Market insights and analysis

How dynamic, risk-managed investment solutions are performing in the current market environment

2nd Quarter | 2022

Market insights and analysis

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Updates on how dynamic, risk-managed investment solutions are performing in the current market environment.

By Jason Teed

The major U.S. stock market indexes rose last week, coming off mid-June lows. The NASDAQ Composite was the strongest performer, up 4.56%. The Dow Jones Industrial Average was the weakest performer, rising just 0.77%. The S&P rose 1.94% on weaker-than-anticipated economic indicators, which reduced expectations for rate increases going forward. The 10-year Treasury bond yield jumped 10 basis points to 3.08%, coming off recent lows. Spot gold closed the week at $1,742.48, down 3.81%.

Five out of 11 sectors were up last week. Communication Services was the best-performing sector, rising 4.92%. Utilities was the worst-performing sector for the week, down 2.87%. On the whole, risk-on sectors rose and risk-off sectors fell.

Stocks

The rebound in stocks last week was likely driven by improving conditions around inflation and signs that the economy may be slowing, a goal of the Federal Reserve in its fight against inflation.

The consumer price index (CPI) numbers will be released this week, but there are signs elsewhere that inflation may be slowing. For example, the U.S. Core Personal Consumption Expenditure (core PCE) Price Index slowed to 4.7% in May from April’s 4.9% reading. Additionally, gasoline prices have fallen for 26 straight days (as of July 10)—the longest stretch since the beginning of the pandemic—and gasoline futures are off about 20% from their recent high.

The prices of commodities and the components of manufacturing processes have also decreased, another sign that inflation may be slowing. These price declines are likely a result of the anticipation of reduced demand, itself a result of a global recession.

While a recession is not necessarily the goal of central banks, decreasing inflation by slowing economic growth is. Recessions are occasionally the result of the pursuit of such goals.

These drops in price can have a significant impact on inflation in general. For example, the price of oil has been a major contributor to the price increases in goods—not only due to transportation costs of the goods themselves but also the raw materials required to make them. Lower commodity prices across the board will lessen inflationary pressures.

The decline in commodities may also be due to an improvement in supply-chain issues. COVID-related snarls in global supply chains have taken years to address. After the pandemic began, the number of commodities reported to be in short supply spiked and continued to remain high. However, in both the manufacturing and service sectors, the number of commodities with shortages has been declining, indicating that the supply chain is beginning to normalize.

Despite these improvements, the market is still facing significant headwinds. In its efforts to rein in inflation, the Federal Reserve may tip the U.S. into a recession. For the first time since 2020, market experts are putting the probability of that scenario at over 50%.

While these estimates suggest the Fed may not need to be as aggressive in raising rates as other scenarios, they also suggest lower earnings for companies and more downside volatility in the equity markets. Many market experts are expecting a recession, though there is surprisingly little consensus as to whether that expectation is currently priced into the markets.

Another global concern is China’s continued zero-tolerance COVID policy, resulting in lockdowns across the country. Shanghai just came out of a two-month lockdown with significant economic repercussions. It seems likely that they will continue to pursue the policy in the face of the more contagious omicron subvariants BA.4 and BA.5. These new variants may make control more difficult and result in more extreme lockdowns in the country. This would once again put pressure on supply chains and lower global demand for commodities and other goods.

Overall, a recession is expected, but it is also expected to be “mild” compared to the 2008 financial crisis. When it will arrive, how equities will respond, and how high inflation will remain when it hits all remain to be seen. Going forward, volatility in both directions should be expected. Bonds will likely continue to be a poor safe haven as interest rates continue to rise, making active management more attractive than passive investing.

Bonds

Treasury yields were up for the week. Shorter-term yields rose faster than those at longer maturities.

The term yield fell 7.6 basis points, and credit spreads fell about 15 basis points—these are mixed signals in terms of future economic performance. Overall, long-term Treasurys underperformed high-yield bonds, and longer-term bonds underperformed shorter-term bonds.

The two-year/10-year yield curve started the week essentially flat, but it inverted once again by the end of the week. The market expects rates will continue to rise, with potentially another 75-basis-point increase this month, as the Fed continues to combat high inflation. Economic messaging from the bond market seems pessimistic this week.

Gold

Spot gold was down last week, reaching new lows for the year. Year to date, the metal is down about 5.2% after experiencing significant volatility.

Gold has suffered headwinds since early March. The U.S. dollar has continued to rise to its strongest levels in nearly two decades. Gold and the U.S. dollar tend to have an inverse relationship. Rising rates make the U.S. dollar more valuable when compared to other currencies. Because additional interest rate hikes are expected, it’s likely a rising dollar will remain a headwind for gold for at least the next few months.

Inflation has been high in recent months. Gold is typically thought of as an inflation hedge. However, that relationship holds up only under long-term analysis. Day-to-day (or even decade-to-decade) movements and gold can deviate from inflation levels.

Non-currency safe-haven assets, such as long-term Treasurys, were also down for the week as rates rose. This occurred alongside a market rebound, suggesting market participants thought prior equity sell-offs were overdone. Given the nature of the pullbacks in stocks and bonds so far this year, it’s not unreasonable to expect a higher correlation between these two asset classes in the near term.

Flexible Plan Investments (FPI) is the subadvisor to the only U.S. gold mutual fund, The Gold Bullion Strategy Fund (QGLDX), designed at its introduction nine years ago to track the daily price changes in the precious metal.

The indicators

Our Political Seasonality Index was fully invested for the week. (Our QFC Political Seasonality Index is available post-login in our Weekly Performance Report section under the Quantified Fund Credit category.) The very short-term-oriented QFC S&P Pattern Recognition strategy’s equity exposure began last week 1.9X long. It changed to 1X long on Wednesday’s close, 0.9X on Thursday’s close, and 0.8X on Friday’s close to begin this week.

Our intermediate-term tactical strategies have mixed exposure. The Volatility Adjusted NASDAQ (VAN) began the week with a 60% inverse exposure to the markets and changed to 40% inverse on Tuesday’s close. The Systematic Advantage (SA) strategy began the week 30% exposed to the market. It changed to 90% exposed on Tuesday, 30% exposed on Wednesday, and 90% exposed on Friday’s close to begin this week. Our QFC Self-adjusting Trend Following (QSTF) strategy began the week 1X exposed to the markets, moved to a neutral position on Wednesday, and remained there to begin this week. VAN, SA, and QSTF can all employ leverage—hence the investment positions may at times be more than 100%.

Our Classic strategy was out of the market for the week. The strategy can trade as frequently as weekly.

Our strategies mostly remain relatively underexposed to the market, having exited several weeks ago. Volatility remains high and the overall market direction has been down year to date. Market professionals expect further downside volatility.

Flexible Plan’s Growth and Inflation measure, one of our Market Regime Indicators, shows that we remain in the Stagflation economic environment stage (meaning a positive monthly change in the inflation rate and negative quarterly GDP reading). This environment has occurred only 9% of the time since 2003 and has been a positive regime state for gold, and bonds, while equities tend to fall. Gold tends to significantly outpace both stocks and bonds on an annualized return basis in this environment, with a lower risk of drawdown than equities. From a risk-adjusted perspective, Stagflation is one of the best stages for gold.

Our S&P volatility regime is registering a High and Rising reading, which favors equities over gold and then bonds from an annualized return standpoint. The combination has occurred 23% of the time since 2000. It is a stage of lower returns and higher volatility for all three major asset classes.



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