2Q 2022 Review and Outlook
Soaring inflation, hawkish central banks, grinding war in Ukraine and a COVID-locked-down Chinese economy made for an abysmal April-June quarter for nearly all categories of financial investments. Large-company U.S. stocks fell 16%; small-caps declined slightly more. Non-U.S. equities performed marginally better: while the developed-market decline was in-line with domestic large-caps, emerging markets fell “only” 11%. Price declines among real-estate securities were comparable to those of other U.S. equities. Commodities displayed relative strength for a second-straight quarter, with oil up 7%, though the price of gold edged lower (-7%). Bond yields continued to march higher: the benchmark 10-year Treasury ended the period at 2.97%, compared to 2.33% at the end of March (and 1.51% to begin the year); all but the shortest-maturity fixed-income investments recorded negative three-month returns for a second-consecutive period.
Among U.S. large-company stocks, economy-sensitive categories (Basic Materials, Industrials, Financial Services and Technology) underperformed those perceived to be more consistent growers (Consumer Staples, Health Care, Communications Services and Utilities). Energy stocks bucked the trend, declining less than other cyclical groups. Value-oriented shares bested their growth counterparts, though an initially wide differential narrowed as the period progressed.
The war in Ukraine morphed from failed blitzkrieg to war of attrition. After an initial assault failed to achieve major objectives, Russian strategy pivoted to securing incremental territorial gains in eastern Ukraine’s “separatist” regions. A near-term resolution seemed unlikely: the western anti-Russia coalition sought to sharpen the sting of economic sanctions, while simultaneously funneling massive military and financial aid to Ukraine and bolstering NATO’s defenses (and membership); meanwhile, Russia threatened to “weaponize” European gas supplies, while negotiations to free millions of tons of stranded grain dragged on inconclusively. Surging commodity prices kindled a “cost of living crisis” in imported-energy-dependent Europe and threatened famine in parts of the developing world.
The COVID pandemic also continued to afflict the global economy. New omicron-related variants drove yet another rise in infections in North America and Europe, though broadening community immunity and improving treatment protocols kept hospitalization and mortality at a fraction of late-2021/early-2022 levels. The continued easing of activity restrictions and arrival of milder weather allowed much of the world to return to something approaching normal. China experienced a markedly different reality, however, with Beijing’s “zero-COVID” policy resulting in draconian lockdowns that cratered output in the world’s second-largest and most globally interconnected economy.
The American economy slowed dramatically from 2021’s heady pace, while a renewed surge in energy prices pushed inflation to a 40+ year high. Aggregate activity (GDP) in January-March was a surprisingly anemic minus 1.5%, though weakness was largely confined to inventory destocking and foreign trade; underlying consumption expanded at nearly a +2% rate. Incoming second-quarter data were also decidedly soft: purchasing-managers surveys in both manufacturing and service industries indicated clear deceleration; mortgage applications dropped sharply (the national average rate of nearly 6% was almost double the year-ago level and the highest since 2008); inflation-adjusted personal spending weakened in April and contracted in May. The jobs market cooled, albeit from a scalding pace: monthly gains, averaging a still-robust 400,000, were the lowest since early 2021; wage growth decelerated from +5.6% in March to +5.2% in May; unemployment was unchanged at a super-low 3.6%. Notably dour news came from gauges of consumer attitudes: the University of Michigan’s consumer confidence survey showed consumers in the foulest mood in the survey’s 70+ year history, while a Gallup poll of economic confidence plumbed depths not seen since the 2007-2009 recession.
Overseas economies labored amid war- and pandemic-induced price spikes and supply disruptions. In Europe, first-quarter growth (+2.5%) was boosted by rapidly easing COVID restrictions, while second-quarter data showed a service-sector upswing being offset by an abrupt manufacturing slow-down due to weak export demand and recurring supply-chain snarls. The Japanese economy contracted (-0.5%) in January-March amid widespread COVID disruptions; with pandemic conditions receding, the second quarter saw marked improvement, especially in the services sector, though manufacturing output was subdued. In China, first-quarter growth was solid (+5.3%) before renewed COVID lockdowns caused activity to plummet; purchasing-managers surveys indicated both manufacturing and services activity contracted in April-May, though a raft of stimulus measures and easing COVID restrictions brought a resumption of growth in June. Inflation surged in Europe, though compared to the U.S. it was more confined to volatile food and energy prices; price pressures remained subdued in the major Asian economies.
Facing very different inflation and growth back-drops, the policy approaches of the world’s major central banks diverged markedly. The U.S. Federal Reserve was joined by central bankers in Australia, Canada, Britain and continental Europe in embarking on aggressive tightening of monetary conditions, while their Japanese and Chinese counterparts maintained highly accommodative stances. Following an initial 0.25% increase in overnight bank-lending rates in March, the Fed signaled a dramatic hawkish turn and delivered two “super-size” hikes of 0.50% and 0.75% at its May and June policy-setting meetings. These moves lifted the short-term rate target to 1.50%-1.75% – the same level that prevailed just before the pandemic hit in March 2020.
