KCS Quarterly Market Review for Q2 2022
July 21, 2022
Overview of the First Half of 2022
The first half of 2022 has been difficult for investors, with both stocks and bonds falling significantly. In fact, equities just finished their worst quarter since 2008. Combined with Q1’s loss, this makes 2022’s first half the worst one for stocks since 1970. The knowledge that this period follows 21 months during which the S&P 500 more than doubled is scant comfort to the investor experiencing both falling markets and raging inflation. That said, we think there are reasons to be optimistic from here, which we discuss below.
Looking at geographic regions and business sectors, during the second quarter we saw that—unlike the early months of the year, where there were corners of the market where you could find gains—every major region and sector finished in the red. Even so, value stocks and less volatile sectors (utilities, consumer staples and healthcare) did outperform more economically sensitive ones. Consumer discretionary, technology and growth stocks led the list of losers, with the tech- and growth-heavy NASDAQ composite shedding -29% so far this year.
Those hoping to find sanctuary in bonds were similarly disappointed, as most bond benchmarks finished the quarter down by double digits. And as with equities, there were few places to hide. Even the 2-year treasury note is down approximately -3% year-to-date, while the 10-year has dropped -13%. Bond prices have now declined nearly continuously since August of 2020, with long-dated Treasuries down over -30% during the period.
KCS’ portfolios have managed to navigate these treacherous markets relatively well, though they are still down significantly. In individual equities, our strong stock selection continued to add value in the second quarter. In fixed income, our emphasis on shorter durations and the use of non-benchmark securities such as individual preferred stocks benefited our bond investments. Going forward, we will continue to actively navigate through turbulent markets with the aim of adding meaningful value to the accounts we manage.
That “R” Word
The most common question we hear from clients recently is, “Are we heading for a recession?” Our typical answer is “Absolutely, at some point.” The important question, of course, is “When?” And once you know when the next recession is likely to occur, how do you position your investments in anticipation?
Humans typically suffer from recency bias, meaning events that happened in the recent past stand out in their minds. Nothing illustrates this more clearly than bear markets, with memories of the portfolio losses of 2020 and 2008 still painfully fresh. But it’s essential to remember that most recessions, as well as the market declines that accompany them, are not like the pandemic, the Global Financial Crisis or even the dot-com bubble. The average recession is much more mundane, with real GDP falling by less than -2.5% and equity markets declining by about -24% from peak to trough. Thus, if the upcoming recession is “average” by historical standards, stocks may well have already seen their bottom.
Our view is that the next recession, whenever it occurs, will be no worse than average. This is largely because—outside of recent elevated inflation—the economy, personal finances and corporate balance sheets are all in good shape. There is not the huge overhang of bad loans, or undercapitalized and overleveraged banks, that we saw in 2007–2009. Similarly, government mandates shutting down the economy—no matter what the coronavirus does—aren’t going to happen again (with China the sole likely exception).
One of the hallmarks of a recession is a decline in real GDP over 2 or more quarters. We may well see that, but keep in mind that real GDP subtracts out price increases. With US inflation running in excess of 9%, a 2.5% contraction in real GDP translates into growth of nominal (real + inflation) GDP of nearly 7%. That is to say, inflation will likely cause GDP to grow in dollar terms even if the economy is technically in contraction mode.
Keep Calm and Carry On
If we sound relatively calm in the face of a looming recession, it’s because we are. Why? First, because job indicators remain very strong. Job openings are still at an all-time high of over 11 million. Weekly unemployment claims, at 244,000, remain near record lows. And wage growth at the entry level continues to be robust, increasing by 6% year-over-year. All severe recessions are accompanied by large increases in unemployment, while the next one is likely to show only a modest uptick in the face of continued labor shortages. And while there is always some risk of an unanticipated shock that pulls the economic rug out from beneath us, nearly every indicator continues to signal that the demand for labor remains high. This is one reason why we think that the next recession will be mild, more akin to the ones we saw in 1980 or 1990 as opposed to more recent ones.
Another reason we remain relatively sanguine: stocks are nominal instruments. Thus, while real growth right now may be slowing, nominal growth at companies like Visa and Pepsi will likely continue to be strong for some time. For example, when Pepsi recently reported that its sales were up +13% in the second quarter, a large part of that increase was from price hikes. Companies like Pepsi that can pass along cost increases, along with companies like Visa whose profits tend to track nominal spending volume, can maintain and even increase profits during an inflationary recession. And those nominal earnings increases flow through to their stock prices over time. For an illustration of this, look at the chart below of the S&P 500’s price versus its earnings per share since 1988. The two tend to track each other rather well.
What we’ve experienced so far in 2022 is a bit of an anomaly: you probably wouldn’t have guessed that, since the start of the year, earnings estimates for the S&P 500 index are up by 7%. At the same time, the ratio of stock prices to earnings (P/E) has declined significantly, so that we’re now paying 27% less for the same amount of earnings. In anticipation of what we think will be a mild recession, stocks are already selling for just 73 cents on the dollar compared with the start of 2022.
A third reason we are hopeful from here is that consumer sentiment is currently more negative than at any point in history. If that sounds counterintuitive, that’s because it is—consumer sentiment is a countercyclical indicator that has proven to be a remarkably good predictor of subsequent stock market returns. Every trough in consumer confidence has been followed by a strong, double digit return in the S&P 500 over the subsequent 12 months, with an average gain of +24.9%. On top of this, as we mentioned in a previous newsletter, investor sentiment is also near all-time lows, further bolstering our case for strong equity returns over the next year or so.
