Jobs stand out as a bright spot, with the unemployment rate remaining low at 3.6%. The odds of a recession have increased in recent weeks, with a number of economic indicators deteriorating, although most economists are still expecting positive GDP growth in 2022, and any recession to occur in 2023 or later. We are hearing of operating margin pressures in private equity markets, which may very well flow through to public equity companies. If this occurs, public equities may experience continued volatility as earnings estimates may be reduced.

Diversification did not mitigate asset value declines during the second quarter of 2022 as equities, fixed income, and some alternative assets suffered losses during the period. After the late rally in March, which had erased much of the damage done in the first quarter, stocks and bonds significantly declined throughout the second quarter. Macro and geopolitical developments tested investors as each wave of news provided evidence of higher inflation, economic instability, and higher interest rates. Fears of inflation and potential recession drove investors away from risky assets.

We entered the quarter with a market weight toward equities and maintained the market weight throughout the period. We are overweighted toward US stocks, tilting toward large and mid-size companies. We also managed portfolios away from the top-heavy market capitalization weighted S&P 500 index by reducing allocations to the large growth stocks that have driven returns during the last decade but are under pressure as investors are selling long-duration assets. We maintained our underweight toward international stocks by targeting zero exposure to emerging market companies. Geopolitical risks with China and Russia appear to be too significant a risk for us to invest in these regions at this time. While emerging market equity performance fell less than US stocks during the second quarter, we continue to avoid this area in the near term.

Bonds also experienced unusual losses during the quarter as interest rates rose and credit spreads widened. We are underweighted fixed income, opting to position client portfolios instead toward alternative investments as a hedge against rising inflation. We came into the quarter with a tilt toward shorter-duration corporate bonds over Treasurys to capture excess yield. We also maintained an overweight position toward high-yield credit and preferred securities to boost yield. Given increasing economic uncertainty as interest rates continued to rise, we reduced our exposure to high-yield bonds and focused on floating rate securities instead. We continued to add Treasury exposure back to portfolios to improve credit quality and take advantage of the highest Treasury yields in a decade. Corporate bonds experienced significant losses during the quarter and longer-duration and high-yield bonds suffered more than short-term and Treasurys, as a result of a weakening economy and increasing recession risk.

Many alternative investments were soft during the second quarter: gold declined by over 5% while real assets were down modestly. We added commodity exposure during the period to further position client portfolios toward a potentially longer than expected bout with inflation. Real estate was the only asset class with a gain for the period, but overall, alternatives provided a stable buffer against falling bond prices. These assets have significantly outperformed bonds and have played the role that bonds typically play. We continue to see them as solid alternatives to fixed income.

Our overall asset allocation remains fairly defensive near-term, as we are cautious regarding the longevity of rallies until there is more economic clarity. Longer-term, we believe broad-based diversification remains warranted.

The second quarter of 2022 was an ugly one for equity markets as valuation excesses that had built up in prior years continued to unwind in spectacular fashion. The primary issue for equity markets has remained the Fed, which began to rapidly remove monetary policy accommodation as inflation pressures broadened out and intensified during the quarter. Inflation and rising interest rates clearly began to take a toll on the economy, and the S&P 500 followed suit as it declined 16.1% during the quarter. This brings the S&P 500 year to date total return to –20.0%, which represents the worst first half of a calendar year since 1970. As we consider the prospects for equities in the second half of the year, we believe that elevated valuations are no longer the primary risk for equity investors and their focus will shift to the outlook for corporate profitability as economic activity slows.

Growth stocks remained under pressure during the quarter as interest rates rose and decreased the appeal of potential profits far off in the future. The S&P 500 Growth declined by 16.1% in the quarter, while the S&P 500 Value held up far better and declined by 11.3%. While losses in the shares of large US corporations have been extensive in both scope and scale, the carnage has been much worse in the more speculative corners of the equity market. For example, over the past 12 months, the S&P 500 has posted a loss of 10.6% while the Small Cap Russell 2000 Growth index has more than tripled those losses and declined by 33.5%. Strategies focused on the most speculative growth companies have fared even worse. A few examples include the ARK Innovation ETF (an actively managed equity ETF focused on disruptive innovation) and Siren NexGen Economy ETF (a passive equity ETF tracking companies that benefit from development of blockchain technology and cryptocurrencies), which have lost 69.3% and 46.1% of their value respectively over the last 12 months.

After years of worrisomely elevated valuations, we believe equities are finally reasonably priced relative to current earnings estimates.  This is illustrated in the chart below, where the S&P 500 in blue has declined recently, but the Price/Earnings ratio (a common valuation measure) in red has declined much more and has returned to levels that were typical before pandemic-era stimulus. The challenge for equity markets from here is the durability of current corporate earnings.  Macroeconomic headwinds have piled up at a frightening rate this year, and yet the earnings per share estimate for the S&P 500 this year stands at $228, which has increased from $220 at the beginning of the year. Earnings estimates for 2023 have also increased and reflect expectations for 9% earnings growth on top of this year’s 18% growth. The unfortunate reality is that the stock market appears to be vulnerable as earnings estimates have not yet declined to reflect the impact of slowing economic growth and rampant inflation on corporate profits.  It is difficult to estimate the potential downside for earnings estimates given the multitude of underlying factors, but 10-20% is common in a recession. At a minimum, uncertainty seems likely to drive heightened volatility and hinder equity markets for at least the next few quarters.

