2022 Q2 Commentary
The Bear Takes Hold
After recording modest declines to start the year, the pain intensified for investors during the second quarter as stock and bond prices continued to fall. The following headlines highlight this treacherous environment.
“The Stock Market’s “Horror Story” First Half of 2022” – Fortune.com
“This Was The Worst First Half For The Market In 50 Years” – CNBC
“Markets Had A Terrible First Half of 2022. ” – Wall Street Journal
Persistent inflation and rising interest rates fueled a rout that left few markets unscathed. The Standard and Poor’s 500 Index (S&P 500) fell 21% through the first half of the year, its worst performance since 1970. Investment grade bonds as measured by the IShares Core U.S. Aggregate Bond exchange-traded fund, lost 11%, recording its worst start to a year in history. Foreign stocks offered no relief either, as slowing global growth and an emerging energy crisis in Europe unsettled investors abroad. While no one knows how the market is likely to perform in the back half of the year, history does offer some hope. When the S&P 500 has fallen at least 15% the first six months of the year, as it did in 1932, 1939, 1940, 1962, and 1970, it has risen an average of 24% in the second half, according to Dow Jones Market Data. As we progress through the year, here are a few items the PYA Waltman Investment Committee will be paying close attention to.
Much of the financial market volatility this year has emanated from inflationary pressures. If these begin to ease, it may help to improve sentiment and confidence. One hopeful sign on this front has been the recent weakness in a broad basket of commodities. Natural gas prices fell 3.9% in the second quarter while U.S. crude oil slipped from highs above $120 a barrel to end around $106. Wheat, corn, and soybeans all wound up cheaper than they were at the end of March. Cotton has lost more than a third of its price since early May. Benchmark prices for building materials such as copper and lumber dropped 22% and 31%, respectively. And while housing remains strong, the recent rise in the interest rate on a 30-year fixed rate mortgage should begin to slow this market as well.
The Federal Reserve
The Fed has been very clear that it is prepared to raise interest rates substantially to bring inflation under control, even if this means throwing the U.S. economy into a recession. While they are attempting to avoid this outcome, it may be difficult. History has shown the Fed has seldom been able to pull off a soft landing in which it slows the economy enough to control inflation but avoids tightening monetary policy to the point of avoiding a recession. The U.S. went into recessions four of the last six times the Fed began raising interest rates according to the Federal Reserve Bank of St. Louis. The good news is that the bond market has already priced in successive rate increases well into 2023. Unless this projected level of tightening is too little, the bond market may have already taken most of its pain.
One could argue the stock market has already priced in inflationary pressures and may be beginning to price in a mild recession. If the Federal Reserve Bank of Atlanta’s GDPNow model is accurate, the U.S. may already be in a recession. This indicator recorded a contraction in economic activity during the first quarter and the current reading on the second quarter is showing the same. The extent to which corporate profits fall in a recession is a function of the severity of the downturn. A mild recession may only lead to a single digit fall in profitability while a deep recession can see profits fall 20 plus percent. One of the risks the Fed runs is overtightening into a slowing economy. Interest rate increases work with a lag effect. We likely won’t know the full impact of the Fed’s recent tightening until later this year or early 2023. If the Fed overtightens, resulting in a hard landing for the economy, stocks may fall further into bear market territory as corporate profits decline in a more substantial way.
There is no shortage of things for an investor to worry about in 2022. The confluence of inflationary pressures, ongoing supply chain issues, and a Fed tightening campaign are all contributing to a very uncertain environment. While we may not know what lies ahead, we remain convicted that owning a diversified portfolio of bonds, real estate, precious metals, and high-quality businesses with strong balance sheets and pricing power is the best way to protect one’s capital over the long-term.
As always, we appreciate the trust you place in us and we remain committed to helping you achieve your financial goals.