The first quarter of 2022 moved quickly and brought us new uncertainty with the potential impact of inflation, monetary tightening, and the war in Ukraine. The consequences of war are hard to fully reconcile. The deep humanitarian crisis of the Ukrainian invasion has implications on the people of Ukraine and around the globe. Our team has been following the developments and is assessing the impact within the context of the broad global economy. Our job is to understand the potential long-term impact of these and other factors in client portfolios. Our hearts continue to go out to all those affected by the conflict in Ukraine and hope for a peaceful resolution.
The Business Cycle Outlook
To help us determine how clients should be allocated from an asset class perspective (stocks versus bonds versus alternatives), we use a framework to help us identify where we are positioned in the current Business Cycle. Throughout history, the risk and return characteristics of different assets have proven to be cyclical. Developing a framework for the business outlook prevents us from making unfounded guesses about where we may be headed in the future. This outlook allows us to focus on where we are today and how we believe assets will be affected moving forward.
Where does Acumen believe we are in the current Business Cycle?
Right now, we believe we are situated in the Late Cycle.
- Leading economic indicators are beginning to slow in terms of rate of change. While we are still seeing upward movement in many leading economic datapoints, the pace of the growth is slowing. Notably, the current outlook, painted by leading indicators, is more Expansionary and less Late Cycle; current economic growth is much higher than it has been throughout history.
- Inflation has proven to be more persistent than the Federal Reserve had originally anticipated which is starting to drag on economic growth. Price pressures from supply chain issues and the Russia/Ukraine conflict are to blame for the recent surge in prices. Food, energy, and service prices are expected to continue to increase throughout 2022. Inflation of goods is expected to moderate soon; tighter financial conditions and stretched consumer budgets will most likely help moderate prices. We expect overall inflation to peak in the second half of 2022 as supply chains continue to ease, the Fed implements restrictive policy, and consumers spending habits shift.
- Monetary Policy has recently shifted from extremely accommodative to very restrictive. The Fed is expected to raise interest rates aggressively throughout 2022 and will begin a cycle of quantitative tightening (the selling of assets from the Fed’s balance sheet) later this year. Restrictive monetary policy will lead to tighter financial conditions hoping to moderate price levels without completely stopping the economy. Restrictive policy is intended to slow demand and we expect this policy to slow economic growth.
- Business confidence is also beginning to wane, shown by lower PMI (Purchasing Managers’ Index) readings throughout the globe.
What are Acumen’s thoughts on the Equity Market right now?
The S&P 500 has returned 26%, 90%, and 112% over the previous one, three, and five years as of 12/31/2021. We have witnessed some astonishing years of gains for equity investors, and the highest across longer time frames than we have seen over the previous 20 years. We do not necessarily use historical returns to assess the probabilities of what might happen in the future, but it is at least noteworthy to point out equity investors have had quite a ride post Great Financial Crisis.
We choose to be forward looking in our approach. From this perspective, there are a few questions we would like to answer to determine if we are a buyer or seller of equity risk in portfolios. On one hand, our Late Cycle forecast inherently causes us to be less constructive on risky assets. During the later stages of the Business Cycle, riskier assets are not able to digest volatility as well. A perfect example of this was 2020 when there were plenty of volatile headlines and risk events for financial markets, but equities were notorious at digesting this volatility because of the newly formed expansion. Essentially, the stage of the Business Cycle had brought equity valuations to a point where enough risk was priced in, and which is not normally the case during the later stages.
This stage of the Business Cycle is a perfect segway into our outlook for valuations and equity market fundamentals. Essentially, we can break up our forecast for the return on equities into two components – the growth in expected earnings and the valuation multiple investors will pay for these earnings – which multiplied together gives us our forecasted price. We believe there are headwinds to both factors today. Unlike many investors, we believe the valuation multiple investors should pay for equity investments is fluid and depends on a few factors. Today, we see restrictive monetary policy, slower forecasted economic growth, and higher bond yields causing headwinds to this multiple. In turn, growth in expected earnings would have to make up for this contraction in valuation multiples. We believe we will see earnings growth normalize to the lower range of the long-term average – around 8%. While we steer clear of making a strict forecast for these variables, we believe we can identify a range of outcomes, and, as a result, build a risk/reward profile. The risk reward profile, given our forecasted range for both variables, spell more downside for equity risk than upside. As a result, we believe investors should be underweight equity risk in their portfolios, and we are managing portfolios accordingly at Acumen.
This belief, of course, is a tactical perspective and we believe investors should continue to buy into equity market weakness. On one hand, there are demographic factors causing us to believe equities will be long-term outperformers over other asset classes. At the same time, the relative valuation for equities is still attractive in the long term, and most businesses are much better capitalized and have higher earnings growth rates than what we have seen historically.
