Perspectives

Princeton Global Second Quarter 2022 Investor Letter

July 7, 2022

Equities sharply declined during the second quarter of 2022, leading to an overall first half correction which was the largest since 1970 for the S&P 500 Index. Investor concern over persistent inflation, particularly in the U.S. and Europe, and the risk to economic growth due to tightening monetary policy led to the selloff. The U.S. stock market broke its trend of outperforming world markets in total return during the second quarter. Emerging markets declined less, reflecting efforts by China to offset the impact of its “zero COVID” policy through stimulative monetary and fiscal policy.

The global equity market outlook for the second half of 2022 depends on how much inflationary pressures ease, reducing the tightening needed by the monetary authorities and the Federal Reserve. According to Federal Reserve Chair Jerome Powell, the commitment to bring down inflation is “unconditional.” This hawkish stance should be reflected in further significant increases in the Federal Funds rate during the remainder of this year, with rates likely to be in the 3% range by year-end. At the same time, the Fed’s $9 trillion balance sheet is gradually reducing. The rise in rates is intended to dampen demand, particularly for consumer durable goods, including housing. If effective, the need for the Federal Reserve to continue increasing interest rates in 2023 will be reduced, lowering the potential for prolonged economic weakness.

The U.S. economy is starting from a relatively strong position in terms of the financial condition of households and a tight labor market with record-low unemployment. However, there is evidence that the economy is slowing down due to rising interest rates. Measurements of consumer confidence such as the University of Michigan and Conference Board surveys are extremely pessimistic as of the end of the second quarter. This sentiment is translating into slowing demand. The housing market is already beginning to soften as a near-doubling of mortgage rates to nearly 6% since the end of 2021 is hurting home sales and cooling the dramatic increase in home prices over the prior year.

On the supply side, there are indications that the supply chain problems are easing (finally!). As of June 24, the number of ships waiting to unload in the Los Angeles/ Long Beach port is down to 16 from a peak of 109. Another revealing signal for an upcoming economic slowdown is the recent decline in key commodities prices. These include copper, tin, and nickel, which have declined by well over 20% since reaching their highest levels in early March this year. The overall outlook is for a slowing U.S. economy and the increasing probability of a recession, although a recession is not inevitable. Following the year-to-date price declines, even a mild recession would have favorable implications for equity prices during the later portion of 2022. This outlook is particularly the case for the shares of companies that can maintain solid earnings and cash flows in the face of inflationary pressure on profit margins.

It was a dreadful start to 2022, but significant intra-year declines in the stock market are not uncommon. Any “less bad” news on inflation or clarity on the economy could lead to a recovery rally, which is also not uncommon:

 

Outside the U.S., Europe is facing a similar problem with inflation. Unlike the U.S., the war in Ukraine results in the risk of energy shortages which could exacerbate the price of gasoline and natural gas in the months ahead with the risk of gas shortages during the winter. The European Central Bank is adopting a hawkish stance to offset the impact of inflation aggressively. Still, the ECB is starting behind the Federal Reserve, so the risk of a significant economic slowdown is greater than the U.S. China has already suffered a significant slowdown due to its aggressive approach to COVID and resultant lockdowns and activity restrictions in major urban areas. The combination of more stimulative monetary and fiscal policy and a slight easing of COVID restrictions should favor relative strength in the Chinese economy. A healthier China would positively affect global economic growth in the coming quarters.

Equity Strategy

Our goal for 2022 remains to preserve the equity gains of prior years and opportunistically “upgrade” individual stock and exchange-traded fund holdings ahead of an eventual recovery. We have seen many of our long-term holdings decline 20-30%, but we remain confident they will rebound, unlike speculative areas of the market we have avoided. We anticipate elevated near-term volatility over the next several months, and the market will likely test new lows as it finds a bottom. The 20% year-to-date decline in the S&P 500 is due entirely to valuation declines resulting from investor uncertainty and risk aversion. We are closely monitoring signs of “capitulation,” which appears closer after watching the market’s recent whipsaw sector rotations (most recently Energy) and days of broad sell-offs (nowhere to hide).

