Despite continued market and geopolitical volatility, there is still a good case that the U.S. equity markets make up ground in the second half of the year.

Posted July 8, 2022

Q2 2022 continued to experience the effects of supply chain constraints, the tapering of Covid while ushering in peak inflation, course correction by the Federal Reserve’s Fed funds rates, and the end of quantitative easing and the beginning of quantitative tightening, a rapid rise in mortgage rates and continued escalation in the 10 Year Treasury bond yield. Consensus corporate earnings estimates continue to be at risk of late-cycle downward revisions and the Russia Ukrainian war presents uncertainty to the global markets and economic activity.

Despite continued market and geopolitical volatility, there is still a good case that the U.S. equity markets make up ground in the second half of the year. A test for the market may be in mid-July when we get GDP numbers for Q2, updated inflation numbers, and Q2 corporate earnings reports and forecast become available. There is a chance GDP is flat or down slightly, inflation remains higher than expected and earnings reports are less than desired. The real question for equities may not be if full-year earnings projections are down, but to what degree. So, for now, we must wait and see what the data brings.

The rocky start to the year has been emotionally challenging for investors who have been put in between a rock and hard spot with the decision to either battle risk (geopolitical volatility) or prepare to fight inflation. To fight inflation, risk-on assets are required, and to fight volatility, risk-off assets are required. So as inflation numbers continue to persist, and geopolitical events continue to unfold, investors will need to find patience and balance in their portfolios and or adjust their goals and constraints in their investment policy statement (IPS).

The relevance to the portfolio(s) from the above events is that we moved to a more defensive posture than in Q1 2022 as we looked to hedge the uncertainty in the markets that resulted from rising rates, increasing inflation, suspect corporate earnings, the tightening of the Federal Reserve, and other geopolitical events.

Portfolio Enhancements/Changes

Our systems and procedures remain the same and the portfolios were adjusted throughout the quarter per our portfolio construction process. Our process blends two schools of thought: Asset Allocation, which is a risk management approach, and Focused Investing which is a concentrated investing approach predominately utilizing individual stock strategies.

The result is a dynamic, global, all-cap, go-anywhere group of portfolio strategies built for all market conditions. These multiple portfolio designs afford us the flexibility to be long and short both equity and fixed income asset classes simultaneously while also utilizing cash and or cash equivalents.

The blended portfolio approach looks for companies that have had strong historical performance and continue to have prospects for sustainable performance in several key value drivers such as:

• Return on invested capital
• Growth
• Cash flows
• Valuations

In addition to fundamental analysis, technical analysis is used to help identify price momentum as well as aid in execution decisions. At any given time, the portfolio strategy may contain securities in various sectors, or it may contain concentrated sector allocations as well as various or concentrated market capitalizations. Although the portfolios are tactically responsive to immediate market movements and trends, they deploy strategic overlays and trade at the end of each month and on a lagged quarterly basis. Some of the more tax-aware portfolio strategies trade once per year.

During the quarter, we rebalanced the portfolios and continued to maintain limited exposure to high beta names accompanied by negative earnings and negative earnings revisions. We shifted to a neutral outlook for the large-cap technology names in the portfolios as increasing interest rates and inflation expectations continued to persist. Additionally, we added exposure to equity and fixed income inverse ETFs in our Focused Tactical Asset Allocation strategies otherwise known as Sailboat strategies.

The increase in inflationary pressures and the Russian military offensive in Ukraine along with other geopolitical and market events brought bearish technical signals throughout the quarter. As a result, we increased our cash position from the beginning of the quarter to help take advantage of any short-term weakness in the market given the backdrop of strength and liquidity in the broader U.S. economy.

Looking Forward

As we have been communicating all year, the need for patience and a diversified portfolio is being highlighted in these uncertain times. However, we also believe market conditions could improve once the market becomes comfortable with the Federal Reserve’s course to tame inflation.

Moreover, clarity with Ukraine and Russia would be welcomed by the market and would be expected to move the market higher. We are not out of the woods yet, and we are less bullish than we were to start the year, however, there is hope.

We will continue to seek out risk-on and risk-off opportunities by continually reevaluating our stance on monetary and fiscal policies, inflation, interest rates, corporate margins and earnings, labor force participation, supply chain, geopolitical/China/Russia, unemployment, and regional/national gauges of manufacturing and service level activities.

From our portfolio management perspective, we are trying not to overmanage the uncertainty of the markets with excess portfolio adjustments. We aspire to adjust each portfolio per its strategy objective per our process and as data is presented. We will continue to monitor, adjust, and communicate the best we can. Although we cannot predict the future or time of the markets, our goal is to provide you with reasonable risk-adjusted portfolios over reasonable periods of time.

Joe Maas, CIO | CFA, CFP®, ChFC, CLU®, MSFS, CVA, ABAR, CM&AA, CCIM
David Stryzewski, CEO | CSA, NSSA