Equities
What “worked” in the quarter is a relative term considering both equities and fixed income broadly delivered negative returns. Against a macro-dominated market environment, no equity asset class delivered positive returns in the second quarter. The S&P 500® officially entered bear market territory in early June — a first for investors since the onset of the pandemic in March 2020. A record-high May Consumer Price Index report catalyzed the market downdraft, as investors tried to quickly recalibrate the potential for much tighter near-term financial conditions, higher-than-expected interest rates and valuation multiple compression. In response, the Federal Reserve (Fed) delivered a 75 basis point (bp) rate hike in June, the largest hike since 1994.
The high-volatility regime continued to dominate during the second quarter. While the CBOE Volatility Index (VIX) averaged a hefty 25.2 in the first quarter, it averaged an even higher 27.3 in the second quarter and remains about two times (x) higher than the long-term average level of equity market volatility. The forward price-to-earnings (P/E) ratio of the S&P 500 compressed 3.7 multiple points, piling onto the 2.0 multiple points decline in the first quarter.
Intra-stock correlations increased modestly. However, despite negative returns across both equities and fixed income, correlations did not result in a “convergence to 1” phenomenon like we saw at the immediate onset of the pandemic. In our view, this volatility is a function of churn beneath the surface, rather than a widespread breakdown in fundamentals. Volatility was high, but correlations were not anywhere near as extreme.
West Texas Intermediate crude oil prices declined 15% in the last three weeks of the quarter to close near a two-month low. While this did not serve as much of a positive market performance catalyst, it may potentially help the inflationary backdrop in the third quarter, which we believe is critical for markets in order to stabilize at these valuation levels.
Fixed Income
While equities have been volatile all year, it pales in comparison to the wild ride in fixed income markets during the second quarter. The ICE BofA MOVE Index (the bond market’s equivalent of the VIX) averaged 120 in the second quarter versus 95 in the first quarter. In fact, the MOVE remained above 100 for all but three days during second quarter. For perspective, a similar extreme level of volatility at the onset of the pandemic in early 2020 only lasted about three weeks.
One key guidepost we are watching closely is fed funds futures for December. Market-based expectations for even just a 25 bps rate hike have come down considerably in recent weeks as concerns about even more aggressive Fed action are starting to fade from the market narrative. Whether a 75 bps or 100 bps hike ultimately occurs in July is not as critical for the market’s path forward as what happens to the expected terminal rate. If the Fed announces a 100 bps hike, but the terminal rate of approximately 3.5% holds (based on the Fed’s latest “dot plot”), we believe markets will be receptive given current valuation levels.
The yield curve, as measured by the spread between 2-year and 10-year U.S. Treasuries, inverted in the last week of the first quarter, then moved back into modestly positive territory during the second quarter, only to invert again in early July. Markets have given the Fed hardly any headroom to tighten policy and raise interest rates given how flat the yield curve continues to be. While headlines are once again swirling about the signaling effect of the 2-year/10-year inversion, the 3-month to 10-year spread is signaling there is still time left on the economic cycle clock.
Financial conditions continued to tighten throughout the quarter, with the Goldman Sachs Financial Conditions Index ending the quarter at 99.7, only slightly above its 10-year average. While financial conditions have tightened relative to the all-time easy conditions during the summer of 2021, we continue to believe financial conditions are not yet in overly restrictive territory for markets and the economy.
What Led in the Quarter
- Leveraged Loans
- Our long-term thesis: We believe leveraged loans provide credit exposure that works as a hedge in a rising rate environment given the asset class has near-zero duration characteristics yet still pays an approximate 4% yield. Additionally, the asset class serves as a complement to high yield bonds, which have a higher correlation to equity market returns. Leveraged loans tend to have a positive correlation with capital markets activity (e.g., mergers & acquisitions [M&A]) and typically have a higher position on the capital structure compared to unsecured debt.
- What worked in the quarter: After a flat first quarter, second quarter returns declined across the credit rating spectrum, led lower by below-investment-grade loans. While leveraged loans outperformed other fixed income asset classes on a relative basis, the loan market was severely and negatively impacted by the Revlon Inc bankruptcy in June, the largest in the U.S. over the past 12 months at nearly $4 billion in liabilities.
- Why we still like it: One of the biggest catalysts for the loan market is not hedging against rate hikes, but activity in debt capital markets, and the M&A market continues to have a robust pipeline for 2022. Growth rates slowed relative to second quarter 2021; however, that quarter had the most M&A activity since the onset of the pandemic, making for a challenging comparison.
- Core Fixed Income
- Our long-term thesis: Core fixed income tends to be the primary ballast in multi-asset portfolios with broad diversification across Treasuries, Corporates and Securitized markets.
- What worked in the quarter: Intra-quarter, the 10-year Treasury jumped 100 bps, which had a profound impact across all fixed income asset classes. The best performing segment of the Bloomberg Aggregate Index was the Treasury component (approximately 40% of the Index), but not due to a flight to safety. It was simply because longer duration exposures in the other components of the Index got hit harder on a relative basis.
