Another volatile quarter has just come to a conclusion. Just when investors were hoping that inflation was in check, we realized that it might not really be. Other worries such as China’s COVID lockdowns, food and energy shortages, and the Russian war also contributed to the uncertainty.
Let’s see how some of the major market components did in Q2 and year-over-year (not for the weak of heart!):
|Index||2nd Quarter||1 Year|
|S&P 500 Large Cap Index||-16.45%||-11.92%|
|S&P Small Cap 600 Index||-14.45%||-17.96%|
|S&P Developed BMI International Index||-16.87%||-17.49%|
|S&P U.S. Aggregate Bond Index (total return)||-4.31%||-9.64%|
|S&P Municipal Bond Index (total return)||-3.02%||-7.91%|
|Dow Jones Equity All REIT Index||-15.50%||-8.83%|
|Dow Jones Commodity Index (total return)||-3.73%||28.61%|
SOURCE: DOW JONES, DATA AS/OF 6-30-2022 (DOESN’T INCLUDE DIVIDENDS UNLESS NOTED). HERE IS A COMPREHENSIVE LIST OF RETURNS.
Looking back, here are some observations.
In Q2, we saw a flat month of May but April and June were pretty ugly. This led to the second consecutive negative quarter, and one of the worst starts to a year (since 1970). I probably don’t need to discuss this further since the media is already doing a stellar job of that!
Looking at the sectors in the S&P500, all 11 sectors were negative for the quarter. As always, some sectors did better than others. Energy held up with the continuation of high oil and natural gas prices, and is the only sector in the green this year. Defensive sectors such as utilities and staples also fared relatively well. Technology, communications, and consumer discretionary were the worst quarterly performers.
Growth stocks continued to take it across the chin as compared to value stocks (-25% versus – 9%). Some popular growth stocks have fallen so significantly that they are now considered value stocks. Stocks like Facebook (META) and Netflix (NFLX) have price-to-book ratios that now have them included in the value indexes (more on how that works here).
We’ve been suggesting that value stocks were poised to outperform growth for many months, and in our portfolios, we’ve made changes in that direction. Acknowledging that very few corners of the stock market emerged unscathed in this year’s selloff, companies with lower book value multiples have held up better than most. Companies like Exxon, Merck, and Molson Coors are good examples, and so far we’ve seen the largest value-outperforming-growth dispersion since 2001. Here’s a chart depicting that:
Foreign markets followed the U.S. market downturn. Even commodities took a breather after being hot for one year plus. The price of oil, copper, gold, etc. pulled back from highs set in Q1.
Here’s one thing that did go up: interest rates! Not that this is necessarily a good thing :o) but the benchmark 10-year Treasury bond jumped to 3.50%, before pulling back below 3% to end June at 2.97%. Three percent may not seem like much in the scheme of things, but that’s pretty much double where we started the year.
Diversifying a portfolio across stocks and bonds is a bedrock strategy for weathering volatility. Bonds typically provide that safe harbor when we see stocks pull back. What we’ve seen this year is unusual, as they both have moved in tandem as competing forces have been competing for our attention.
It’s been commonly discussed, but I think a major contributor to the issues we see today is because our government handed out a plethora of checks over the past two years. They essentially allowed American consumers to “borrow from the future” and spend it all post-COVID. In fact, consumers spent more in the past 2 years than they would have otherwise done if no pandemic had ever occurred!
Add on the fact that there were mandatory shutdowns, and we’ve still got supply chains that are a mess. It’s been noted that the market functions best when the pricing system is allowed to function. It’s easy for us to observe from afar but I think too many rules, mandates, and regulations worked against us. The market is still trying to find its normal. In the spirit of the recent Independence Day, an appropriate comment might be, “freedom works”!
On the inflation front, it’s safe to say that inflation is above the Fed’s “comfort zone”. And the Fed has made that pretty apparent. Thankfully, there have already been some signs of inflation cooling off (for example the May personal consumption expenditures price index, which the Federal Reserve uses for its inflation target, rose less than expected). The next few months will tell us a lot.
And there is more “good news” (as always, I try to spin the positive angle)! The unemployment rate is down to 3.6%, very close to where it was pre-COVID. The labor market looks pretty good, and manufacturing production is higher than in pre-COVID days as well.
A “recession” is generally a slowdown in economic activity over consecutive quarters. I am often asked, “Are we in one now, or will we be soon?” And it’s a hard question for anyone to answer. Maybe no recession this year – but the chances of it occurring in the next couple of years have certainly increased. We never actually know until after it actually happens since economists need to view the data after it transpires.
In studying prior “recessions”, most of the stock market damage has occurred leading UP TO the recession… more than during the recession period itself. This would imply that by the time we realize we are in one (or WERE in one), the market may have well rebounded already. Past performance does not guarantee future results, but I do like to use prior instances as a basis.
Interest rates will play a big part. Many of the major central banks across the globe (including our own Fed) are attempting a delicate balancing act. They are trying to tighten monetary policy (raise rates) to cool the economy and lower inflation, yet not tighten too much (raise rates too high, too quick) to send the economies into recession. We’d all root for the Fed to “thread the needle” and get us to a soft landing, but history has shown that is difficult to do. It might be a little rocky.
Depending on what happens with Russia and Ukraine, we think the results could create two very different scenarios. In one case, if the war drags out and we see things like the Russian energy cut-off, we could see higher inflation and lower global growth. After all, people will spend less if it’s costing them a lot more to fill their gas tanks. We could see further market declines until this gets resolved.
On the other hand, if the war outlook improves, the reduced geopolitical risk would boost global growth and lower the chance of a recession. Central banks would not be pressured to keep raising rates in this scenario. Most investors would probably prefer this scenario.
Statistically speaking, we can look at data going back to 1957 and see if the second half of any given year was correlated to the first half of the year. The numbers say there has been an equal 50-50% chance of up or down, so really…no correlation.
What is encouraging is when we look back at other years the market started off a year as it has in 2022. In this WSJ article, you will see similar instances occurred in 1962 and 1970. In those years, the market rallied in the second half by 15% and 27% respectively. By no means should this suggest we can expect the same this year, but it doesn’t negate the plausible possibilities.
And I will end with this thought: the market may have already priced in the worst-case scenario. It usually does. If inflation cools off, I think this makes for a positive backdrop for stocks. Looking back at any chart that tracks stock markets over time, those visuals show strong growth spurts follow the periodic downturns. This is why we always preach staying invested, as widely and globally diversified as possible.
There is no lack of excitement these days, and no one’s crystal ball works perfectly…including mine! We might have to live with this short-term volatility and discomfort. But hang in there.
Disclaimer: This information contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the advisor. The information should not be construed as legal, tax, nor investment advice. Never make investment or financial decisions based on information provided here, without first consulting with your professional investment advisor. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Dow Jones. Data is taken from sources generally believed to be reliable, but no guarantee is given to its accuracy.