Client Letter 2022 Q2

Q2 2022 Market Results

The second quarter was a rough one for the markets.  The S&P 500 was down -16.1% and down -19.96% for the year.  The most recent YTD low was on June 16.  International markets were down -14.29% for the quarter and down -19.25% YTD.  Emerging markets were down -11.92% and are down -17.47% YTD.  The general bond market was down -4.69% for the quarter and is down -10.35% YTD.  Short treasuries were down -0.51% for the quarter and down -2.95% YTD.

Portfolio Thoughts

Portfolios were down again across the board in Q2-2022.  Both equities (stocks) and bonds were down in the U.S.  And because of that, both aggressive and conservative portfolios were down.  None of our portfolio strategies held up particularly well, though our Tactical portfolios did slightly better mostly due to the specific tactical options we included.  Historically, this is a very strange looking market considering that the S&P 500 was up over 13% in the second half of 2021, then down close to -20% in the first half of 2022.  It’s easy to let down markets like this play into our emotions.  But, from our view, the pace of this decline has made it too late to sell, and perhaps, too early to buy.  We just don’t think the current uncertainty is resolved and we could possibly see more lows in the next month or two.  Markets are worried, and for good reason, that the Federal Reserve (FED) will raise rates so quickly and aggressively that the economy will get pushed into recession in 2023.  We feel there is a 50-50 chance this happens.

Our belief is that we should see improvements in the labor market and supply chain, which could ease inflation as we get into August.  But, if those improvements come slower than we expect and the FED continues raising rates, we could see a recession in 2023.  We don’t think we will see a recession in 2022, but the odds have gotten worse in the last month.  The most recent Atlanta Federal Reserve Bank prediction is for another negative Gross Domestic Product (GDP) reading in the second quarter, which would put us in technical recession now.  We feel Q2 GDP will come in positive, but no guarantee.  Worst case scenario as we see it is a recession in early 2023 that is not very deep and doesn’t last very long.  We expect to see a healthy recovery by mid-2023 if this happens.  Thus, for now, as hard as it is, we have to grit our teeth and get through this volatility.  Better days are coming.

Q2 2022 Notes

Without question the biggest story so far this year is the Russian invasion of Ukraine.  Let me be clear that I believe this invasion is the biggest geopolitical event of my lifetime.  Russia has decided to invade, destroy, and politically takeover, a country it feels needs to be part of its sphere of influence.  This kind of invasion hasn’t happened in eighty years.

Russia already had a high level of control in the Donbass region of eastern Urkraine, and that area is near completely surrounded by Russian soldiers.  Russian soldiers and heavy artillery are also surrounding the areas of Mariupol in the southeast and Kherson in the south.  Most analysts believe these areas are crucial to Russia building, and controlling, a land bridge from Russia to Crimea.  There is also significant bombing activity around the Ukrainian capital of Kyiv, and though the city is a shell of its former self, it has not fallen into Russian control.  Odessa, an important Black Sea port city has seen some shelling but has not yet been devastated as in other areas.  Western parts of Ukraine such as Lviv have been bombed but not to the same extent as other areas.  That could be because Lviv is not far from the border with Pola

One important topic to cover here in the U.S. is tied to our Federal Reserve Bank (FED).  After a surprisingly high inflation rate was announced for May, the FED increased interest rates at its June meeting by 75 bps (0.75%).  This after FED Chair Powell had said at the May FED meeting that a 75 bps increase was off the table.  Their surprising move indicates that the FED is feeling a bit behind the eight ball on inflation, and they need to increase rates more quickly than most everyone expected.  This move has the stock market and economists worried that the FED may go too far and too fast with rates and result in recession.  The challenge here is that we have three areas of concern for the economy: inflation, the labor market, and the supply chain.  As the FED works to get a handle on inflation with interest rates, they may move the needle closer to recession.  But the other two items have influence as well.  The labor market and supply chains are both improving, albeit slowly.  If they improve enough, it may offer some balance to increasing interest rates, and recession may be avoided.  Lots of moving parts and very hard to predict.  Our base case is that we feel we have a 50-50 chance of recession come 2023.  Not the best odds, but we also feel it would be a relatively weak and short recession.  As said earlier, better days are coming.

