Quarter 2 Commentary
· The second quarter of 2022 ended, closing out the first half of the year with nearly all markets down in a significant way, many in a bear market territory. If you are a newer investor who just got into investing during the COVID craze, this is first time you are experiencing such a downturn. If you have been investing during the financial crisis or the “dotcom bubble”, you might recognize this feeling. However, with the S&P 500 down nearly 20%, you have never experienced anything like this first half of the calendar year, unless you were invested in 1970 (Proxy, however, was not even born yet).
· With the S&P 500 down so much, was there a better place to be? From a broad market perspective, the answer is “not really”. The NASDAQ index closed the quarter at -29%, mid and small cap growth were down even more. Even Value which had help up the best was -12.87% to -17.24% ranging from large to small cap. Internationally, we were no better off, MSCI EAFE was -19.23% and MSCI EM was -17.57%.
· Bonds, the usual safe haven from a poor equity market also failed us in this high inflation, raising rate world we now live. In the US the BARC Aggregate Bond Index was -10.29% & BARC High Yield Index was -14.19%. Outside of the United States was even worse, Non-UDS WGBI was -18.41. A year ago, the 10-year US treasury was at a rate of 1.47%, as of Jun 30, 2022, it was 3.01%. you don’t need a calculator to know that more than doubled.
· Real Estate as represented by the FTSE Equity REITs index decreased -19.17%. Even gold ended the 2nd quarter in the red at -1.16%, as second quarter saw it give back 7.28%. The BBG Commodity Index, comprised most of Energy (~30% of index) and Grains (~22% of index) was one of the few bright spots for Alternatives posting a positive 18.5% on the year.
· The next logical question is what happened to drive such a broad sell off across equities and fixed income, both domestic and aboard? To sum it up, Global Inflation. Economic measures of inflation have hit 40-year highs (8.6% YOY), caused by loose monetary policy, supply chain issues (both COVID & war related), and a strong demand for good supported by high levels of employment.
· In this unique situation, the US Fed and other global central banks are being forced to take a very “hawkish” approach towards tightening monetary policies. Treasury Yield rose as much as 199bps from 1.51% to a high of 3.50%, while the national (30-year fixed-rate mortgage nearly doubled from the low 3% level towards 6%). Over the last three FOMC meetings, the Fed hiked the Fed Fund Rate (FFR) three times in increasing increments of 25bps (March), 50bps (May), and 75bps (June). To illustrate just how much this inflation has caught us all off guard, most markets were pricing in three to four 25bps FFR rate hikes for all of 2022. Perhaps Fed Chair Powell said it best when recently stated “I think we now understand better how little we understand about inflation.”
· Some other central banks are acting as well. The Swiss National Bank surprised global markets with a 50bps rate hike the first hike in 15 years, Brazil’s central bank raised its lending rate by 50bps, and the Bank of England raised its rate by 25bps. However, there are still many other global central banks that catching up to do and will have to act fast.
What we Did:
· As illustrated above, there have been almost no safe places to hide in 2022, however there are actions we took to help limit the downside. Much of the action taken was either at the end of 2021 or very beginning of 2022, as we try to look ahead and be cautiously proactive, not reactive.
· Examples of adjustments made are increasing out tactical cash position, increasing our gold exposure and utilizing TIPS in the Proxy Global Equity Portfolio. We also had shifted away more towards value and dividend paying companies, as well as minimizing Emerging Market exposure. Some of these tactical shifts have help to provide downside protect while others have provided any short-term benefits. Exposure to global semiconductor companies has been a detractor as well as an overweight to developed Europe in lieu of emerging markets. The net result of these shifts was positive, resulting in outperformance of about 230 bps YTD.
· Some examples of what has worked increasing gold (IAU), Treasury Inflation Protected Securities, also known as TIPS (SCHP), Value/Dividend Companies (SCHD) as well as just
simple cash. These 4 tactical shifts made up 18.5% of the portfolio allocation and were only down about 5.6% on average. As mentioned above, the biggest detractor was our Semiconductor (SMH), down -35% which we have increased to 3% of the allocation. While our Semiconductor play has underperformed the broad market YTD, it is a longer-term strategic play. We have also increased our direct exposure to this segment in our growth clients. Global demand for semiconductors remains high and while supply chain issue plague the sector, as they have so many facets of the economy, we see many of the top players in the space to be financially stable the upside in significant. The net result of these shifts was positive resulting in outperformance of about 230 bpts YTD. Global Equity was -17.7 vs the S&P 500 and MSCI ACWI which were both about – 20%.
