tactical views and positioning on international and EM stocks have not changed. Our base case five-year expected returns for EM and developed international stocks are in the low double digits, supported by low starting valuations and cyclically depressed earnings.

In terms of our fixed-income positioning in our balanced portfolios, we have maintained our significant underweight to traditional core bonds, reflecting our concerns about rising interest-rates and very low starting yields.

The Gardner Group isn’t in the business of making short-term predictions, but nonetheless believe it is prudent to be prepared for more downside for the stock market over the next several months or quarters. If that happens, we’re more likely to be buyers rather than sellers, and will look to increase our exposure to stocks at more attractive prices. On the other hand, if the economy avoids recession (for now) and the markets rebound, we are well positioned to benefit with our slight overweight to stocks and large allocations to actively managed credit-oriented bond funds.