— 2022 Q2 UPDATE —
Summary:
- The Federal Reserve (Fed) is in the process of raising interest rates to combat inflation which is a reversal of the easy monetary policy since the Great Financial Crises.
- Quantitative easing (QE) and fiscal deficits led stock and bond markets to very high valuations which are having a healthy correction due to policy reversal.
- We view this market correction as a potential opportunity rather than a systemic risk to the system, unlike 2008.
Quarterly & Year-to-Date Returns:
Q2 Market Returns:
Source: Y-Charts
See important disclosures at the end of document
Equity Style Snapshot Benchmarks: Large Value – CRSP US Large Cap Value Index Total Return, Large Blend, CRSP US Large Cap Index Total Return, Large Growth – CRSP US Large Cap Growth Index Total Return, Mid Value – CRSP US Mid Cap Value Index Total Return, Mid Blend – CRSP US Mid Cap Index Total Return, Mid Growth – CRSP US Mid Cap Growth Index Total Return, Small Value – CRSP US Small Cap Value Index Total Return, Small Blend - CRSP US Small Cap Index Total Return, Small Growth – CRSP US Small Cap Growth Index Total Return> The Center for Research in Security Prices (CRSP) is a provider of research-quality, historical market data and returns. Once securities are assigned to a size-based market cap index, they are made eligible for assignment to a growth or value index using CRSP’s multifactor model. Securities are scored and ranked for both Value and Growth factors, then ranked. Investors cannot invest directly in a benchmark.
Year-to-date Returns:
Source: Y-Charts
See important disclosures at the end of document
Equity Style Snapshot Benchmarks: Large Value – CRSP US Large Cap Value Index Total Return, Large Blend, CRSP US Large Cap Index Total Return, Large Growth – CRSP US Large Cap Growth Index Total Return, Mid Value – CRSP US Mid Cap Value Index Total Return, Mid Blend – CRSP US Mid Cap Index Total Return, Mid Growth – CRSP US Mid Cap Growth Index Total Return, Small Value – CRSP US Small Cap Value Index Total Return, Small Blend - CRSP US Small Cap Index Total Return, Small Growth – CRSP US Small Cap Growth Index Total Return> The Center for Research in Security Prices (CRSP) is a provider of research-quality, historical market data and returns. Once securities are assigned to a size-based market cap index, they are made eligible for assignment to a growth or value index using CRSP’s multifactor model. Securities are scored and ranked for both Value and Growth factors, then ranked. Investors cannot invest directly in a benchmark.
General Market Update:
The first half of 2022 has been a challenging time for many investors. Inflation (as measured by CPI) is at a 40-year high and making new highs almost every month, the US Index of Consumer Sentiment is the lowest it has ever been since the index began measuring in 1952, and the S&P 500 had the worst first half of the year performance since 1970 and the 4th worst performance in market history. (1) (2) The two main questions investors have asked this year are: what has happened and where are we going?!
What Has Happened:
The 2008 Great Financial Crises (GFC) sparked a new wave of unconventional monetary policy called quantitative easing (QE), a process where the Federal Reserve (Fed) bought inordinate amounts of toxic assets off the balance sheets of banks and other entities in order to preserve the financial system. (3) This process had the typical supply and demand effects of raising the price of those assets (lowering the interest rates) which affected valuations throughout the financial markets. The issue is that the Fed did not stop quantitative easing once stability had returned after the GFC, instead, they continued with round after round of QE until their balance sheet was almost up to $3.8T worth of securities held outright before Covid hit.
Source: FRED
By all accounts, quantitative easing had been a massive success. It had played a huge role in helping the financial system from completely collapsing in the GFC, it had sparked a decade-long bull market in both equities and bonds, and it accomplished those things while inflation (as measured by CPI) was low. In late 2019, there was a general idea that it was time for the Fed to begin letting the assets on their balance sheet mature and let the process unwind. (4). As this unwinding started, it caused the repurchase agreement markets (repo markets) to freeze from lack of liquidity which caused rates to spike, and the Fed had to step in to restore liquidity in the markets.
Repo Rates:
Source: Tradingeconomics.com
After this liquidity event, the Fed realized the delicate spot they had put themselves in, they had made themselves an integral part of the way financial markets operated, and it would be much more difficult to reverse course than continue forward. Therefore, quantitative easing restarted in a slow but deliberate manner.
Source: FRED
However, that slow and deliberate process would fall by the wayside as soon as the Covid lockdowns hit. With the global economy in a shutdown, the Fed floored the gas pedal on QE and new unconventional monetary policies, and the Treasury Department began printing. We hit the stage of helicopter money where money was created by the Treasury Department, financed by the federal reserve, and put directly into the pockets of consumers and institutions.
Source: FRED
Source: FRED
This explosion of money juiced the financial system with trillions of dollars worth of reserves on banks' balance sheets, unprecedented real average savings for Americans, and pushed the entire yield curve towards 0% interest rates. This combination of factors that led to such easy money increased aggregate demand coming out of lockdowns. This increased consumer demand was not seen as a risk towards our current inflationary environment because it was viewed as more of the same quantitative easing over the previous decade since the GFC. However, there were three main differences between the situation coming out of the Covid lockdowns and the decade-long quantitative easing that happened between the GFC and Covid.
3 Main Differences:
- Fiscal policy sending out direct checks to businesses and individuals through outsized omnibus stimulus packages.
- Global supply chain crises and continued intermittent lockdowns of various countries at varying times.
