SUMMARY
This is a retrospective article that looks back at select asset returns for the first five months of 2022. Global markets have come down from the stimulus-fuelled pandemic high with a crash as stretched valuations, higher energy prices, an unexpected attack on Ukraine by Russia, raging inflation, on-going supply chain disruptions, and central banks turning decisively hawkish have caused sentiment to sour. Of course, looking back is interesting but not necessarily a reflection of what might lay ahead as this has been a particularly turbulent year in global financial markets. Nonetheless, there might be messages we can glean by looking at what has transpired so far this year.
DATA INCLUDED: INDICES AND ASSET CLASSES
For purposes of the indices and asset classes, I have mainly followed those that I track and update each week in E-MorningCoffee. The exceptions I have made include:
The NASDAQ 100 has been included as one of the US equity indices in lieu of the NASDAQ Composite,
Total returns have been presented for US Treasuries and corporate bonds instead of simply presenting yields and spreads, and
An index for US real estate – the Dow Jones Real Estate Index (DJUSRE) – has been added. [1]
For the equity indices, I have measured YtD returns two ways: one including the (pro rata) dividend yield, and one for the index only without dividends, which is the way I track returns in the weekly updates I have also included current P/E ratios (TTM), gathered from a variety of sources, and I acknowledge that the data is not necessarily consistent from index to index but is close enough. The P/E ratios should give you a sense of relative valuation across the various global and US equity indices.
The four tables I have included in this article are:
Six global equity indices: S&P 500 (US); FTSE 100 (UK); STOXX 600 (Europe including UK); Nikkei 225 (Japan); Shanghai Composite (China) and MSCI EM index (emerging markets).
Four US equity indices: S&P 500 (same as for the global indices); DJIA; Russell 2000; and NASDAQ 100.
Total returns for US Treasury and corporate bond indices:
Two US Treasury (total returns): 7-10 year maturities (intermediate duration); and 20+ year maturities (long duration)
Three corporate bond indices: one USD-denominated investment grade; one USD-denominated non-IG (high yield); and one EUR-denominated non-IG (Euro high yield)
Four other asset classes: gold; oil (WTI crude); Bitcoin (as a cryptocurrency proxy); and US real estate (principally commercial REITs, as mentioned above).
For each table, I have shaded the best relative return for the period in green, and the worst relative return for the period in red.
THE DATA AND WHAT IT MEANS
Global equities
Global equities, part 1: S&P 500 and FTSE 100: Amongst the six indices I track, the S&P 500 has been the worst performing equity market YtD, and the FTSE 100 has been the best. In fact, the FTSE 100 is the only index with a positive return so far this year. The overall poor performance of the S&P 500 this year (-13.8%) vis-à-vis 2019 (+28.9%), 2020 (+16.3%) and 2021 (+26.9%) can be traced to several things. Firstly, US equity markets generally were the most expensive going into 2022 (and still are). Secondly, the performance of technology giants – including the FAMAG stocks, Tesla and Nvidia, all of which are sharply down on the year – remain very influential as far as driving returns for the S&P 500. In contrast, the FTSE 100 – the best performing index YtD – is “tech light”, and the weighting of the FTSE components is skewed towards some of the best-performing sectors globally in 2022, including energy / oil companies and commodities companies. The FTSE 100 also has traditionally been - and remains - the cheapest of the four developed market equity indices I track. Lastly, the high dividend yield (circa 3.5%/annum) of the FTSE 100 provides downside cushion and is defensive in difficult times. Whether or not the strong relative performance of the FTSE 100 will continue remains to be seen. I have doubts because the U.K. is heading quickly towards a period of stagflation and a likely recession in early 2023, neither of which would be friendly for stocks, or at least those components that are more domestic/European focused.
Global equities, part 2: China: China has been a difficult place to invest over the last 12 months or so for a variety of reasons, the most recent related to COVID-related shutdowns. However, it you are able to park your biases on China (and emerging markets stocks generally), the data suggests that Chinese equities might have bottomed and are starting to gain some momentum. China was the best performing index I track in May, and Chinese equities also remain the least expensive from a valuation perspective. Having been burned now on Chinese stocks in the past (and one unfortunate Russian stock), I remain sceptical of emerging markets generally because of “black swan” events that seem to occur from time to time. Nonetheless, it appears that Chinese equities are slowly coming back into favour.
US equities
I touched on the issues in the “global equity indices” section that have contributed to the decline in the S&P 500 this year. As you can see in the table above, the issues that I mentioned which have led to the decline in the S&P 500 have spared none of the other US equity indices. The most perversely affected – perhaps not surprisingly – has been the NASDAQ 100, an index loaded not only with the large tech names, but also with many (relatively newer) “high flyer” technology companies which have taking a beating for many months now, in fact dating back to early 2021. The Russell 2000 – a perceived value play – is perhaps anything but that on the surface, as this index has the highest P/E ratio of any of the US indices (because many of the small and mid-cap companies are barely profitable or still lose money). The DJIA has been the best relative performer amongst the US indices so far this year because – not dis-similar to some of the characteristics I mentioned regarding the FTSE 100 – it is more diversified by sector than the other US indices presented, has the highest dividend yield and has the lowest P/E ratio. The index is also relatively concentrated with only 30 components. (Check out this article from S&P Global if you want to find out more about the differences between the S&P 500 and the DJIA.)
