Authored by :
Michael G. Dow, CAIA, CFA, CPA, Chief Investment Officer
Julien R. Frazzo, Director of Risk Management and Securities Research
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The Quick Facts
- Equity markets finished May close to flat despite the S&P 500 coming within points of a bear market during the month
- The Federal Reserve (Fed) signals 50bps rate hike at its June 15th and July 27th meetings
- Inflation remains elevated with the latest CPI (Consumer Price Index) print at 8.3% over the last 12 months
- Large Cap Value outperformance over Large Cap Growth reaches 17.4% year-to-date (YTD)
- The Fed’s ~$9 trillion Quantitative Tightening (QT) program starts on June 1st; a process intended to supplement rate hikes and help fight inflation
A tumultuous May for markets ended almost exactly where it started in equities with the S&P 500 up 0.2% for the month. May saw volatility surge then recover as debates rage around inflation, the Federal Reserve’s plan to subdue it, and the impact on the economy. During the month, the S&P 500 surged more than 9% after falling within points of a 20% drop from a record high, signifying a bear market. Ten-year Treasury yields closed at 2.84%, 9bps below where they started the month.
Since the intraday low on May 20, the index rallied nearly 9.0%. The key question for the market is whether this latest rally is a bear market rally? The risk-off narrative continues to prevail, with concerns focused on inflation, monetary tightening, lingering supply chain issues, and geopolitical tensions. Peak inflation remains a hot topic – whether we have reached it yet is unclear. Consumer sentiment, housing, and other economic data show signs of slowing growth. Tightening financial conditions appear to be having the desired effect.
On a total return basis, Energy was the best-performing sector, up 16%, while Real Estate and Consumer Discretionary were the laggards, both down 5.1%. Energy and Utilities are the only two sectors up YTD with 58.6% and 4.5% total returns, respectively. Consumer Discretionary, Communication Services and Technology are the worst performing sectors YTD with 24.3%, 22.3% and 19.1% drops, respectively.
May Asset Class Performance
Value strategies outperformed, signaling the market’s return to defense. Large Cap growth stocks fell 2.3%, while Large Cap value, as measured by the Russell 1000 Value, outperformed by 4.2%, with a +1.9% return for the month. The Large Cap value outperformance over Large Cap growth is now 17.4% YTD. The ESG segment of the market, as measured by the MSCI USA ESG Select Index, was down 0.1% in May, 30bps off the S&P 500. Over the last three years, the ESG index is up 63.6% and approximately 5.8% ahead of the S&P 500 on a total return basis. Outside of the U.S., the MSCI Emerging Markets Index posted a 0.4% gain in May. The MSCI EAFE (Europe, Australasia and the Far East) Index was up 0.9% in May, outperforming the U.S. Large Cap equity benchmark by 0.7% YTD.
The Fed’s monetary tightening policy remains the key variable. How far and how fast will the Fed need to hike rates to get inflation expectations back in line? At its May meeting, the Fed announced a 50bps rate hike, in line with expectations, and guided for another 50bps hike at its June 15 and July 27 meeting. Chair Powell acknowledged that getting inflation under control would be tricky with a narrow path to a “soft-ish” landing for the economy, as opposed to a recession. As central banks around the world continue to raise interest rates to cool off inflation that is becoming more and more unanchored, growth is beginning to slow with the U.S. GDP falling unexpectedly in 1Q 2022.
On June 1st, the Fed began Quantitative Tightening (QT), or the reduction of the Fed’s U.S. Treasury and mortgage-backed securities holdings. This reduction should prove to be an effective, complementary tool to tighten financial conditions. QT is the opposite of quantitative easing and works much like interest rate hikes. It is basically a way to reduce the money supply floating around in the economy. QT’s main impact is in the financial markets. It also helps drive up real or inflation-adjusted yields, which in turn makes risk assets somewhat less attractive.
The yield on the benchmark U.S. 10-year Treasury saw a significant increase from a low of 1.51% at the beginning of the year, to a high of 3.13% on May 6. At the end of May, the yield on the 10-year stood at 2.84%. The 2-year saw a similar appreciation, with the yield moving from 0.73% at the beginning of the year to 2.78% on May 3, a level not seen since early 2019. At the end of May, the yield on the 2-year stood at 2.56%.
