It has been a difficult year in the markets, with equity markets down more than 20% and “low-risk” bond markets registering low double-digit losses. The S&P 500 dropped 16.1% for the quarter and is now down 20% for the year, after being down as much as 24% through mid-June. Foreign stocks fared slightly better with Developed international markets (MSCI EAFE Index) down 14.5% for the quarter and 19.6% YTD. Emerging Market (MSCI Emerging Markets Index) stocks held up a bit better, dropping 11.4% for the quarter, and down 17.6% YTD.
Core investment-grade bonds struggled again in the second quarter, with the benchmark Bloomberg U.S. Aggregate Bond Index (the “Agg”) dropping 4.7%. This puts the “safe-haven” Agg down an incredible 10.3% for the year to date — its worst first-half ever.
Our portfolios have been underweight core bonds for a couple of years, primarily due to concerns related to how traditional fixed income behaves in an inflationary (rising interest rate) environment.
OJM PORTFOLIO UPDATE
While absolute returns were disappointing this quarter, our balanced portfolios outperformed their benchmarks.
Our equity portfolios benefit from a tilt towards quality and value, contributing to relative outperformance of our domestic stock allocation. High growth-low profitability stocks were harshly punished for the second consecutive quarter. The Russell 1000 Growth Index lost 20.92% in the quarter, compared to a 12.21% decline in the Russell 1000 Value index. Investors participating in our sector rotation strategy also benefitted from the technical strategy’s modest outperformance vs the S&P 500.
The bonds within our portfolios slightly underperformed the Aggregated bond index in the second quarter. Our bonds’ shorter duration relative to the index added value, however non-investment grade debt underperformed as investors prioritized high quality over yield.
In addition, our allocation to alternative investments, added value relative to the core bond index (Bloomberg U.S. Aggregate Bond Index). Alternative investments are funded from our core bond budget, utilizing positions in long/short equity and managed futures strategies.
INVESTMENT AND PORTFOLIO POSITIONING
Over the past few months, investors have become concerned with high inflation and slowing growth, as the Federal Reserve and other global central banks aggressively tighten monetary policy. A sharp economic growth slowdown in the U.S. (and abroad) is all but certain this year and the risk of recession over the next 12 months has risen.
Our best guess at this point is that if the U.S. economy does fall into a recession, it is likely to be a more “normal” type of cyclical recession rather than like the 2008-09 financial crisis, the 2000-2002 dotcom bubble burst, or the 2020 COVID recession.
Given the sharp stock and bond market declines we have already experienced this year, this leads us to a relatively positive medium-term (five-year) outlook for financial markets and asset class returns. And if U.S. stocks drop further this year – for example, due to increasing recession fears – we will start adding incrementally more to our portfolio allocations.
In terms of our fixed-income positioning in our balanced portfolios, we have maintained our significant underweight to traditional core bonds, reflecting our concerns about rising interest rates and extremely low starting yields.
A key part of our fixed-income diversification has been our allocation to “Alternatives.” We believe well-managed alternative strategies with reasonable fees can add beneficial diversification and improve risk-adjusted returns as part of traditional stock/bond balanced portfolios. Alternative investments have different risk and return drivers than traditional stock and bond investments. Given the current macro risks and market backdrop, we think alternatives are especially valuable.
We are not ruling out the possibility of further downside for the stock market over the next several months or quarters. If that happens, we are more likely to be buyers rather than sellers and will look to increase our exposure to stocks at more attractive prices. On the other hand, if the economy avoids recession (for now) and the markets rebound, we are well-positioned to benefit.