Weak Second Half of August Pushes Stocks & Bonds Lower

HIGHLIGHTS:

• Market strength from July failed to continue through August as stocks and bonds declined during the month.
• Bonds rallied in July, but the 10-year U.S. Treasury yield rose in August. After ending July at 2.67%, the yield closed August at 3.15%, which created a challenging environment for bonds.
• No FOMC meeting was held in August, but the annual meeting of central bankers in Jackson Hole, Wyoming was consequential. Chairman Powell’s keynote speech reinforced his current hawkish stance and stocks tumbled.
• Slower growth is impacting the economy with the Fed poised to continue to hike rates. We don’t believe we are in a recession currently, but the odds of a mild recession next year have increased.

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EQUITY MARKETS

Equity index returns for August were as follows: The S&P 500 fell -4.08%, the Dow Jones Industrial Average declined -3.72%, the Russell 3000 slid -3.73%, the NASDAQ Composite slumped -4.53%, and the Russell 2000 Index, a measure of small-cap stocks, had the most modest declines, down -2.05%. For the first eight months of 2022, the returns in the same order were as follows: -16.14%, -12.01%, -16.92%, -24.07%, and -17.16%.

After coming off a strong July, stocks could not continue that momentum through August under the pressure of rising interest rates. Stocks started the month off strong, completing close to a 50% retracement from the low point reached by the S&P 500 in mid-June. However, the second half of August proved challenging, and stocks dropped from that point to close the month in negative territory. Likewise, the VIX Index made a rather steady move higher from the mid-point of the month going from below 20 to end August at 25.87. Ongoing concerns of elevated inflation and the Fed’s aggressive response of raising rates continued to weigh on the market and create a more volatile period for stocks during the month.

Although most pockets of the equity market struggled in August, growth came under particular pressure once again. The headline Russell 1000 Index fell -3.84% in August with the Russell 1000 Growth Index down -4.66% and the Russell 1000 Value Index declining a more modest -2.98%. That continued a theme seen most of the year with value outperforming growth on a relative basis and for the first eight months of 2022, those two indices were down -23.19% and -9.85%, respectively.

Small caps had a better relative August compared to large caps, but in contrast to large caps, the bias favored growth. The Russell 2000 Value Index declined by -3.16% in August, while the Russell 2000 Growth Index fell a more modest -0.94%. Year to date, those indices are still down -12.17% and -22.29%, respectively. We at Clark Capital continue to use our disciplined approach of seeking out what we believe are high-quality companies with improving business conditions and good prices, and those companies can be found in both the value and growth universe.

International stocks were mixed in August as emerging markets were able to post a modest gain while developed markets declined. The MSCI ACWI ex USA Index, a broad measure of international equities, fell -3.22% for the month, and was off -18.34% so far this year. The MSCI Emerging Markets Index posted a modest gain of 0.42% but was still off by -17.49% year to date. As would be expected with the Russian invasion of Ukraine, emerging Eastern European stocks continue to be the worst regional area this year. Both U.S. and international equities have struggled this year with an aggressive Fed rate hike cycle, high inflation, and slowing economic growth.

Fixed Income

Fixed income returns were as follows for August: the Bloomberg U.S. Aggregate Bond Index declined -2.83%, the Bloomberg U.S. Credit Index dropped -2.83%, the Bloomberg U.S. Corporate High Yield Index slid -2.30% and the Bloomberg Municipal Index fell -2.19%. As would be expected, the 30-year U.S. Treasury Index had some of the worst results, dropping -4.41% for the month, while the general U.S. Treasury Index slumped -2.48%. For the first eight months of 2022, the returns for these indices in the same order were as follows: -10.75%, -13.70%, -11.22%, -8.62%, -24.97%, and -9.98%.