Investor and consumer sentiment on the market and the economy has deteriorated to historic lows. Depressed sentiment coincides with depressed market levels, but it is a bullish contrarian indicator:

If history is any guide, equities have sharp rebounds following horrible periods like the one we just experienced. Below are forward returns after similar scenarios:

Source: Bespoke

Corporate earnings have been excellent over the past five quarters, and earnings upside led to strong market returns in 2021. Estimates so far for 2022 have been resilient, and analysts currently expect over 10% earnings growth for the year, consistent with constructive first-quarter outlooks from management teams. However, as recent economic data has softened and company profit margins will be pressured by inflation, we anticipate earnings growth will decelerate and potentially briefly decline. The stock market is a leading indicator, but the magnitude of the dislocation between the market drop vs. positive earnings forecasts is rare. It has only occurred twice in the last 30 years. On both occasions, earnings growth forecasts turned briefly negative and were better than feared, leading to positive future market returns. In second-quarter reports, we believe many companies will use the poor market sentiment to adjust earnings expectations lower and set up future upside.

Has the market overshot the earnings impact of a worsening macro outlook? The below chart is busy, but 2022 has similarities to 2002 & 2011, which experienced sharp recoveries:

The deep stock market correction has created opportunities, and we see many quality companies trading at pre-pandemic valuations. We have made selective portfolio changes and see opportunities in several areas:

  • Value stocks are in the early innings of outperformance vs. Growth stocks. Our preferred approach is blending Value with Quality characteristics, particularly in Health Care and Technology.
  • Mid-cap stocks are attractively valued compared to the largest stocks in the indices. At the recent market lows, smaller-cap stocks priced in a full recession.
  • Many stocks have experienced significant valuation declines despite improving company earnings outlooks.
  • The necessity for global energy infrastructure investments is critical and should be less immune to economic weakness. Select Industrials companies are well-positioned for this megatrend.
  • Companies with pricing power can offset inflation and maintain prices if input costs decline.
  • There are extreme value opportunities in the Consumer Discretionary sector. We see a resilient U.S. consumer but a shift in consumer behavior toward experiences over goods.

The pandemic caused a shift into goods over services consumption, which is reversing:

Source: KKR

Fixed Income Strategy

As a result of the shifting of Federal Reserve policy to combat inflation, U.S. interest rates continued to rise in the second quarter leading to a 10.4% year-to-date decline in the Bloomberg U.S. Aggregate Bond Index. Yields on Treasuries increased across the curve in 1Q & 2Q:

Yields in the shorter-term end of the bond market have reached attractive levels, with investment-grade corporates now providing yields of as much as 4%. We favor short-duration fixed income investments in client portfolios to provide ballast and diversification to equity exposure. We have recently increased investment-grade corporate bond purchases in the one to three-year maturity range to complement ultra-short and floating-rate fixed income exposure. Short-term bonds have similar interest rates to “core” bonds and longer-term bonds with significantly less interest rate risk. Even if yields were to rise further, the bond principal would be returned in a relatively short period, providing positive returns and the ability to reinvest in the higher rates of return.

Source: Bloomberg, J.P. Morgan Asset Management

Despite the unsettling volatility, we are staying the prudent course and not losing sight of your long-term goals and objectives. We are always available to discuss any investment or financial matters you may have.

Sincerely,

Princeton Global

Important Disclosures:
This report is for informational purposes only and contains data based on information from Princeton Global Asset Management (PGAM) believed to be accurate. However, PGAM cannot assure the accuracy of the data. Past performance is not a guarantee of future results. Portfolio holdings and characteristics are subject to change. The information in this report should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of these securities transactions or holdings that may be cited were or will prove to be profitable or the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities cited.