Market Commentary - Q2 2022 - Stock Markets Post Worst First Half of a Year in Over Five Decades

Key Takeaways:

  • Major global indexes down 20%+ in the first half
  • Bitcoin down 60%
  • Value outperforms growth for first time in years
  • Reactive Fed raises 0.75%
  • CPI highest in 40 years
  • Consumer sentiment lowest ever
  • A recession is likely coming by year-end, if not here already
  • Bolster emergency funds/cash reserves to weather a recession
  • Stay calm and keep a long-term perspective

Stock Markets Post Worst First Half of a Year in Over Five Decades

Accelerating inflation and rising interest rates fueled months of risk aversion that sent markets sharply lower in the first half of the year. The relentless selling left few markets unscathed.

The S&P 500 fell 21%, suffering its worst first half of a year since 1970, according to Dow Jones Market Data. Investment-grade bonds, as measured by the iShares Core US Aggregate Bond exchange-traded fund, lost 11%, posting their worst start to a year in history. The blue-chip Dow Jones Industrial Average lost 15%. The Nasdaq fell 29.4% and Russell 2000 lost 23.9%, both posting their worst first half of any year on record, according to Dow Jones Market Data.

European stocks fell sharply as well. The Euro Stoxx 50 was down -20.2% for the first half. While Bitcoin lost 60% of its market value.

About the only thing that rose in the first half was commodities prices. Oil prices surged above $100 a barrel, and US gas prices hit records after the Russia-Ukraine war upended imports from Russia, the world’s third-largest oil producer.

Value outperforms growth, we believe this trend continues

One of the central themes in the stock market’s downturn this year is that investors have seemingly lost their appetite for risk. This is evident through the broad based selling across multiple asset classes, exacerbated in “riskier” parts of the market like crypto, tech, and other highly valued sectors. Value stocks are on pace to outperform growth stocks for the first time in years.

In the past few decades, value stocks, which tend to trade at a lower multiple of their book value or net worth, have typically underperformed growth stocks, their pricier counterparts. Growth stocks can be attractive to investors who expect that the companies will become bigger and more profitable.

Shares of less-proven growth companies were particularly favored during the COVID-19 pandemic, when the Fed lowered interest rates to near zero, pushing investors into riskier assets. Now the central bank is raising rates, and the tables have turned. Higher rates make the expected future earnings of higher-growth companies less attractive, ultimately hurting demand for tech shares.

Many of the large tech-related companies that drove the rise of the S&P 500 in the past decade dragged it into a bear market this year.

Even consumer staples stocks fell. Initially, many traders had seen shares of companies selling everyday goods that consumers rely on as relatively safe investments, since in theory, demand for their goods should stay the same even in a cooling economy.

Recently, that view has weakened as some major retailers have warned that they, too, are being hit by rising inflation. Data showed US consumer spending rose at its slowest pace yet this year in May as inflation is beginning to impact consumer spending behavior.

US 10-year Treasury yield rose in the first half to its highest level since 2011

Rising inflation combined with expectations of more interest-rate increases have contributed to a selloff in the bond market. Bond prices fall as yields rise.

The Fed has taken an increasingly aggressive and reactive stance to combat inflation, even at the risk of raising the likelihood that the economy will fall into a recession. Uncertainty over the outlook for the economy and the Fed’s policy has resulted in greater volatility in bond markets.

The yield on the shorter-term two-year Treasury note has risen to its highest level in more than a decade. It has converged this year with the 10-year and 30-year yields, an indicator that the market is anticipating a possible near-term US recession. This red flag, when the gap between shorter- and longer-term yields closes, is known as the flattening of the yield curve and has been a leading indicator in 9 of the last 10 recessions.

Inflation accelerates, Fed gives no clear guidance on their plans to combat inflation… markets don’t like uncertainty

US consumer inflation reached its highest level in more than four decades with a CPI reading of 8.6% in May as surging energy and food costs pushed prices higher, with little indication of when the upward trend could ease.

May’s increase was driven in part by sharp rises in the prices for energy, which rose 34.6% from a year earlier, and groceries, which jumped 11.9% on the year, the biggest increase since 1979. However, inflation pressures were distinctly broad-based in May.

In a frantic response to accelerating inflation, the Fed  approved the largest interest-rate increase since 1994 and signaled it would continue lifting rates this year at the most rapid pace in decades to fight inflation that is running at a 40-year high.