At the beginning of the year, trailing equity returns stood well above historical averages and we expected that returns going forward would be lower to compensate for elevated valuations. After the decline of the past six months, the view from both the rear-view mirror (returns over the past 3 or 5 years) and the windshield (longer term forward-looking projections) seem much closer to “normal” than they have in years. While “normal” equity returns include periodic corrections, recessions, et cetera, they have also proven to be one of the most reliable ways to outpace inflation over time.  We remain cautious on equities short term and continue to emphasize higher quality companies in equity portfolios as a result. Longer term, we remain as optimistic as ever on the potential for corporate profits to expand and drive shareholder returns over time.

Fixed Income Focus: Value in Municipal Bonds

A combination of mutual fund/ETF outflows and a risk-off mentality has made longer-term municipal bonds especially cheap in our view. In general, the lower liquidity of municipal bonds makes the market vulnerable to sell-offs. Recently, rising interest rates and market volatility have led to persistent sector outflows and weakness. The Investment Company Institute’s (ICI) measure of weekly ETF and mutual fund flows shows that investors withdrew money from municipal bonds in 21 out of the first 24 weeks of 20221, which has made yields attractive. Currently, a 15-year, callable bond from a high-quality municipal issuer can yield upwards of 3.75%. On a tax-equivalent basis this equates to a 5.75%2 annual yield. Fundamentally, we acknowledge that smaller municipal issuers will struggle with inflationary pressures and higher debt servicing costs, but overall credit quality in the sector is strong. The finances of states and large municipal issuers are still flush from soaring property taxes, stable sales tax collections, and Covid-relief funds. In the first quarter of 2022, every state saw year-over-year tax revenue growth with total tax revenue increasing 21.5%.3 The combination of valuation and credit health make longer-term municipal bonds a compelling investment.

Over the last few months there has been a series of negative media articles about “ESG” and critical comments from high-profile figures such as Elon Musk and Mike Pence. In these articles, tweets, and speeches, the common thread is that ESG is a silver bullet intended to weed out “bad” companies, drive social and environmental impact, stop climate change, and other “woke” objectives. With decades of experience in sustainable investing (SI), we know that there are no silver bullets anywhere in markets, no shortcuts, no one-size-fits-all. We also know that words matter and if we are not speaking the same language, the result will be confusion and misunderstanding.

Let’s start with a few facts. Investors can’t solve all the world’s problems; governments, companies, and consumers must all take action. Clients do not all have the same objectives, so different approaches to SI are required. ESG is just one of a number of SI approaches and is often used in combination with other approaches.

The history of SI is often described as an evolution, though in reality it was more an ongoing development of new approaches that are all relevant and widely used today. Decades ago, there were two primary SI approaches, exclusionary socially responsible investing (SRI) and activist investors pushing companies to improve behavior and transparency. Both SRI and activist investors were often driven by ethics or values. One of the most important outcomes of the SRI and activist movement in the latter part of the 20th century was an increase in transparency from listed corporations.

Improving corporate disclosure enabled a more rigorous approach to assessing the environmental, social, and governance (ESG) risks corporations face. The spark that created ESG can be tied back to papers written in 2004 titled Who Cares Wins and The Materiality of Social, Environmental and Corporate Governance Issues to Equity Pricing.  These papers and the work done by the United Nations  Environment Programme Finance Initiative led to the formation of the UN Principles for Responsible Investment. The conversation shifted toward material ESG issues that would resonate with institutional investors and leverage capital markets to better measure and manage ESG risks. Nearly a decade later, research from Harvard and other prominent academic institutions began to show that integration of material ESG factors into the investment process could result in improved risk adjusted returns, primarily through the reduction of risk.

Over the last twenty years, environmental and social thematic and impact investment approaches have gained scale and are growing rapidly. Unlike exclusionary or risk-based approaches, thematic investing seeks to target or emphasize investments aligned with one or more environmental or social growth themes. Impact investments often target similar environmental or social challenges, though unlike thematic investments, driving direct and measurable outcomes must be a primary objective of impact investments.

As client interest in SI has grown, so has product development and marketing by financial firms. Unfortunately, with this growth, terms have been used interchangeably and “ESG” is often used as an umbrella term. The lack of agreed-upon terminology combined with a marketing-driven narrative have created confusion.