April’s headline CPI (released on May 11) was in line (+0.3% m/m and +8.3% Y/Y) yet saw another increase in Food (+0.9% m/m and +9.4% Y/Y) while Energy decreased (-2.7% m/m and +30.3% Y/Y). Less Food and Energy, core CPI increased +0.6% m/m and +6.2% Y/Y. The composition of inflation matters. U.S. inflation has surged due to bottlenecks in goods markets, but these are expected to reverse. A key problem is that services inflation, which is “stickier” and accounts for ~60% of the CPI, is starting to move higher. Goods inflation is set by global factors whereas services inflation is set by domestic factors, including wage increases. The Fed’s key concern about lasting inflation is closely tied to the overheating labor market. The pathway for a soft landing involves the Fed destroying job openings rather than destroying jobs. The hope is that inflation is peaking, but the trend in April’s numbers was not as positive as many hoped. All eyes are now set on the next set of inflation data which will be released by the U.S. Bureau of Labor Statistics on June 10.
Bitcoin closed 17.1% lower in May, continuing a soft 2022 for the most popular cryptocurrency. Bitcoin lost nearly 33% in May to below $26,000 before rallying back above $30,000 late in the month. Since its November all-time high of $67,734, Bitcoin is down over 50%. Prices for Ethereum decreased 33.1% during the month of May, which brings the negative performance to -47.1% YTD. Oil prices rallied 11.4% in May, with the WTI topping $115 a barrel. Gold was down in May (-3.1%) but remains up 0.4 YTD.
Higher Fed rates, given a persistent level of high inflation, helped accelerate the U.S. dollar rally. The U.S Dollar Index (DXY Index) reached a 20-year high of nearly $105 on May 12 before paring gains to end the month down 1.2%. The DXY Index is up 6.4% in 2022 and 13.3% Y/Y. Volatility subsided by month’s end to ~26. The CBOE Volatility Index (VIX) spiked early in the month to above 35 on concerns of a slowing economy before closing out May near the monthly lows.
Chart of the Month: Financial Conditions – How the Fed Manages the Economy
This chart shows the performance of the stock market as measured by the S&P 500 (orange dotted line) and the Financial Conditions Index (inverted, blue line) going back to 2016. Financial Conditions reflect the availability of funding in an economy and are watched closely by central bankers. How loose or tight they are dictates spending, saving and investment plans of businesses and households. Risk assets, including stock prices, are tightly linked to Financial Conditions. The Fed is explicitly tightening Financial Conditions to slow economic growth, and it is causing lower stock prices, higher volatility, and higher economy-wide cost of funding.
Half of the Fed’s dual mandate is stable prices (the two goals of price stability and maximum sustainable employment are known collectively as the “dual mandate”); that requires cooling the economy when inflation is running hot and in some cases, intentionally throwing the economy into a recession. This is the cure to fight inflation, and it will make the patient – i.e., the economy and the market – healthier going forward. High inflation is a headwind for long-run growth, distorting household and business decision-making and lowering standards of living. Inflation must be dealt with, and tightening Financial Conditions is the best way to do it.
Being invested in the stock market is not a smooth ride, but in the long run, investors have been rewarded. Volatility – and drawdowns – is the price investors pay to build wealth. Staying invested through the market’s ups and downs gives investors a better chance of achieving their long-term goals.
Quote of the Month
“A simple rule dictates my buying: Be fearful when others are greedy and be greedy when others are fearful.”
– Warren Buffet
Major Asset Class Dashboard
Important Disclosure: This report is for informational purposes only. Opinions expressed herein are subject to change without notice. Beacon Pointe has exercised all reasonable professional care in preparing this information. The information has been obtained from sources we believe to be reliable; however, Beacon Pointe has not independently verified, or attested to, the accuracy or authenticity of the information. Nothing contained herein should be construed or relied upon as investment, legal or tax advice. All investments involve risks, including the loss of principal. Investors should consult with their financial professional before making any investment decisions. Past performance is not a guarantee of future results.
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