10 Jun Q1 2022
Inflation, war, and rising interest rates were a potent cocktail for financial markets during the first quarter of 2022. All major stock and bond markets posted negative returns for the quarter. The first five to six weeks of the year in the stock market saw a rotation out of stocks that carry higher valuation multiples as interest rates increased. The Federal Reserve began sending stronger signals that easy-money policy was nearing an end, triggering a rotation out of growth stocks into more defensive stocks. The negative start to the year intensified in February when Russia invaded Ukraine. As we discussed in our mid-quarter update, stock markets tend to react to geopolitical events with a quick pullback that typically lasts for a few weeks, followed up by a quick upward bounce. To date, this conflict has followed the past playbook fairly closely, as the market bottomed in early March and ended the quarter around early-February levels.
Volatility was not limited to stock markets, as yields rose sharply across bond markets. The increase in yields was so substantial that it led to the worst quarter return for the Bloomberg Aggregate Bond Index since 1980. Yields are primarily rising on the expectation that the Federal Reserve will have to increase the Fed Funds rate faster than previously anticipated as inflation becomes more entrenched and worrisome.
Inflation is caused by a mismatch of supply and demand. Covid-19 was the first hit to pricing equilibrium, affecting both supply and demand. Factory shutdowns throughout the globe snarled supply chains, disrupting the availability of goods. At the same time, consumer savings increased due to fiscal support from governments and the inability to spend money on travel, events, etc. As Covid restrictions eased, consumers were ready to spend, but the supply of goods could not meet demand. Prior to Russia’s invasion of Ukraine, we were seeing signs that some of the supply bottlenecks were easing, which would likely lead to a slowing pace of inflation increases. Russia’s invasion of Ukraine roiled commodity markets, particularly oil, natural gas, and grains. Increasing commodity prices put further pressure on inflation, elongating the time it will likely take for supply and demand to rebalance. This increase of time out of equilibrium threatens price stability by increasing the risk that inflation becomes embedded. Price stability is one of the Fed’s core mandates, and since they can’t control supply, the Fed must decrease demand to reduce inflation. The mechanism by which the Fed decreases demand is to make money more expensive by raising interest rates.
Whether the Fed can raise interest rates to a level that slows inflation without causing a recession is a major variable that will likely have significant impact on financial markets over the next few years. Although recession does not look likely for this year, risk of recession in 2023 or 2024 has increased over the last few months due to the rapid increase in interest rates.
From a PCA portfolio perspective, our Diversified Income and Covered Call portfolios held up better than overall stock and bond markets due to the rotation into defensive equities. Below please find more detailed information about our portfolios during the quarter.
The top performing stock in the Core Equity portfolio was Phillips 66, as energy was by far the best performing sector during the quarter. AES Corp and Grocery Outlet also posted strong double-digit returns in a down market. AES Corp is the most recent addition to the portfolio, and the double-digit return calculation is measured from purchase in mid-February. AES is a global power producer that is transitioning its portfolio to clean energy development, and we believe the company is well-positioned for the future. The worst performing stock during the quarter was Zebra Technologies. Zebra has been one of our top performing stocks for many years, but valuation became stretched, and the stock suffered from the rotation out of growth stocks. Xylem and Home Depot were other laggards during the quarter.
Trading activity increased in the quarter in comparison to the relatively quiet period last year:
- New positions – Linde and AES Corp
- Increased position size – Disney, Amazon, and Xylem
- Exited positions – Fiserv
- Decreased position size – Bank of America, Phillips 66, Grocery Outlet, and Apple
On average, five to six options expire each month in our covered call portfolio. If the option expires worthless, we typically sell another option on the same stock. If the stock price is above the option strike, and the underlying stock is called away, we typically replace the holding with a new covered call position. Trading activity during the quarter:
- New positions – Comcast, Apple, Pepsico, Medtronic, Cisco Systems, Merck, Dupont
- Positions called away – McDonalds, Merck, IBM, Boston Scientific, Dow
- Option rewrites – Citigroup, Starbucks, TJX Companies, Walmart, State Street, Disney, Oracle, Comcast, Dover, Emerson, Corning
- Positions sold – FIS
The Diversified Income portfolio was our top performing portfolio during the quarter, as investors moved money to more defensive, higher-yielding equities. The top performing stocks in the portfolio were Chevron, Valero, Abbvie, and Bristol-Myers Squibb. Laggards were the preferred stocks, 3M, and Kimberly Clark.
Trading activity also increased in this portfolio in comparison to last year:
- New positions – STORE Capital, Bank of America preferred stock Series QQ, and Ares Capital Corp
- Increased position size – iShares High Yield ETF, AT&T, US Bancorp, and Healthcare Realty Trust
- Exited positions – Unilever and Kimberly Clark
- Decreased position size – Broadcom, Old Republic, Prudential, Abbvie, and Chevron
As mentioned earlier, the bond market had its worst quarter since 1980. Rising interest rates help highlight the advantages of individual bonds over bond funds. When we purchase a bond for a client, the return of the bond until maturity is known (absent default). Changes in interest rates affect the prices of the bonds, but the price will move back to par if held to maturity. In contrast, bond funds do not have a maturity date. In addition to this inherent advantage, our bond portfolio has an average time until maturity that is much less than market averages. The relatively short time until maturity decreases price volatility in the portfolio as interest rates rise.
Tom Searson, CFA
The analysis and performance information contained herein reflects that of portfolios used by Providence Capital Advisors, LLC, a Securities and Exchange Commission Registered Investment Advisor. This information should not be relied upon for tax purposes and is based upon sources believed to be reliable. No guarantee is made to the completeness or accuracy of this information. Providence Capital Advisors, LLC shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses or opinions contained herein or their use, which do not constitute investment advice, are provided as of the date written, are provided solely for informational purposes, and therefore are not an offer to buy or sell a security. This information has not been tailored to suit any individual.
Providence Capital Advisors, LLC does not guarantee the results of its advice or recommendations, or that the objectives of a strategy will be achieved. Portfolios offered by Providence Capital Advisors, LLC may not have contained and/or may not currently contain the same underlying holdings and may have been and/or may currently be managed according to rules or restrictions established by Providence Capital Advisors, LLC. The income numbers for Covered Call and Diversified Income are based on one portfolio in the composite that serves as the model portfolio. Actual income returns may be different for other portfolios. Employees of Providence Capital Advisors, LLC may have holdings in the securities and/or utilize the same portfolio strategies as presented herein.
Benchmark returns are used for comparative purposes only and are not intended to directly parallel the risk or investment style of the accounts included in our investments. The volatility of the indices compared herein may be materially different from that of the compared Providence Capital Advisors, LLC strategy. There is no guarantee that the strategies will outperform, or even match, benchmark returns over the long term.
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