Recession Coming—But We’re Not There Yet
Back to the question of when the recession will begin. That’s always a tough one to answer, and there may be a rare disconnect between the timing of the subsequent recovery and that of the stock market. Normally, stocks bottom 5 to 6 months before the economy. But given the confounding factors of high inflation and an aggressive Fed, the recovery in stocks may well lead the economy by more than 6 months. We shall see. In the meantime, our best guess as to the start of the recession is sometime between this fall and next spring. We disagree with those who say the recession has started already, as the indicators belie this assessment.
Where could we be wrong in our assessment? Probably the most uncertain part of our forecast is around inflation, which we think will gradually decline over the next year or so. Supply chains are gradually normalizing, central bankers seem to be doing everything in their power to keep inflation expectations at bay, and commodity prices are finally coming down. These welcome developments should lead to more subdued price increases within a reasonable time frame (though rising rents may cause inflation to hang on a bit longer). In addition, controlling today’s inflation should be less difficult than in the 70s, when energy prices had a far greater influence on global inflation than they do now. On the other hand, the huge increase in the money supply over the past few years needs to be reversed before we can be confident that inflation has been licked for good. We will be keeping a close eye on this data point in coming months and years.
Note that even if we’re wrong and higher inflation is here for a while, stocks are still the best game in town. That’s because, as we mentioned above, stocks are nominal instruments and can stand up to inflation rather well (and far better than bonds). For example, during the raging inflation of 1973 – 1983, stocks managed to more than double in dollar value.
Another risk to our forecast is geopolitical, as the fallout from the war in Ukraine has spread far beyond Eastern Europe. A significant portion of recent inflation is the result of food and fuel shortages caused by the war. Germany is even suffering some supply chain shortages owing to Ukrainian factory shutdowns. It’s possible these shortages could worsen if the war drags on. Even more of a risk is a complete shutdown of natural gas from Russia, which Putin has been indirectly threatening for a while. The loss of all Russian natural gas would be a major blow to the European economy, especially the German manufacturing and export powerhouse. While we believe that the markets have at least partially discounted this possibility, if Europe lost all Russian natural gas, European stocks in particular would likely fall more as the continent entered a moderate recession.
But there could also be upside surprises. Russia wants (and needs) a ceasefire, as they are literally running out of both troops and ammunition. If this happened, Putin would no longer have a reason to shut off Europe’s natural gas or block wheat and other goods from leaving Ukraine. This would naturally cause stocks (and likely bonds) to rally worldwide and Europe in particular to soar. Similarly, the Federal Reserve will eventually stop raising interest rates. If they do so sooner than currently expected—which is possible if inflation were to ease or the economy to slow within the next few months—this would also lead to a rally in both stocks and bonds. We believe that both of these occurrences are at least as likely as Russia shutting off natural gas to Europe.
KCS Investment Positioning
Given all the above, how are we positioning our portfolios for the rest of the year?
Toward the end of 2021, we started fortifying your portfolios by increasing our weight to cash-rich, staples-like businesses. We were also shunning high yield (junk) bonds and preparing for the potential of higher interest rates by shortening our bond durations. Now, we think it’s time to make another shift.
Even after the recent market decline, some stocks remain expensive, and we are selling or trimming those; others look cheap even in a recession scenario, and we are buying more of those. Specifically, we are trimming consumer staples and some healthcare stocks that have become relatively expensive because of fear in the market, while using the proceeds to buy quality companies in other sectors that have been beaten down to unsustainably low prices. Many of the businesses we are selling remain at well over 20 times earnings, a premium for stability that we think is too high given other opportunities in this market. Those we are buying have much lower price/earnings ratios, often in the single digits. For example, we think that financials do not fully reflect the value that will accrue to them as the Fed continues to raise interest rates, so we are increasing our positions in some of the strongest global banks. We are also starting to add to some of our tech positions, as several quality companies have seen their stocks decimated by what we believe are exaggerated near-term worries.
On the fixed income side, we think the market is overestimating how aggressive the Fed will eventually be, and for this reason many high-grade bonds are yielding more than they should. Top tier issuers like Microsoft now offer yields over 4%, and there’s even more value to be had just slightly down the quality ladder. We are seeing opportunities in several areas, including the high-yield bonds that we were shunning as recently as last year, and municipal bonds. We have started buying more of these, as well as adding to preferred issues that are much safer than the market implies, and that are not available to larger investment firms because of the small size of these issues.
In sum, our analysis suggests that now is a good time to invest in both the equity and the bond markets, with our estimate of bottom-up returns on the stocks in our portfolios now in solid double-digit territory, while the yields on our bond sleeves exceed 5%. There are risks, of course, but these risks are far lower than they were at the beginning of 2022, when stocks were over 20% higher and the 10-year Treasury note yielded a mere 1.7% vs. 3% today. But success won’t come overnight. As Warren Buffett said, “the stock market is a device for transferring money from the impatient to the patient.” Be patient and be rewarded.
The KCS Investment Team
 But what about all those tech companies recently announcing layoffs and hiring freezes? They make headlines, but overall, the labor market remains surprisingly strong. According to consulting firm Challenger, Gray & Christmas, “So far this year, employers announced plans to cut 133,211 jobs, down 37% from the 212,661 cuts announced through the first half of 2021. It is the lowest recorded January-June total since Challenger began tracking monthly job cut announcements in 1993.”
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