After hitting a multi-year closing high of 3.49% on June 14, the 10-year U.S. Treasury yield moved lower from mid-June through July, but that trend reversed course in August as yields rose sharply again. Simply put, the 10-year U.S Treasury yield closed August 1 at 2.60% but closed August 31 at 3.15%. Clearly, that increase in interest rates put pressure on bond prices and returns suffered during August. While short-term returns are negatively impacted by rising rates, long-term returns for bonds have become more attractive with the higher yields being offered.

Bonds have struggled this year as there has been a repricing of interest rates across the yield curve and across bond sectors under this Fed rate tightening cycle. Recall that in 2021, the Bloomberg U.S. Aggregate Bond Index recorded only its fourth annual decline since its inception in 1976 – and the worst year on record for the Agg was 1994 when it declined -2.92%. As it turns out, the year 1994 was another period when the Fed was in a rate hike cycle. We maintain our long-standing position favoring credit versus pure rate exposure in this interest rate environment. We also believe that the role bonds play in a portfolio, to provide stable cash flows and to help offset the volatility of stocks in the long run, has not changed. In fact, bonds are offering higher yields than they have in a number of years and as a result, we believe they are becoming a more attractive asset class.

Economic Data and Outlook

Job additions surged in July. The change in non-farm payrolls were more than twice as strong (528,000) as expectations (250,000). The unemployment rate declined to 3.5% – the same unemployment level as February 2020 prior to the pandemic. However, as the Fed is analyzing data, this “good” news might be perceived as “bad” news showing too much economic strength and more work that the Fed needs to do to slow economic growth and control inflation. Typically, one tends to see the unemployment rate start to rise heading into a recession, but at this point in the cycle, employers are still looking for workers to fill open roles. Ultimately, the job market is important to track with about 70% of U.S. economic activity driven by consumer spending.

Housing continues to show a slowing trend. Housing starts, existing home sales, and new home sales were all below expectations in July and lower than June’s levels. Building permits ticked lower as well, but they did beat expectations. The rise in mortgage rates has taken some steam out of the housing market, and June did see home price increases slow compared to recent readings. Based on the year-over-year reading of the S&P CoreLogic CS 20-City Index, home prices rose by “only” 18.65%. This compares to expectations of 19.2% and the prior month’s revised mark of 20.51%. The housing market has been a source of strength in the economy and has historically been a good leading indicator as well. However, the impact of higher mortgage rates, along with high home prices, is having a dampening effect on housing and home activity will likely slow as the broader economy slows down as well.

The ISM Manufacturing Index declined in July to 52.8 from the 53.0 level in June, the lowest reading for this index since June 2020, but it did beat expectations. The New Orders and Employment components recorded readings below 50 once again, but the employment reading did improve to 49.9 showing improvement and surpassing expectations. New orders were lower than expected and dropped from June’s level. The ISM Non-Manufacturing Index, which covers the much larger service industries in the U.S. economy, was a bright spot improving to 56.7, well ahead of estimates of 53.5 and better than June’s level of 55.3. Manufacturing and service industries are still showing growth, but following the recent trend, moderation in the pace of growth has occurred. Recall that ISM readings above 50 indicate expansion and below 50 signal contraction, so these current headline readings remain in growth territory.

Retail sales (ex. auto and gas) rose to a better-than-expected 0.7% in July, matching the increase from June. It is important to note that higher prices, meaning inflation, can be a significant factor for this reading as the retail sales data is not inflation adjusted. Not surprising following a strong stock market rebound in July and ongoing job market strength, consumer confidence, based on the preliminary University of Michigan Sentiment reading for August (which came out August 12), improved to 55.1 – surpassing expectations and the prior month. The Conference Board’s Leading Index declined again in July, this time by -0.4%, which was modestly better than the -0.5% expectation. Q2 2022 GDP was revised in its second reading to a -0.6% annualized decline, which was an improvement from the first reading (-0.9%) and better than expectations of -0.7%. We at Clark Capital understand that GDP growth has weakened in 2022, but we are still anticipating positive growth for the year. We do not believe we are currently in a recession but acknowledge the risk of a mild recession, most likely next year, has increased.