What are we doing within Equity exposure to represent this viewpoint?
Of course, we do not believe in attempting to “time” the market. Instead, we observe the risk/reward profile for different assets and move tactically around targets based on this. Right now, based on fundamentals and our outlook on the Business Cycle, we see more risk than reward for equities. As a result, we have positioned portfolios to be underweight their typical equity target and underweight equity risk as a whole. However, because we do not want to try to time the market, equity exposure will remain in portfolios. Within this exposure, we are allocated to areas of the equity market we believe will outperform on a relative basis during this phase of the cycle. While 2020 and even some of 2021 saw high growth and speculative equity investments outperform in a large way, we are more focused on identifying high quality companies traded at a fair price. These are investments in companies we believe will last throughout different phases of the market cycle. This belief is our current primary focus within equity exposure.
What are Acumen’s thoughts on the Bond Market?
The bond market is experiencing one of the worst drawdowns in recent history. We have not seen price decreases like this since the bond bear market of the late 1970’s and the Great Financial Crisis of 2008. A hawkish Federal Reserve, looking to abate decade high inflation, has been the catalyst for pushing yields higher. As a result, volatility in fixed income markets should be expected to continue throughout the year; the Fed is embarking on a very quick rate hike cycle, credit spreads are widening, and geopolitical tensions are high. Higher credit risk should also be expected as tighter financial conditions and lower growth expectations raises credit risk. U.S. companies have benefited from years of low-cost financing and have healthy balance sheets. Therefore, most companies should be set up to avoid default, but as financial conditions do become worse, credit spreads should expect to widen.
Even though volatility is expected to remain, yields have risen significantly and there are opportunities to lock in higher yields. Going forward, headwinds for bonds are still present, but the risk/return in fixed income is looking better than we have seen in recent years.
What are we doing within Fixed Income exposure?
Our core fixed income exposure will continue to be investment grade municipal bonds. As financial conditions tighten, we feel comfortable with the capacity of municipal governments to service their debt. Most state and local governments still have unspent federal aid from 2021 that will continue to provide some fiscal cushion. Yields have risen significantly, and valuations for munis are attractive. We want to take advantage of opportunities to lock in higher yields when they are available.
If we are underweighted in Equities and Bonds, what are we allocating?
Our views going in to 2022 was to be underweight both equities and bonds. This decision has turned out to be a good asset allocation as the S&P 500 is down more than 3.00% and the Bloomberg Barclays U.S. Aggregate Bond Index is down 6.30% year to date (as of 3/30/2022). However, to be underweight in both of the primary asset classes, we need to be overweight something else. Over the last year, as both the equity market and the bond market have looked more overvalued, we have been allocating a portion of portfolios to Alternatives. Now, Alternative Assets is a technical term with different meanings to various money managers, but to us, this just means something other than traditional equity or bond exposure. Alternative Assets could include commodities, private assets, hedge strategies, etc. During this environment, we have favored strategies that provide some equity market exposure, but also provide income opportunity through options strategies. We continue to favor similar strategies in the current environment.
Acumen’s Investment Views
Information used in this commentary was obtained via Bloomberg L.P.
The opinions expressed in this commentary should not be considered as fact. All opinions expressed are as of the published date and are subject to change. Information contained herein is not and should not be construed as an offer, solicitation, or recommendation to buy or sell securities. Investments in securities involves risk, will fluctuate in price, and may result in losses. The information has been obtained from sources we believe to be reliable; however no guarantee is made or implied with respect to its accuracy, timeliness, or completeness. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. Comments concerning the past performance are not intended to be forward looking and should not be viewed as an indication of future results. Diversification does not protect against loss of principal.
A business cycle, sometimes called a “trade cycle” or “economic cycle,” refers to a series of stages in the economy as it expands and contracts. Constantly repeating, it is primarily measured by the rise and fall of gross domestic product (GDP) in a country.
The S&P 500 Index is widely regarded as the best single gauge of the U.S. equities market. The index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. The S&P 500 Index focuses on the large-cap segment of the market; however, since it includes a significant portion of the total value of the market, it also represents the market. The Bloomberg Barclays Aggregate Bond Index is an index used by bond traders, mutual funds, and ETFs as a benchmark to measure their relative performance. The index is broadly considered to be the best total market bond index, as it is used by more than 90% of investors in the United States.
All indexes are unmanaged and an individual cannot invest directly in an index. Index returns do not include fees or expenses.
Acumen Wealth Advisors, LLC® is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Acumen Wealth Advisors, LLC® and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Acumen Wealth Advisors, LLC® unless a client service agreement is in place.