- Why we still like it: Over the long-term, we remain confident that core fixed income can still provide ballast in portfolios and generate positive real total returns. However, in the near-term, the Fed’s aggressive shift in policy stance and its planned path of rate increases will continue to dominate the environment. As a result, we expect continued high volatility and relative performance challenges until the Fed pauses its hikes or we gain clarity on the length and duration of the path forward.
- Emerging Markets Debt
- Our long-term thesis: We remain constructive on emerging market (EM) debt as we believe the asset class offers better fundamentals and higher yield than developed markets. We also prefer U.S. dollar-denominated EM debt, which should provide an additional tailwind in periods of dollar strength.
- What worked in the quarter: Corporates led on a relative basis (i.e., EM Asia), while sovereigns with country-specific issues lagged, such as Argentina and Turkey bonds.
- Why we still like it: EM debt offers an attractive yield pickup like U.S. high yield but with stronger underlying fundamentals relative to the slower growth prospects across the developed world. However, valuations now appear rich relative to other fixed income asset classes.
What Lagged in the Quarter
- U.S. Large-Cap Growth
- Our long-term thesis: We believe large-cap growth equity is the growth and innovation engine of the public equity asset class universe, with sustainable, high-quality fundamental characteristics.
- What didn’t work in the quarter: For U.S. large-cap growth, it was the worst quarter since 2008, with the forward P/E for the Index falling six multiple points in three months. On a year-to-date basis, the Nasdaq100 has a strong inverse correlation (-0.84) with the fed funds rate, which began the year at just 0.25% and is now at 1.75% and climbing.
- Why we still like it: Despite the steep decline in valuations, the next-12-month (NTM) earnings per share (EPS) estimate ended the quarter at an all-time high, indicating the selloff is not driven by a crack in the underlying fundamentals. Several long-term support levels held during the June selloff, suggesting deeply oversold conditions — all else equal — rather than a permanent regime change.
- Developed International Small-Cap Growth
- Our long-term thesis: Like U.S. small cap, we believe in the long-term benefit of a small-cap premium for developed international markets. Unlike developed international large cap, small-cap companies are typically found outside of core Europe and offer much stronger growth prospects given they tend to be the innovation engine for countries such as Japan, the U.K. and Canada.
- What didn’t work in the quarter: It was the worst quarterly return since the first quarter of 2020, as the forward P/E declined three multiple points, nearly matching the multiple point decline in the first quarter. As commodity prices peaked in early June, we believe much of the decline actually came from cyclical growth stocks in the metals & mining and semiconductor industries.
- Why we still like it: The forward P/E of the Index has fallen to an attractive 16.4x compared to its 20-year average of 17.6x, whereas NTM EPS are near all-time highs. While Europe continues to face significant geopolitical and economic uncertainties, an early-stage recovery in China (aided by more stimulus) and easing global supply chain bottlenecks could be important near-term tailwinds for the asset class.
- U.S. Small-Cap Growth
- Our long-term thesis: We have a positive view on the long-term benefits of the small-cap premium. Small-cap growth in particular has exposure to a number of industries focused on key long-term secular trends such as the connected world of the metaverse, alternative energy and biotechnology.
- What didn’t work in the quarter: It was the worst quarter for U.S. small-cap growth since the fourth quarter of 2018 when the Fed last tightened financial conditions. As a result, the forward P/E for the Russell 2000 Growth Index compressed by 18 multiple points during the second quarter, the third-largest decline in 20 years.
- Why we still like it: After the Russell indices rebalance at month-end, the forward P/E has dropped to 23.0x, well below the 20-year average of 37.0x. And yet, like other growth indices, NTM EPS is at an all-time high.
The most challenged asset classes so far this year have one major theme in common: Growth. While we still believe in the long-term growth and innovation associated with these asset classes, Growth as a style is under tremendous pressure from the rapid regime change in monetary policy and the aggressive expected future path of interest rates. We continue to be in an extreme multiyear market dynamic where the pendulum is either fully Growth or fully Value, with hardly any relative outperformance middle ground. We are keeping a close watch on this relationship.
While we do not envision shifting positioning fully toward Value-oriented exposures, an easing of the high- volatility regime might offer an opportunity for us to revisit the mix between Growth and Value exposures. Markets are dynamic, and we need to be as well. Key guideposts we continue to evaluate include structural/long-term inflation issues, a deterioration in the health of the consumer and signs of shifting in the phase of the business cycle.
What Worked & What Didn’t
What Led in Q2 |
||
Asset Class |
Index |
Total Returns YTD |
Leveraged Loans |
S&P/LSTA Leveraged Loan |
-4.45% |
Core Fixed Income |
Bloomberg U.S. Aggregate |
-4.96% |
Emerging Markets Debt |
Bloomberg EM Aggregate |
-8.72% |
What Lagged in Q2 |
||
Asset Class |
Index |
Total Returns YTD |
U.S. Large-Cap Growth |
Nasdaq-100® |
-19.25% |
Developed International Small-Cap Growth |
MSCI World Ex USA Small Growth |
-20.37% |
U.S. Small-Cap Growth |
Russell 2000® Growth |
-22.30% |
Based on Total Returns YTD
