Volatility abounds on fears of a looming recession

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Q2 2022 Putnam Retirement Advantage Funds Q&A

• High inflation, rising interest rates, a decelerating Chinese economy, and the war in Ukraine fueled sell-offs of stocks and bonds.
• Shorter-term, fixed income-oriented portfolios outperformed longer-term portfolios with larger equity allocations.
• The U.S. could be headed for a recession if the Fed hikes rates too aggressively, in our view.

How were market conditions in the second quarter?

High inflation, rising interest rates, a decelerating Chinese economy, and the war in Ukraine fueled sell-offs of stocks and bonds in the second quarter. U.S. stocks, as measured by the S&P 500 Index, returned –16.10%, while international stocks, as measured by the MSCI EAFE Index [ND], returned –14.51%.

After a brief rally, stocks fell into market correction territory, which is a decline of at least 10% from a recent high, in April. China’s economic deceleration, exacerbated by extended Covid-19 lockdowns, added to global growth worries. The Russia-Ukraine War continued to disrupt global supply chains and drive up commodity prices, especially oil. Wage gains and a surge in energy costs threatened to erode corporate earnings. To counter stubborn inflation, the U.S. Federal Reserve raised rates by 0.50% in May and another 0.75% in June, its largest rate hike since 1994. Policymakers noted that the federal funds rate was on pace to reach 3.25% to 3.50% by year-end 2022.

The Fed’s hawkish policy stance drove bond yields higher and prices lower over the quarter. The yield on the 2-year Treasury note climbed from 2.28% on March 31, 2022, to 2.92% on June 30, 2022. The yield on the benchmark 10-year Treasury note rose from 2.32% to 2.98% over the same period. At times, yields on shorter-term U.S. Treasuries, such as the 2-year note, edged above those of longer-term U.S. Treasuries. This created a flat or inverted yield curve, which usually signals an economic recession. The Bloomberg U.S. Aggregate Bond Index, which includes U.S. Treasuries, highly rated corporate bonds, and mortgage-backed securities, returned –4.69% for the second quarter.

What role did the glide path play in performance?

The glide path of Retirement Advantage strategies is an important feature that distinguishes Putnam from its peers. Our glide path is more aggressive early on. For funds serving people retiring in the 2060s, we have a higher equity weighting compared with the average of our peer group. Our glide path becomes more conservative relative to our peers for funds serving investors nearing retirement in the 2020s. For the quarter, global equity and U.S. fixed income markets experienced negative absolute returns. With equities experiencing greater weakness than fixed income, longer-dated strategies suffered larger losses than shorter-dated, fixed income-oriented portfolios nearing retirement.

Longer-dated portfolio losses were a product of their higher equity allocations and the sell-off experienced by risk assets during the quarter. Shorter-dated strategies were also impacted by this decline but finished with higher returns as fixed income outperformed equities.

What strategies affected performance?

Overall, our asset allocation decisions detracted from benchmark-relative performance. This negative result was primarily driven by our equity allocation decisions. Relative to the custom benchmark, the portfolios were neutral to equity risk before we shifted to a modest overweight position at the end of May. This hurt performance as stocks declined due to rising inflation and fears that the Fed would not be able to execute a soft landing, pushing the economy into recession. We decreased our position to slightly underweight equity risk in mid-June. An out-of-benchmark modest long position to commodity risk contributed a small loss. We increased this position at quarter-end. The portfolios were neutral with respect to interest-rate risk.

Security selection benefited benchmark-relative performance over the quarter. Our quantitative U.S. large-cap core equity strategy enhanced results. In quantitative strategies, our team analyzes stock market history to identify characteristics of stocks [factors] that have excess risk-adjusted returns. During the quarter, our short interest and valuation factors were additive to results. Our fundamental U.S. large-cap value equity strategy also finished positive. Our opportunistic fixed income strategy detracted over the quarter. Portfolios furthest from retirement experienced some additional weakness from our fundamental emerging market equity strategy. Our fundamental international equity strategy contributed a small gain.

What is your near-term outlook for the markets?

Volatility has been a major constant across markets year to date. Rising inflation, supply chain disruptions, monetary policy tightening, and the war in Ukraine have weighed down most asset classes. Looking ahead, we expect market volatility to persist and investor sentiment to waver given many uncertainties and fears of a looming recession.

Our near-term outlook for equities is slightly bearish. We expect the Fed is willing to do whatever it takes to tackle inflation, potentially driving the U.S. economy into recession by hiking rates too aggressively. Our view is also supported by signs of a slowdown in the housing market, as inventories are starting to increase.

Our outlook for rate-sensitive fixed income is neutral. Yields have moved higher due to a significant shift in Fed expectations. By the end of June 2022, the Fed had raised interest rates by a total of 1.5%. Markets have priced in another increase in July followed by several more in 2022. We expect a balanced distribution of outcomes this year.

Our view on commodities is bullish. Prices are skewed to the upside due to low inventories across many commodities. Additionally, the recent sell-off has been driven more by technicals [price and volume] than fundamentals, creating a buying opportunity, in our view.

Against this backdrop, we continue to have conviction in our investment strategies given our ability to adapt the portfolios to changing market conditions.