As readers of our June and July letters know, this has been a painful year for most investors. Year to date, the financial markets are down significantly. While these declines have been unusually severe, one bright spot is the fact that in the month of July, markets recovered significantly. For the month of July, the S&P 500 Index increased by 9.22 percent and Bloomberg bond index is up 2.44 percent. With investing, monitoring the past is essential, but most would agree that the more important question is to what will happen in the future. The future performance of financial markets particularly in the short term is not predictable, but we can look at current market conditions and position our clients’ portfolios based on the risks and valuation of those conditions.
In the first half of 2022, market volatility increased significantly. Using the VIX volatility index published by the Chicago Board Options Exchange (CBOE) as a forward-looking measure of stock market volatility, the volatility was high in the second quarter with readings for many days in April, May, and June exceeding 30 percent. However, the average volatility declined dramatically in July finishing the month at 21 per cent. This July closing value is only marginally above the long run average of volatility, and broadly representative of what would be thought of as expected. This average reading suggests that markets now reflect the current expected impact of the Ukraine conflict and incorporate the economic implications of the current high level of inflation, leading to this normalization of volatility. However, one must attach a note of caution to such a conclusion since many unpredictable future events, such as unexpected Ukraine related developments or economic shocks that impact inflation expectations, could cause an immediate volatility boost and put downward pressure on market values.
Real economic growth declined in the first two quarters of this year with GDP declining 1.6 percent in the first quarter and 0.9 percent in the second quarter. Using the traditional definition of a recession, these two successive quarters of a decline in GDP would imply that we are in a recession. While many are now quibbling with the use of this traditional definition of a recession, the conclusion that economic activity has slowed down is largely unquestioned. What this tells us about future economic activity is key for market valuation. A reading of the consensus view is that with the job market reasonably strong and with inflation moderating, economic growth is likely to be positive over the next year but much lower than we have observed in 2021. Projected real growth does provide support for current market valuations.
However, even with the economy growing, downward pressure on market values can be present. The possibility of higher than expected inflation is one concern. The latest reading of inflation for the year ended June 30 is 9.1 percent. It has been more than forty years since the annual increase registered by the Consumers price Index (CPI) was this high. What is the current state of inflation? One of the mandates of the Federal Reserve Bank is to stabilize prices and control inflation. The Fed has been actively pursuing this objective, increasing the Fed Funds Rate four times in 2022. While the impact of these Fed actions is still uncertain, there is evidence that inflation is declining below the current high levels. For example, commodity prices and housing values have recently declined somewhat. But the Fed must be cautious as the general increases in interest rates that accompany an increase in the Fed Funds Rate can lead to a decline in economic activity commonly referred to as a “hard landing.”
How can inflation concerns be addressed in one’s investment portfolio? The values of equities empirically tend to have relatively low sensitivity to the rate of inflation. An equity allocation does represent a longer-term inflation hedge because shares of common stock represent claims on real assets and the value of most real assets will increase with inflation. However, some corporations, whose values are driven mostly by expected growth in future earnings rather than from current assets, are more sensitive to unexpected inflation. These corporations will generally be “growth stocks” and inflation concerns can be addressed with a modest allocation shift from growth stocks to value stock, whose value is driven more by current earnings
For fixed income allocations, higher inflation will put significant downward pressure on bond prices due to the increasing interest rates. This pressure will be greatest for longer maturity nominal bonds since it is the present value of further out nominal flows that are impacted the most with rate increases. This downward pressure on bond prices can be reduced by holding shorter maturities and by holding bonds that are inflation protected. (For inflation protected securities, both the bond principal and coupon payments adjust based on inflation.) This differential impact of inflation has already been observed in the bond market as treasury inflation protected bonds and short-term bonds have performed better than the aggregate bond index this year. To provide inflation protection, PMA has reduced the duration (effective maturity) of its fixed income allocation and included an allocation to short term treasury inflation protected securities.
What about other valuation measures? Most are not far from what would be expected given the current environment. The price to earnings ratio of the S&P 500 Index is approximately 22 which is in line with the historical average. The dividend yield in the equity market is also close to recent history at 1.6 percent. These current values do represent a normalization relative to values observed during the pandemic.
At PMA, on an ongoing basis, we continue to monitor risks driven by the current environment and make changes when justified. We have modestly increased our equity allocation to value stocks and altered our fixed income allocation to include inflation protected securities and to have a lower duration. These changes reflect that there are many things happening in the marketplace and many factors that need to be considered when analyzing the valuation and risk of stocks and bonds.