- The magnitude and velocity of the quantitative easing was much greater than previous rounds of QE that took place pre-Covid.
This combination meant that consumers pocketbooks' were full to the brim coming out of lockdowns, which means aggregate demand was high. Meanwhile, the labor market and global supply chains were not ready to bring aggregate supply up to the point of this increased aggregate demand. This leaves a situation where too many dollars are chasing too few goods, leading to inflation. This takes us to our current market situation, and with one question left to answer, where are we going?
Where Are We Going:
The Fed has raised interest rates multiple times this year and promised to begin unloading its balance sheet in the hopes of quelling inflationary pressures. The Fed is trying to do this without causing a recession, something they have called a “soft landing” for the economy, which implies the general direction they are attempting to take the economy. The difficult part for investors is that bottom barrel interest rates and continued demand for financial assets by the Fed have fueled a large part of the stock market and bond market success over the past decade-plus and now the Fed is in a position where they are forced to reverse course to attempt to rein in inflationary pressures. Essentially, the Fed and Treasury overheated the car by flooring it when the engine was not working properly, and now instead of trying to get the car home in record time like they were before, they are simply just trying to get the car home!
This situation may be worrisome to many investors but here at K2, there are a few reasons we are not worried about this situation but instead view this situation as an opportunity.
- Historical valuations were nearing tech bubble levels at the end of 2021 which is simply unsustainable. We view this reversal as a healthy market correction rather than a systemic issue with the system like the toxic Mortgage-Backed Securities (MBS) were in 2008 during the GFC. Therefore, having a healthy valuation correction can mean wonderful opportunities for long-term investors.
- A healthy financial system should not have long-term negative real interest rates. Therefore, interest rates rising, while they may cause short-term pain by reducing equity values and reducing bond values, are a major positive for long-term investors because bonds will provide higher income in the future.
- Runaway inflation is a real systemic risk to any economy in the world and throughout history. Therefore, with the Fed aggressively focusing on reining inflation in back towards their 2% target, the long-term risk to the economy is reduced when compared to a scenario where they keep interest rates low and do not fight inflation. (5)
- The fourth and most important point is that here at K2 Financial Partners, we build portfolios with these types of market events in mind and our advisors understand your specific financial situation to put you in the appropriate investments for the potential of long-term success, specifically with economic corrections in mind. Therefore, general market corrections are built into the assumptions of you reaching your financial goals.
Therefore, here at K2 Financial Partners, we do not view this current market environment as a doom and gloom scenario, rather we view it as a structural adjustment in the economy and a potentially excellent long-term opportunity to invest at better valuations.
Conclusion:
Here at K2 Financial Partners, our main mission is to help you reach your financial goals. We understand that the financial markets are an ever-changing adaptive marketplace, and that is only exacerbated during a time when inflationary pressures are at the forefront. Therefore, it is important to have a well-diversified portfolio and contact your advisor when you have questions, comments, or concerns. At the end of the day we are here to help you!
Sources:
- US Index of Consumer Sentiment (ycharts.com)
- The stock market had its worst first half since 1970 (axios.com)
- Quantitative Easing: How Well Does This Tool Work? | St. Louis Fed (stlouisfed.org)
- Investors fear that the unwinding of QE is causing market turbulence | The Economist
- Fresh US Inflation Peak to Keep Fed on Aggressive Interest Rate Path - Bloomberg
The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Lincoln Investment. The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. Past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.
The Standard & Poor's 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the NASDAQ. The DJIA was invented by Charles Dow back in 1896. The MSCI ACWI ex USA Index captures large and mid cap representation across 22 of 23 Developed Markets (DM) countries (excluding the US) and 24 Emerging Markets (EM) countries. With 2,312 constituents, the index covers approximately 85% of the global equity opportunity set outside the US. The Nasdaq Composite is an index of the common stocks and similar securities listed on the NASDAQ stock market and is considered a broad indicator of the performance of stocks of technology companies and growth companies. The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 3000 Index consists of the 3,000 largest U.S. companies as determined by total market capitalization. It assumes the reinvestment of dividends and capital gains and excludes management fees and expenses. Morgan Stanley Capital International (MSCI) EAFE Index (Europe, Australasia and Far East) is an index created by Morgan Stanley Capital International (MSCI) that serves as a benchmark of the performance in major international equity markets as represented by major MSCI indexes from Europe, Australia and Southeast Asia. The MSCI AC Asia Pacific Index captures large and mid cap representation across 5 Developed Markets countries and 8 Emerging Markets countries in the Asia Pacific region. With 1,546 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
The MSCI Emerging Markets Index is an index created by Morgan Stanley Capital International (MSCI) and is a float-adjusted market capitalization index that is designed to measure equity market performance in emerging markets. It consists of indices in 23 emerging market country indexes. With 834 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. The MSCI Europe Index captures large and mid-cap representation across 15 Developed Markets (DM) countries in Europe. With 440 constituents, the index covers approximately 85% of the free float-adjusted market capitalization across the European Developed Markets equity universe Bloomberg U.S. Aggregate Bond Index is a composite of four major sub-indexes: US Government Index, US Credit Index, US Mortgage-Backed Securities Index, and US Asset-Based Securities Index, including securities that are of investment grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $100 million. Investors cannot invest directly in an index.
Consumer Price Index (CPI) measures prices of a fixed basket of goods bought by a typical consumer, widely used as a cost-of-living benchmark, and uses January 1982 as the base year.
ARCHIVED MARKET UPDATES
We'll keep track of our past market updates so you can always access them.
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2020 Q4 Update
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