· While were able to make a shift towards value, away from tech and growth companies in our top-down Global portfolios, Proxy Growth strategy, because it is a style-pure portfolio, must remain focused on companies with higher than average long-term growth potential. Growth is, by nature, more volatile, and in the current environment, it has been even more so out of favor on Wall Street. In this current risk-off, high inflation environment we have been in, investors are not willing to pay high multiples for future earnings growth and looks to avoid the higher volatility of companies with smaller market caps. In anticipation of such a reaction, we did make some adjustments early in the year. First, we increased our cash position to provide us with liquid capital to invest as opportunism presented themselves. Second, as we do not want to shift away from growth in this portfolio, we reduced (not completely removed) some allocations towards longer term, smaller cap companies who are not yet reporting substantial earnings. While the -35% return as of end of Q2, might not make it seems as if that worked, it in fact did prevent future losses. The top 1/3 of our positions were down -22.5% on average, compared to the Nasdaq which was down 29.2%. This does of course mean that smaller allocations to the long-term growth were down significantly, dragging down the overall performance of the portfolio. Some examples of companies that are down significantly which have held all year and that we still like long term are The Trade Desk (TTD), Snowflake Inc. (SNOW), Okta, Inc. (OKTA) and Lam Research Technologies (LRCX).
· The cash on hand downside has been partially deployed. It was invested in companies that have also taken a big hit this year but we are excited about their current prices and long term. Some examples of companies which we have initiated small positions (and may increase in time) are Nvidia (NVDA), Zebra Technologies Inc (ZBRA) and Roku (ROKU).
· Lastly, on the equity side of our strategies, is the Proxy Dividend Income portfolio. Here we have made very few changes in the past 6 month, as our investment objective is
simple; to invest in companies that have strong cash flow, pay consistent dividends, and provide investment upside. This value-oriented approach has help up very well as investors had a flight from risk and hopes of huge upside to stable companies with consistent earnings and cash flow. With over 40% of the positions in the portfolio up YTD there have not been many significant detractors. Where we have seen a significant drop has been in Innovative Industrial Properties (IIPR, -55%), Equitrans Midstream Corp (ETRN, -40%) & WPP Inc (WPP, -37%). The silver lining is that the portfolios average dividend yield now exceeds 4%, while we have no real concerns about these last few companies or any of our other holding cutting dividends. With the tactical cash reserve held towards the start of the year we had added a few new companies which have helped strengthen the total yield, such as Whirlpool Corp. (WHR) and Stellantis N.V. (STLA). In addition to the attractive yield the overall portfolio’s total return YTD is -7.7%, which outperforms the S&P 500 by roughly -12%.
· For the fixed Income strategies were manage, we also have made few adjustments this past quarter. We had already decided to limit the overall duration of our portfolios and to diversify across multiple sectors in anticipation of more hawkish Fed actions. The result has been lower volatility and less downside. Our longer-term Core Fixed Income portfolio was -7.8% compared to the Barclay’s Aggregate Index at -10.35% in 2Q22. Proxy’s more strategic, Low Duration Fixed Income portfolio held up even better, at -5.4%. The largest detractors in Low Duration have been preferred and high yield, yet the increased income generated helps off set its downside.
What we are Watching:
· All eyes are on that cheap money. And what is driving money supply from the Fed right now is the inflation rate in the US. We will continue to keep a close eye on the various inflation readings and the actions taken by the FED and other Global Central Banks. As the likelihood of a recession has increased. The inflation, the Feds increases in the interest rates and, in the future, unemployment numbers, will give us insight as to the length a depth of this “self-fulfilling” and impending recession.
· We continue to watch as the global political landscapes seems to be shifting at a more rapid pace. There have always been many moving parts in this regard, but the
solidification of the Left political parties across Latin American governments, the approximation of Russia, Iran and China and many more big scale movements are happening in the wake of a 2-year global pandemic. Lots to watch there.
· We are also closely watching the 2Q22 earnings season and Corporate guidance going forward. While politics and the economy can have a huge effect on the broad equity markets, the underlying health and success of the companies we invest in are what drive investments in the long term. So far this year we have witnessed a significant sell off in the price of the stock market as we anticipate corporate earnings to decline at some point. As of the end of June the S&P 500 has a forward 12-month PE ratio of about 15.75. That number is below the five-year and ten- year averages of 18.6 and 16.9. How much 2Q22 and 3Q22 earnings do in fact decline will show us how much value there is in the broad market at this time. As Proxy does invest in individual stocks, we believe we will see a lot of value in fundamentally sound, long-term investments, which will prove to have been oversold in this current market decline.
· At Proxy, we work every day with an eye towards the future to help our clients build towards their goals and dreams. We understand that we can’t ignore all the uncertainty of the here and now. These are difficult times. We are faced with high inflation, quantitative tightening, significant rate hikes, the possibility of slowing economic growth, supply chain issues, global energy and food shortages and the ongoing Russian War. However, our investment philosophy and methodologies have been tried over the years. We arrived at your investment allocation, specifically counting on volatility (ie. hard times like these), so this does not come as a surprise for us. Stay the course.
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