2022 is off to a rocky start. This week marked the seventh straight week of declines for equity markets. Since the start of the year, the Dow Jones Industrial Average is down about 13% while the S&P 500 officially moved into bear market territory (down 20% from the high) before reversing higher at the end of the day. Year-to-date, the S&P is down 17.8%. Losses in the technology-focused Nasdaq Index are even more severe, with the index down over 27% since the start of the year.

The path of least resistance has been lower as the Federal Reserve and other central banks around the world embark on a policy shift. After two years of zero interest rates and quantitative easing, the Fed abruptly changed course early this year as it read the tea leaves on surging inflation due to lingering supply chain issues, disruption from the war in Ukraine, and recent Covid-related shutdowns in China. The Fed most often uses two tools to try and bring inflation under control: 1. Moral Suasion, which is affecting the markets expectations via public pronouncements are future actions and 2. Increasing the Federal Funds Rate, which is the rate at which banks borrow money from the Fed or each other for one day.  A third tool is called Quantitative Tightening (QT). This has only been used once before, briefly in 2018. QT is the process of the Fed reducing the size of its balance sheet. The Fed announced their intent to raise the upper band of the Fed Funds rate from 0.25% to 1.00% in its last two meetings and is expected to announce four more increases, bringing us to a range of 1.75%-2.00% by the end of the year.  The Fed has not yet embarked on quantitative tightening, but it plans to begin selling assets and reducing its balance sheet in June.

The market is reacting to these anticipated changes and to the possibility that the Fed will not be able to achieve a “soft landing,” meaning it will not be able to rein in inflation without causing an economic recession. In addition to these macroeconomic overhangs, a slew of dire retail results from Walmart (tkr: WMT), Target (tkr: TGT), Ross Stores (tkr: ROST) this week noted worsening pressures on margins and earnings due to inflation and supply chain pressures alongside the continued shift in spending from goods toward services. This could be an indication that we are beginning to see demand destruction on the consumer side due to surging costs in food and fuel. Meanwhile, consumer debt levels are creeping higher and personal savings rates have bled lower as consumers are burning through the pandemic stimulus funds they received over the last two year. The average 30-year mortgage rate has risen to 5.25%, sparking questions about the future of the recent housing boom. The Conference Board noted that 68% of CEOs are worried that Fed tightening will spark some form of recession.

So where do we go from here? Goldman Sachs noted that the S&P 500 has seen an average contraction of 24% for 12 recessions since World War II. The S&P 500 forward price-to-earnings ratio has compressed to 17.1x from over 22.7x earlier this year, but is still slightly above the 16.8x average over the past 25 years. Rising yields make the TINA (“there is no alternative”) phenomenon less persuasive—there actually IS an alternative with Treasures producing some yield now—and place more pressure on stock market valuations, which could mean further downside ahead.

In client portfolios, we have made changes in both the fixed income and equity portions to reduce volatility and increase security. We have scaled back historically high equity allocations and trimmed or sold those stocks that carry high valuations in favor of more defensive equities that have low valuations and pay dividends. In the Fixed Income side of our larger portfolios we have reduced the ETF holdings and bought short term US Treasury “Ladders” with 25% of the Ladder maturing in 6, 12, 18 and 24 months.  This has raised liquidity and reduced credit risk.  With funds maturing every six months we will be able to benefit from rising rates without significant capital losses.

Individual investment positions detailed in this post should not be construed as a recommendation to purchase or sell the security. Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Employees and/or owners of Nelson Capital Management, LLC may have a position securities mentioned in this post. Please contact us for a complete list of portfolio holdings. For additional information please contact us at 650-322-4000.