All Cap Value – Q2 2022 Commentary

The first half of 2022 experienced some of the worst inflation in decades, resulting in a sharp increase in interest rates along with a sharp decline in stock and bond valuations. The acceleration in inflation stemmed from both demand-pull inflation and cost-push inflation. The demand-pull inflation came from excessive fiscal and monetary stimulus which helped create strong aggregate demand which exceeded the ability of the supply chain to meet the strong aggregate demand. The cost-push inflation came from underinvestment in energy (Refineries, Exploration and Production) and Industrial Commodities along with supply constraints from the Russian/Ukraine war which has curtailed the aggregate global supply of energy, industrial and food commodities. The cost-push inflation is also being created by a tight labor force which is driving higher wage inflation. The Federal Reserve has begun to aggressively deal with the higher inflation through steep increases in the Federal Funds Rate. In addition, market interest rates are also increasing with corporate borrowing rates, mortgage rates and auto loan rates increasing sharply as well. During the first half of the year the S&P® 500 declined 21% while the iShares Core U.S Aggregate Bond Exchange declined 11%. (Otani, WSJ)

The seeds of the current inflation were sown during Covid19 Pandemic and then became more elevated due to Russian/Ukraine War. During 2020 and 2021, strong stimulus was unleashed from a one-two punch by the Federal Reserve and the Federal Government to offset the negative impact on Covid-19. At the start of the Covid-19 pandemic, the Federal Reserve cut interest rates to zero and committed billions of dollars to support financial markets including the direct purchase of US treasuries, mortgage-backed securities, and municipal bonds. The Federal Government spent around $6.2 trillion during 2020 and 2021 on economic stimulus including $3.1 trillion from the Trump admin ($2.2t CARES act 3/27/2020, $900b Covid-19 relief bill 12/27/2020) and $3.1 trillion from the Biden Administration ($1.9t Covid Relief 3/11/2020, $1.2t Infrastructure 12/15/21). The large amount of federal stimulus was so large that it exceeded the total spending of $4.7 trillion spent during World War 2. (Harrington, Swenson USA Today) The strong stimulus helped push aggregate demand to exceed aggregate supply sparking inflation. Adding to the inflation was the Russian Ukraine war which disrupted the flow of energy, industrial commodities and food which further aggravated the inflation problem resulting in the highest inflation since the late 1970s. The Federal Reserve was slow to act at first but has become much more aggressive in removing the stimulus from the Covid-19 era and aggressively raising the Federal Funds rate. We are starting to see some things deflate as result including lower commodity prices and economic weakness in developing and emerging markets overseas but have yet to see a significant slowdown in the US labor market which continues to add close to 400,000 jobs per month with 380,000 jobs added in June. I expect the Federal Reserve to continue to be hawkish with more interest rate increases in store for the remainder of the year.

Stock valuations have declined sharply because of the Federal Reserve’s monetary tightening and are starting to discount the eventual economic slowdown from the interest rate increases. For the first half of 2022, All Cap Value declined 12.41% (gross of fees) and 12.70% (net of fees) vs the Russell 3000® Value Index falling 13.15%. Positive stock selection and asset allocation has helped drive the positive relative performance for the year with good contribution from Health Care, Energy, and Financials which more than offset weakness from Consumer Discretionary, Industrials and Utilities.

Even with the recent turmoil from inflation and subsequent decline in equity values, our investment approach, which focuses on a bottom-up approach focused on improvement in returns on invested capital, continues to uncover good companies at reasonable valuations.

As always, we want to thank you for the confidence you have placed in Kennedy Capital, and we appreciate the opportunity to manage your accounts.

Sincerely,

Frank Latuda, Jr., CFA®

Chief Investment Officer & Portfolio Manager

Thomas Leritz, CFA®

Assistant Portfolio Manager

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