Officials agreed to a 0.75% rate increase in June, which raised the Fed’s benchmark federal-funds rate to a range between 1.5% and 1.75%.

Markets reacted poorly to Powell’s reactive rate hike as the previous plan was to raise rates by 0.5%, not 0.75%. Equities sold off and bond yields rose sharply, indicating that the market thinks the Fed is too late to raise rates and now is frantically trying to play catch, which is often a losing strategy that results in a recession. 

More pain to come?

Even those finding buying opportunities these days say they are focusing on specific companies, instead of buying broadly. They concede that the current economic environment, in which inflation is high, borrowing costs are rising and growth is expected to slow, makes it difficult to be enthusiastic about many parts of the market.

Economists surveyed by The Wall Street Journal in June said they saw a 44% probability of a recession in the US in the next 12 months, compared with 18% in January.

History also has shown the Fed has seldom been able to pull off a “soft landing,” a scenario in which it slows the economy enough to rein in inflation but avoids tightening monetary policy to the point of causing a recession. The US went into recession four of the last six times the Fed began raising interest rates, according to research from the Federal Reserve Bank of St. Louis that looked at monetary policy tightening cycles since the 1980s. 

“The runway for the Fed to manage a soft landing is not only narrow but also winding and bumpy,” said Lauren Goodwin, economist and portfolio strategist at New York Life Investments.

Consumer spending cools, sentiment is the worst ever

US households are the most depressed they have been since the University of Michigan began its long-running Consumer Sentiment index in the 1950s. When consumers are worried about their finances and the economy, the danger is a self-fulfilling cut in spending that brings on a recession. 

There is good news and bad news. The good news is that consumers don’t seem to be slashing spending in line with what they tell the Michigan statisticians. The bad news is that it might be on the way. That may be in part because consumer balance sheets still remain relatively strong thanks to COVID stimulus and savings built up. However, the bad news is that consumers began to tap into these savings to cope with record high inflation. Consumers are concerned how long these reserve funds will last now that inflation is much higher than expected.

Typically inflation has the biggest impact on low income households, however, households at almost all income levels drew down accumulations in the first quarter to cover costs. 

From the start of the pandemic to the end of 2021, US households built up $2.7 trillion in extra savings, according to Moody’s Analytics. Covid-19 lockdowns kept people at home with nowhere to spend money, and three rounds of stimulus payments boosted their incomes. 

Now, with inflation at its highest point in decades and wage gains trailing behind, Americans are turning to that stash to cover costs. Households have used about $114 billion of their pandemic savings so far, according to a Moody’s Analytics analysis of government data.

The personal saving rate, a measure of how much money people have left over after spending and taxes, reached 5.4% in May. That figure is below the average of the last decade and far below the record of 34% in April 2020, according to the Bureau of Economic Analysis. Families have tapped about $114 billion of their pandemic savings so far, according to Moody’s Analytics, which analyzed government data.

“Most households have a cash cushion to navigate through the very high inflation,” said Mark Zandi, Moody’s Analytics chief economist. “This is allowing consumers to stay in the game.”

Falling commodity prices raise hopes that inflation has peaked, however solidifies growth/recession fears

A steep sell-off  in all manner of raw-materials prices—corn, wheat, copper and more—is stirring hopes that a significant source of inflationary pressure might be starting to ease.

Natural-gas prices shot up more than 60% before falling back to close the quarter 3.9% lower. US crude slipped from highs above $120 a barrel to end around $106. 

Many raw materials remain historically high-price, to be sure. And there are matters of supply and demand behind the declines, from a fire at a Texas gas-export terminal to better crop-growing weather. Yet some investors are starting to view the reversals as a sign that the Federal Reserve’s efforts to slow the economy are reducing demand.

While commodity prices are potentially showing a sign of peak prices, recent collapse of prices  is consistent with the growing concerns about the global economic slowdown and the rapidly rising risk of recessions in major economies. It is also consistent with the markets’ transition from the inflation/interest rate risk factor to also recession/credit risk.

While a decline in commodity prices may potentially signal a peak in inflation, the largest component of CPI, shelter, is one-third of the total and is smoothed and lagged. According to the Bureau of Labor Statistics (BLS), their chosen measure for the cost of home ownership, owners’ equivalent rent (OER), is up 7.3% in the last two years, while the S&P/Case-Shiller Home Price Index shows that US home prices have risen by 37% in the two years ended March. The BLS switched to OER after the last inflationary surge in 1979–81; indeed, if inflation was calculated today like it was in 1981, we would already be solidly into double digits.