Bond investors reacted violently to the abruptly changing monetary regime and rapidly evolving growth outlook. The two-year Treasury yield, which is especially sensitive to near-term changes in central-bank policy, surged to 2.92% compared to just 0.73% at the end of 2021. Meanwhile, 10- and 30-year yields, which are more responsive to the longer-term interplay between growth and inflation, spiked to nearly 3.5% in mid-June before slumping to 2.80% and 3.03%, respectively, as this letter went to press. Rising market yields and widening credit spreads pushed the prices of existing bonds down: 10-year Treasury notes provided a three-month return of minus 5.2%, bringing the year-to-date figure to -11.5%; comparable figures for the Barclays Aggregate (taxable) U.S. Bond index were -4.7% and -10.4%.
Diverging growth outlooks and monetary-policy stances also roiled currency and industrial-commodity markets. Contributing to a rapid tightening of financial conditions, the U.S. dollar appreciated 7% against a basket of global currencies. The Japanese yen was particularly hard-hit, dropping nearly 12% to a 24-year low against the greenback; the euro/dollar rate also approached a 20-year low. Industrial commodity prices were firm early in the period, though mounting evidence of flagging global growth reversed the trend: copper (sometimes referred to by investors as the commodity with an economics PhD) finished June more than 25% below its April highs.
Entering April just 5% off all-time highs, U.S. stock prices surrendered 9% in April, tread water to finish May unchanged, and came under renewed selling pressure in June, dropping an additional 8%. Finishing with a six-month decline of nearly 21%, the S&P 500 posted its fourth-worst first-half performance on record (lagging only 1932, 1962, and 1970). Large-cap U.S. stocks “officially” entered a bear market – closing 20% below the early-January high – on June 13th and charted a maximum (closing) low of nearly -24% on June 16th. Greatest damage was inflicted on high-valuation growth stocks: the mega-cap/tech-dominated NASDAQ 100 was off 32% at its nadir; large-cap value stocks declined less than half as much at their worst. Chinese stocks surprised with a gain of nearly 6% on the quarter (and +21% from early-May lows) to finish less than 6% below early-January levels.
The quarter was truly catastrophic for more speculative investments. Bitcoin fell nearly 57%; at the June 18th low it was more than 74% below its November 2021 peak; the total value of all outstanding crypto “tokens” fell from over $3 trillion to around $900 billion. Other lowlights included the implosion of several “stable-coins,” while a number of “De-Fi” lending platforms and crypto-focused hedge funds were forced to restrict customer withdrawals or had to be bailed out by deep-pocketed industry insiders. Elsewhere, Cathie Wood’s ARK fund, specializing in long-term (long-shot?) growth ideas, fell more than 39% and at the mid-June low stood 77% below its February 2021 apex. An ETF tracking special-purpose acquisition vehicles (SPACs; also known as “blank-check companies”) fell 56% and finished nearly 70% below its year-end value.
Corporate profits reported during the period – mostly covering the January-March quarter – came in a healthy 13% above the year-earlier figure; the trailing-twelve-month tally showed an impressive gain of more than 40%. Looking ahead, Wall Street analysts expect growth of just 4% for the current quarter. Full-year 2022 and 2023 estimates indicating gains of greater than 13% each are, in our view, overly optimistic. Though the process should be widely anticipated, whittling down these projections will likely be a headwind for stocks in coming months.
To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:
1) Dividend Income (for three months this is the annual yield divided by four)
2) +/- Change in Earnings per Share* (average for S&P 500 companies)
3) +/- Change in Valuation (Price/Earnings Ratio)
= Total Return
* based on forecast earnings for next 12 months (Source: S&P Outlook)
So, what changed during the recent quarter to produce the -16.2% S&P 500 total return
Second Quarter (April - June) 2022
+ Change in Earnings
+ Change in Valuation
= Total Return
Our read: Soaring bond yields continued to push valuations lower; we doubt analysts’ rosy view of future profits can stand up to mounting signs of slowing growth.
While war in Ukraine and U.S. mid-term elections should provide ample distraction, the main driver of near-term investment outcomes is almost certain to be the interplay between inflation, economic growth (or lack thereof) and central-bank monetary policy: investors will seek to divine whether soaring prices will force central bankers into a “policy accident” that tips economies into recession.
Over the past six months, the U.S. Federal Reserve has dramatically shifted its internal view – and external messaging – to emphasize the serious threat posed by persistent inflation. With their last-minute, un-telegraphed decision to hike overnight rates by 0.75% in June, Fed bankers seemed especially keen to demonstrate inflation-fighting zeal. In comments following the June meeting, Chair Jerome Powell averred the central bankers need to see “clear and compelling evidence” that inflation is falling before they let up on the monetary-policy brakes. And the updated post-meeting “dot plot” showed Fed bankers expected short-term rates to rise straight through 2023 to a level approaching 4.0%. Given the lag between rate hikes and economic impacts, the dramatic hawkish turn – coinciding inopportunely with a marked deterioration in economic news – struck many as a sub-optimal game plan: too much, too late.