US fixed income: US Treasuries and corporate bonds
As poor as returns have been for the S&P 500 this year, the total return on long-dated US Treasuries(20+ year total return index) has been even worse. The main culprit of course has been rising inflation and the Federal Reserve’s ongoing hawkish steps to reign this in, including both raising the Federal Funds rate and now reducing its balance sheet (started June 1st). This cocktail of circumstances has put yields under pressure all year, with longer-duration bonds being the most severely affected, as you can see in the table above. Unusually, the traditional “bonds up, equities down” relationship has been thrown out of the window as the negative correlation between the asset classes has become positive, with both bonds and stocks getting hammered at the same time most of the year. This has been the case in both the US and Europe. It is hard to believe that the negative return on the 20+ year UST index has been substantially worse that the negative return on the S&P 500 index! In May, USTs caught a “flight-to-quality” bid, but this faded after three weeks, and now it seems we are back to a positive correlation between stocks and bonds as they both head lower.
In the corporate bonds (credit) asset class, the investment grade corporate bond index has had the worst performance because this index is most influenced by increases in yields on underlying USTs. US high yield (non-investment grade) has underperformed European high yield most months and YtD, aside from March when investors were leaving European high yield bonds because of proximity concerns related to the Russian invasion of Ukraine. Although not shown in this data (because it is not sufficiently granular), drilling down further into the USD non-investment grade universe shows a fairly sharp sell-off at the weaker end of the credit spectrum (B and CCC) over the last few weeks as the Fed has emphasised over and over again that it would be tightening monetary policy. Even so, there is – at least so far – no definitive data suggesting that the “Achilles Heel” of high yield - higher delinquencies / defaults - is becoming an issue.
Other assets: gold, oil, Bitcoin and real estate
As far as the other assets and perhaps not surprisingly, oil has been a big winner YtD. The rising price of oil (WTI crude up nearly 50% in the first five months of 2022) has filtered positively into oil and energy-related stocks. Setting cash aside as an asset class for a moment, gold has actually had the third best return across the asset classes I have presented, positive for the year and only slightly weaker than the return on the FTSE 100. US real estate (albeit mainly commercial REITs) has also declined, more or less similarly to the S&P 500 and long-dated UST bonds. The market is most certainly cooling in residential real estate in the US, although as with equities, the gyrations have remained orderly for the time being. The culprit here is rising interest rates, which negatively affect income-driven real estate because the discount rate is higher.
Cryptocurrencies have also been on a wild ride this year. I will not go into the details, but all cryptos are not created equally and have therefore not performed the same. Recall the issues with stable coins in early May, which rocked the crypto market. I have included Bitcoin in the table above because it is the best known and largest cryptocurrency. There is an argument that I have recently heard that within the asset class, a “flight to quality” has occurred as investors have left lesser cryptos and moved into Bitcoin, providing some support for the price of Bitcoin vis-à-vis other coins. Still, Bitcoin’s YtD return is far worse that the worst US equity index – the NASDAQ 100 – and is in fact the worst-performing asset class this year so far of all the indices and asset classes that I track.
CONCLUSION
We are well off pandemic highs in almost every asset class I have included aside from oil and marginally, the FTSE 100 and gold. I suspect the cocktail of issues I mentioned at the beginning of this presentation have a ways to go before the excesses are wrung out of financial markets. Valuations matter as investors are being forced to become more and more discriminate under increasingly challenging market conditions. Keep in mind that asset returns eventually revert to their long-term mean, and this will be the case even though there has been excess manipulation by governments and central banks during the pandemic. Conditions are getting tighter, and the best advice I can offer is to diversify, stay the course, and focus on asset classes and individual stocks and bonds that have the best characteristics to (relatively speaking) withstand increasingly difficult market conditions.
If I were forced to be more specific for the remainder of 2022, I would probably lean towards value and defensive US sectors / stocks (pharma, consumer non-discretionary, healthcare), energy /oil & gas / commodity stocks, Chinese equities (small allocation), high yield bonds (avoiding B/CCC if possible) and leveraged loans/floating-rate HY funds (as a hedge against increases in the Fed Funds rate). I also think intermediate and even long duration US Treasuries might be attractive from time to time because yields are probably are near peak levels, although there is risk that yields could go higher if inflation is not confidently believed to be under control and on a downward trend. Rising interest rates and higher oil prices will both eventually prove to be drags on economic growth, and these shape my longer-term concerns around asset classes like lower-rated high yield bonds and cyclical equities. Also, I am far from confident we have seen the bottom in global equities. If sentiment continues to sour and there are knock-on wealth effects, things could very well get worse before they get better. Valuations will ultimately provide a floor, but most equity markets (including US stocks) arguably remain over-valued. I am confident though about one thing – markets will overshoot on the downside and trying to time the perfect entry is a fool’s game.
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[1] With respect to real estate, my preference would be to identify a residential real estate index rather than a commercial / property index, especially since the DJUSRE is mainly comprised of select REITs. I am still working on this because the residential real estate measures I have come across are severely lagging. Any suggestions?
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