Similarly, the BLS estimate of rental prices, rent of primary residence (RPR), is up a near-identical 7.1% in the last two years, while the CoreLogic Single-Family Rent Index is up twice that in the last year alone (and an astounding 41% in Miami). The BLS uses survey data to gauge shelter inflation. Homeowners’ perceptions of their property rental values anchor on the past and only respond to soaring home prices slowly, gradually, and over several years.

The one-third of CPI for shelter will be playing catch-up for some years to come. Empirically, most of that catch-up occurs over the subsequent two to three years. Note that this inflation has already happened; it simply hasn’t made its way into CPI quite yet.

A recession is likely coming, if not here already. There’s no excuse not to be prepared. Here’s what we recommend:

For many US households, multi-decade high inflation has them feeling like the economy is already in a recession. The US economy shrank in the first quarter of 2022 and it is seemingly inevitable that GDP numbers will shrink in the second quarter as well, meaning the US economy would officially enter a recession - defined as two consecutive quarters of shrinking GDP growth. 

The biggest risks right now are inflation and how the Fed will react. Investors should be keeping a close eye on economic data to gauge how much rising interest rates are weighing on growth over the next few months. 

However, while investors should proceed with caution, ensure they have ample emergency funds, and reevaluate risk levels in portfolios, you don’t want to be whipsawed by the markets. It is important to stay disciplined to long-term investing goals and allocations.

About 70% of investors expect the US to enter a recession by the end of the year, according to a survey published by Bloomberg and CivicScience. Many investors are also bracing for further losses. Despite the S&P 500 having tumbled into a bear market, defined as a 20% drop from a recent high, 72% of investors surveyed said they expect the S&P 500 to fall further before it stages a sustained recovery.

One reason for that could be that some investors still think many stocks are overvalued following a largely uninterrupted run-up in share prices the preceding two years. Many asset classes or individual companies still have astronomical valuations with little or negative earnings. We believe areas most at risk for further decline are cryptocurrencies, electric vehicle manufacturers, software companies, consumer discretionary, and the overall tech sector excluding meg-cap tech. We strongly favor quality value companies over growth in 2022 and beyond.


Business Cycle 

As a continuation to our research piece and investing thesis of “Seeking opportunities in business cycles”, we believe that the US economy is now in the late stage to recession stage of the business cycle.

While commodities are potentially showing a sign of peak prices, recent collapse of prices  is consistent with the growing concerns about the global economic slowdown and the rapidly rising risk of recessions in major economies. It is also consistent with the markets’ transition from the inflation/interest rate risk factor to also recession/credit risk.

While investors shouldn’t panic and sell all of their stocks in preparation of a potential recession, there are certainly reasons for concern and recession risk is elevated. 

Investors shouldn’t react emotionally or aggressively when rebalancing portfolios to reduce risk exposure. Aggressive market-timing attempts, such as shifting an entire portfolio into cash, can backfire. Some of the strongest returns can occur during the late stages of an economic cycle or immediately after a market bottom. It’s often better to stay invested to avoid missing out on the upswing.

However, investors at or near retirement should be cautious and look to build cash/safe-haven reserves with equity markets near all-time highs after a tremendous bull run as inflation risks continue to put the economy at risk. We recommend investors at or near retirement hold a minimum of 2 years of expenses in cash and a maximum of 5 years of expenses in cash. Medium to long-term investors should hold 12 months to 24 months of expenses in cash (elevated from a typical 6 month emergency fund).

As interest rates continue to rise and inflation persists, we are still overweight US equities as they provide strong inflation protection overtime.

At some point in the second half of 2022, we believe government and corporate bonds will look extremely attractive to start building long-term positions as rates and inflation top out and provide meaningful real yields net inflation.

Finally, only if sufficient cash reserves have been accumulated, consider using the sell-off to build longer-term positions. Equity valuations have been the most attractive that we have seen in years. That being said, investors should proceed with caution when buying equities and do so with a dollar cost averaging approach.

We believe areas most at risk for further decline are cryptocurrencies, electric vehicle manufacturers, software companies, consumer discretionary, and the overall tech sector excluding meg-cap tech (although they may get caught up in further selling of the Nasdaq). We strongly favor quality value companies over growth in 2022 and beyond.

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter (article), will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions.

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