The integration of ESG analysis into the investment process can help investors manage risk by comparing how companies measure and manage the material ESG risks they face relative to peers. ESG integration will not weed out all companies subjectively considered morally or ethically abhorrent, nor will it explicitly target companies with products or services aligned with a more sustainable world. While ESG at scale may harness capital markets to drive positive outcomes at the systems level over time, it will not result in direct, tangible, or intentional impact at the micro level.

The approaches outlined above have different risk/return profiles and different key metrics used for implementation. Additionally, clients have different time horizons, risk tolerances, return objectives, and financial goals. Some clients may want to avoid certain types of companies, while otherwise seeking diversified market exposure through a mix of stocks and bonds. Some may seek higher returns by targeting certain environmental themes through stocks that may offer higher levels of growth, though not without the potential for higher volatility and perhaps other risks. Matching investment solutions with client objectives and risk tolerance is critical to meeting client expectations and more broadly to reduce confusion in the industry.

While recent media attention is justified by the state of confusion, the path to a stronger and more durable SI industry is being laid by regulators and industry organizations. We are encouraged by the recent release of the CFA Institute’s product level disclosure standards and the US SEC’s push to improve both corporate and investment firm disclosure and communication.  These are important steps to reduce confusion, build a strong foundation for future growth, and improve alignment with sustainability objectives.

Private Equity

While early in the 2Q22 performance reporting cycle, we anticipate greater dispersion across strategies and within strategies relative to the last several years. Private equity managers have mentioned strong revenues within their businesses combined with higher financing and input/labor costs leading to margin pressures. Thus, they have emphasized operational execution and are seeking cheaper entry multiples with lower leverage. The average large US buyout deal has a leverage ratio of about 6.0x EBITDA, or about 3.0x interest coverage. As buyouts are primarily financed with floating rate debt, rising rates reduce flexibility for the most levered companies, especially if the economy hits a hard landing in 2023.

Growth/Crossover managers, which tend to invest in established venture businesses (real revenue, but no earnings) 1-2 years before an IPO, are facing the greatest pressure and potential for markdowns given the spread between private and public markets. Many deals consummated in 2021 were at excessive valuations. For example, the average company in PitchBook’s VC IPO index is 75% below its 52-week high. These managements are working to avoid down rounds by cutting costs, extending their runway, and slowing top-line growth to accelerate the path to bottom-line profitability. Businesses that can postpone financing activity over the next year will be able to come to market in more normalized conditions thereafter. Holding periods for this portion of the market will be substantially longer and IRRs will be lower than underwritten, as companies will need time to grow into their 2021 valuations. Overall, we expect a wide range of outcomes going forward and an increased number of down rounds over the coming quarters. Early-stage and mid-stage venture capital remains largely unimpacted for the time being because the investments are far from exit and significantly less sensitive to capital market conditions. In addition, unicorn hunting is being deemphasized in favor of smaller businesses where the path to profitability is nearer-term and substantially less capital is required.

The silver lining in today’s environment, and an important contrast relative to 2008, is the massive amount of dry powder across PE/VC, which will be used to support and grow good businesses. Private equity will go so far as to support marginal businesses, as long as the capital that is contributed is enough to change the valuation paradigm or risk of capital loss.

Real Estate

Early indications of performance suggest low single- digit performance for core real estate strategies. As the market was absorbing higher interest rates in the quarter, there was a slowdown of purchasing activity and there was some cap rate expansion in cities and asset-types where investors have lower conviction in lease-rate growth potential going forward. That said, most capital has continued to flow to the growth markets (primarily in the Southern US) where strong long-term lease rate growth expectations have allowed for activity to continue and for valuations to be flat to positive. The real estate market continues to be structurally strong. Given the strength of consumer balance sheets and the continued strength of the digital economy, multifamily and industrial sectors continue to outperform. While the US housing market remains undersupplied, which should be positive for prices, it has undergone the largest affordability shock in 50 years given the increase in mortgage rates. This should slow home purchasing activity considerably, which is a net positive for the large multi-family exposures that have been built within core and core+ real estate portfolios.

Private Credit

Private credit performed well for the quarter, with early indications of performance in the low to mid-single digits. So far, economic conditions have remained strong as corporate America is doing well, and that has been reflected in continued strong returns across corporate lending strategies. That said, the pressures facing businesses (higher financing, labor, input, etc. costs) are unlikely to abate in the near term, which could result in an increase in debt covenant breaches in the coming quarters. In the short term, that is likely to be positive as managers will utilize these breaches to increase security, charge restructuring fees, and attain higher rates on debt. In the medium-to-longer term, it suggests that investors should expect a higher level of true defaults, which will put the burden on maximizing value to the restructuring teams at the lenders. With respect to consumer credits and other specialty finance assets, the story is much the same. Payments have continued and conditions appear favorable, but the consumer and small businesses are feeling greater strain that is likely indicative of higher delinquencies and defaults in the medium-to-longer-term. We have seen managers shift their underwriting to get more conservative in response.

Disclosures