If there had been any lingering doubts about his views, Fed Chairman Powell reiterated his clear and almost singular focus on defeating inflation during his Jackson Hole, Wyoming speech. The markets had perceived a somewhat more dovish tone from Powell after the last FOMC meeting in July and Fed officials, and Chairman Powell himself, have been trying to bolster their inflation-fighting credibility to the market since. Ironically, inflation has started to improve with the headline Consumer Price Index dropping to 8.5% in July from the 9.1% reading in June and that was lower than expectations of 8.7%. Recall as well that the Fed targets the core reading of the Personal Consumption Expenditures index and that declined to 4.6% in July from 4.8% in June and was also better than expectations of 4.7%. One month is not a trend, but it has been our long-standing opinion that inflation readings would start to improve in the second part of 2022, and Core PCE has now declined in 4 of the last 5 months. Furthermore, forward inflation expectations have been rolling over for the past few months, so long-term inflation worries have not become an imbedded part of the economic outlook. The Fed meets again in September and a 50 or 75 basis point rate hike is expected at that time, but we believe we are in the latter innings of this rate hike cycle heading into the last few months of the year.

The shift in Fed policy from a stimulatory environment to more restrictive monetary conditions is having an impact on the economy. The job market has been an area of strength and it is a critical component of our overall economy. The Fed is focused on bringing inflation under control, but its primary tool in achieving that goal is raising interest rates, which is a headwind to economic activity. Markets are resetting valuations based on higher interest rates and lower corporate earnings expectations in this rate-tightening cycle. We continue to expect the economy to grow this year, but the chances of the Fed pushing us into a recession, due to their aggressive rate hikes, have risen. We believe it is imperative for investors to stay focused on their long-term goals and not let short-term swings in the market derail them from their longer-term objectives. Importantly, stocks historically have hit their lows early in the rate hike cycle, well before the Fed has made its final rate hikes.

Investment Implications

Clark Capital’s Top-Down, Quantitative Strategies

Federal Reserve Chairman Jerome Powell reiterated his commitment to quashing inflation expectations and acknowledged the potential economic pain of lifting short-term rates. The Fed is now set to double the pace of quantitative tightening or balance sheet reduction, and is expected to increase the Fed Funds rate by another 0.50% – 0.75% in September. After a brief 2-month rally from mid-June to mid-August, volatility increased with the market giving back some of its gains into month-end. Risk assets across the board came under pressure following Powell’s comments and high yield credit spreads widened but remain well below their early-July peak.

September has historically been a seasonally weak month, especially in midterm election years, so we anticipate some additional volatility over the coming weeks. Some of our tactical strategies turned defensive with the Fixed Income Total Return and Global Tactical portfolios reallocating into a risk-off position as the month ended.

Clark Capital’s Bottom-Up, Fundamental Strategies

The July rally ended in August with low volume and persistent selling pressure spurred by Powell’s hawkish comments at Jackson Hole and expectations for a longer stretch of monetary tightening well into 2023. Chairman Powell’s “keep at it until the job is done” commentary leaves Treasury yields close to resistance, with the 10-Year Treasury yield back above 3.0%. Longer duration stocks weakened as evidenced by the Russell 1000 Growth versus the Russell 1000 Value ratio retreating, indicating a shift to value outperformance ahead.

Although earnings have come in better than expected, fears of flatter earnings could fuel more volatility into September, a historically bad month for the market. We continue to invest the High Dividend Equity portfolio in dividend growers at what we believe are reasonable prices with exposure to both cyclical and growth sectors. We also see opportunity in international markets, with valuations about one-third less than U.S. benchmarks. International ADR continues to seek out what we believe are undervalued, high-quality companies in both developed and emerging markets to add to the portfolio. In our fixed income portfolios, we continue to shift into higher quality, more liquid holdings in anticipation of wider spreads going into the large amount of new issue supply in September.

ECONOMIC DATA

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