Globally, it makes sense to spend some time talking about Russia and Ukraine.  As you all know, Russia invaded Ukraine on February 24, 2022 and for the most part did not have the best military showing in the early stages.  Strategy, tactics, logistics and training all appeared to be lacking in those early days.  At the same time, Ukraine showed remarkable resilience and presented a leader of incredible bravery to the world stage.  The expected 72 hour collapse of Ukraine did not happen.  All the while the North Atlantic Treaty Organization (NATO) was unifying an anti-Russia strategy by both supporting Ukraine’s military needs and imposing crippling economic sanctions of Russia.  NATO hasn’t been this organized, unified, and relevant since the 1950’s.

But that’s all water under the bridge.  The newest phase of the war is showing Russia to be willing to learn from mistakes and adjust to the current reality.  They have shifted away from population centers in the center to south of the country and focused much more on the eastern to south-eastern areas of the Donbas region south toward Crimea.  Thus, they are pursuing a smaller region and concentrating their men and artillery in support.  Keep in mind that Russia has more men, more artillery, more armor and likely more reserves than Ukraine will ever have.  Russia is now using a well-known, and well-established practice of scorched-earth tactics to utterly destroy not only Ukraine’s military, but they are purposely destroying all manner of infrastructure.  The idea is to leave Ukraine a barren wasteland that can’t even support a rag-tag resistance.  As the number of refugees grows and Ukrainian soldiers realize their country is evaporating the resistance will naturally decline.  Russia is banking on its ability to grind away and erode the Ukrainian forces to a point where they will either surrender or be obliterated.  The war is heading toward an end where Russia ends the fighting in exchange for annexing the Donbas region south to Crimea and Ukraine has little option but to agree to the deal.

But what about NATO and the United States support for Ukraine and their ability to send military aid?  Well, this is where geopolitics starts to become important.  The United States, and NATO (which essentially doesn’t exist without the U.S.) needs to be sure that Ukraine, as a whole country, does not fall to the Russians.  This would leave Russia’s border zone directly adjacent to Poland, a NATO country.  That would be unacceptable.  But, the idea of Russia annexing the eastern portion of Ukraine (this after annexing Crimea from Ukraine in 2014) is less of a critical concern.  Ukraine would continue to exist as a country, Russia would have its extended border zone and the threat to other NATO countries would be reduced, though not completely eliminated.  Finding a compromise solution is geopolitically critical because the U.S. has already sent Ukraine a substantial portion of its military stock and will need to continue spending money, and political capital, to make weapons and ship them to Ukraine.  That process can’t go on forever and the U.S. knows it.  We have no idea how long this will take, but as we approach winter it seems we may see signs of something developing.

As always, we will watch and research the global economy and make investment choices to the best of our ability for each and every client portfolio.  If you have questions about your portfolio, our views expressed in this letter, or anything else financial, please do not hesitate to call.

nd, risking escalation.  Or, it could be that Russia just hasn’t gotten there yet with heavy artillery.

The good news, as best we can understand it, is that the Ukrainian military, and even citizens, are pushing back and holding up against a vastly superior force.  Russia has more men, more guns, more tanks, and more artillery than Ukraine.  But Russian errors in planning and logistics have prevented the 72-hour full takeover many experts were expecting after the invasion.  Now we are a month into the war and Ukraine has not fallen.  NATO countries have been a huge help by sending important military equipment, mostly anti-tank and anti-aircraft weapons that have stunned Russia’s advance.  Every day that goes by makes people wonder if Ukraine could win this war.  Others believe it is only a matter of time before Russia gets its act together and ramps up its wanton destruction.  We’ll just have to wait and see.

So, what does this all mean going forward?  Well, let’s assume Russia does get its act together and starts more forcefully, and effectively bombarding Ukraine into submission.  Ukrainian President Volodymyr Zelenskyy may be forced to capitulate to Russia, give up his polity and allow Russia to control all of Ukraine’s territory.  The other option to this scenario is that NATO continues to shuttle military equipment into Ukraine and the resistance continues a long, and bloody, fight.  Given the amount of valor and courage displayed by the Ukrainians this option is not outrageous.  The second scenario is that given the high level of setbacks and losses Russia has experienced they decide to back away from the western and central areas of Ukraine and focuses on the eastern region and the land bridge to Crimea.  The logic here being that they effectively take over those areas and either formally, or informally, annex them.  The Ukrainian response here would be a difficult choice; give up territory and sovereignty or continue to fight a guerilla style resistance to retain Ukrainian territory.  Not an easy choice.

As always, we will watch and research the global economy and make investment choices to the best of our ability for each and every client portfolio.  If you have questions about your portfolio, our views expressed in this letter, or anything else financial, please do not hesitate to call.

Best Regards,

Jim