But perhaps evidence of easing inflation is relatively near at hand. Oil and other commodity prices have moderated in recent weeks; supply-chain disruptions show signs of easing; wage gains seem to be decelerating; and widely acknowledged “base effects” will kick in as large price jumps pass out of year-over-year comparisons. Crucially, there is still scant indication of mass-psychological changes that would “entrench” the inflationary surge: a late-June revision largely reversed what initially appeared to be an alarming jump in consumers’ expectations for future inflation (prior to the revision, this had been cited as a proximate cause of the Fed’s surprise jumbo rate hike). Likewise, bond-market-derived measures of investors’ views regarding inflation five- to 10-years out spiked earlier this year but have drifted meaningfully lower, finishing June below the average level of 2004-2014 – a period of low and falling inflation.
Likewise, the U.S. economy may be on sounder footing than recent data suggest. As noted, underlying consumption, though slowing, has been more resilient than volatile headline GDP figures. Consumer finances – cash balances, net worth, debt-service burdens – are notably healthy. The jobs market remains super-strong. Ongoing improvement (or, at worst, normalization) of pandemic conditions and easing de facto restrictions will support service-sector activity (e.g., restaurants, movies, sporting events, travel) in the months ahead. Finally, outside the relatively small crypto-finance space – which, thanks in part to post-2008 regulation, has scant connection to mainstream banking – we see no financial-system imbalances that would exacerbate a slowdown: the nation’s 34 “systemically important” financial institutions were given a fresh clean bill of health by Federal Reserve examiners in the most recent annual “stress tests” released in late June.
So perhaps a salutary combination of rapidly easing inflation and underappreciated economic resilience will avert a Fed-induced policy accident. Perhaps. But more plausibly, in our view, aggressive – and, arguably, tardy – monetary tightening increases the likelihood of a downturn. According to a multi-input gauge of financial conditions recently published by the Federal Reserve Bank of San Francisco, the current episode already represents the most rapid tightening since the early 1980s. Meanwhile, ubiquitous media recession hype raises anxiety among consumers, investors and businesspeople, potentially becoming a self-fulfilling prophecy. Wall Street economists, including Mark Zandi of Moody’s and Goldman’s Jan Hatzius, have upped their recession odds: most now see it as roughly a 50/50 call. And though top-tier research provider Capital Economics sees “near zero” chance of a U.S. recession over the next year, they nevertheless expect growth to slow markedly, leaving little margin for error. Even the Fed acknowledges the battle against inflation will entail at least a modicum of pain: in June they projected for the first time a small increase in joblessness in coming months. Investors clearly concur with this darkening mood: growth-sensitive long-term bond yields and cyclical-stock prices have swooned in tandem in recent weeks, while the “recession-warning flag” spread between two- and ten-year Treasury yields is again flirting with zero.
Despite broadening evidence of an economic slow-down, this year’s stock-market swoon appears, on the surface, to be mostly about higher interest rates compressing valuations (all else equal, higher rates lower what investors will pay today for profits to be earned in the future): as noted in our What’s Changed? box above, Wall Street earnings projections have continued to inch higher even as stock prices have fallen. We suspect investors have taken heed of rising down-turn risks and applied an increasingly healthy discount to analysts’ figures (especially in recent weeks, as price declines among economy-sensitive stocks have played catch-up with those of long-term growth companies hit hard earlier in the period). Back-of-the-envelope calculations suggest a 15%-20% drop in stock prices can be explained by higher rates (this is a necessarily imprecise exercise due to the fluctuating level of bond yields); to the extent declines exceed that level, they likely begin to factor in lower earnings (which may fail to materialize if the economy manages to skirt recession). But a bona fide recession would likely bring a meaningful decline in profits (minus 15-20% is a reasonable guess); it seems unlikely the mid-June lows fully discount that outcome.
Though year-to-date stock- and bond-market declines have been painful, it is important to acknowledge the potentially salutary effect they have on prospective (that is, future) portfolio returns. Yields on high-quality, intermediate-term bonds have risen from under 2% to around 4%; that change alone improves the expected annual return of a 60/40 (stock/bond) balanced portfolio by almost a full percentage point. Even “cash” (money-market funds) sports a non-microscopic yield for the first time in years: the ultimate safe asset could be producing income near 3% in coming months if the Fed stays its tightening course. Meanwhile, market history shows that stock returns following significant declines are frequently several percentage points better than those measured from seemingly more auspicious starting points (see accompanying graphic). While it is impossible to predict future returns with any precision, we believe this year’s price declines substantially increase the likelihood that portfolios will provide attractive returns in the years ahead.
As an old Wall Street saw has it, no one rings a bell at the bottom. But as we have attempted to quantify in the preceding paragraph and graphic, we believe this year’s market swoon, even if it doesn’t (yet?) reflect a worst-case scenario, means the time is approaching to rebalance portfolios by re-investing the cash and near-cash “dry powder” accumulated during the 2020-2021 bull market. The next few months seem likely to feature waxing and waning recession fears. Even if an outright downturn fails to materialize, intermittent “recession scares” may provide (multiple?) opportunities to acquire high-quality investments at attractive (possibly lower than today’s) prices. We will strive to make the most of such opportunities on your behalf.
Please call or email a member of the Oarsman team any time to discuss our management of your investment portfolio. We hope you are having a great summer.