The S&P 500 sank -16.1% over the second quarter of 2022, falling into bear-market territory. The index declined sharply as spiking inflation and corresponding rate hikes from the Federal Reserve (Fed) depressed consumer sentiment and enhanced selling pressure. Overseas, the MSCI EAFE Index dropped -14.5% while the MSCI Emerging Markets Index declined -11.5%. Fixed-income markets were not spared from the turmoil, with the Bloomberg US Universal Bond Index falling -5.1%. US GDP declined at an annual rate of -1.6% over the first quarter of the year, and the unemployment rate stabilized at a near-record low of 3.6% in June.
In mid-June, the S&P 500 officially entered a bear market, defined as at least a 20% drop from a recent high. Over the quarter, the S&P 500 tumbled -16.1%, dragging year-to-date returns for the large-cap index down to -20%. Not since 1970 has the S&P 500 declined more in the first six months of a year.
Stocks fell in response to persistent inflation and corresponding rate hikes from the Federal Reserve. In May, the latest month for which data is available, inflation rose at an annual rate of 8.6%, its fastest rate of increase since December 1981. The Federal Reserve lifted its federal funds rate twice during the quarter, first by .50% in May and second by .75% in June. After starting the year at a range between zero and .25%, the federal funds rate now stands at a range between 1.50% and 1.75%. June’s rate hike was the largest since 1994. Additionally, investors were caught off guard by the news that U.S. gross domestic product (GDP) declined at an annual rate of -1.6% over the first quarter of the year after climbing 7% in the fourth quarter.
All of the 11 underlying sectors within the S&P 500 fell for the quarter, with growth sectors like information technology, communication services, and consumer discretionary suffering the deepest drawdowns. Defensive sectors like utilities, health care, and consumer staples experienced the shallowest declines. On the strength of surging oil prices, energy is the lone sector in positive territory for the year.
Large-cap stocks gave up slightly less ground than small-cap stocks, and value stocks fared better than growth stocks. The Russell 1000 Value Index, for example, shed -12.2% for the quarter, while the Russell 1000 Growth Index dropped -20.9%. Growth stocks have lagged in 2022, primarily due to elevated valuations to start the year and concerns that rising interest rates would dampen growth prospects.
The MSCI EAFE Index of international developed stocks fell -14.5%, pulling year-to-date returns down to -19.6%. The U.S. is not the only major economy experiencing elevated inflation. In the Eurozone, inflation rose at an annual rate of 8.1% in May, its fastest pace on record. To stave off inflation, European Central Bank President, Christine Lagarde, indicated that the ECB will begin raising its key interest rate, which is currently -.50%, in July. The interest rate hike will be the first for the ECB in 11 years, ending an eight-year experiment by the bank with negative interest rates. Likewise, in the UK, inflation rose at an annual rate of 9.1% in May, also a record. In June, the Bank of England moved to increase its bank rate from .25% to 1.25%, its fifth consecutive rate hike. International returns were dampened by a surging U.S. dollar, which increased 5.7% versus the Euro in the quarter. International returns are adjusted downward for domestic investors when the dollar strengthens. The dollar is sitting at a 20-year high after the recent increase in value.
Meanwhile, the MSCI Emerging Markets Index declined -11.5%, taking year-to-date returns to -17.6%. China, the largest weighting within the MSCI Emerging Markets Index, was a rare bright spot for investors, rising 3.4% over the quarter. In contrast to other major economies, inflation in China has been modest. In May, inflation in China rose at an annual rate of just 2.1%. Though details remain sparse, Chinese President Xi Jinping underscored the government’s commitment to meeting its 5.5% GDP growth target for 2022 in June, bolstering markets. Unlike the majority of global central banks, China cut its borrowing rate in the quarter to help boost growth, which has been dampened by a recent shutdown of several large cities in response to a spike in Covid cases.
Over the second quarter of the year, the Bloomberg U.S. Aggregate Bond Index declined -4.7% while the broader Bloomberg U.S. Universal Bond Index fell -5.1%. Respectively, year-to-date returns for the indexes now stand at -10.4% and -10.9%. The Bloomberg U.S. Aggregate Bond Index has not had a worse six-month stretch since 1980.
The yield on the 10-Year US Treasury rose .51% over the quarter, starting at 2.38% and ending at 2.89%. In mid-June, the yield on the 10-Year Treasury briefly touched 3.48%, its highest level since 2011. Shortly after the Fed’s .75% rate hike, interest rates declined in response to a more aggressive rate hike campaign that is expected to reel in inflation. Although short-term rates remained stable, longer-term interest rates declined in the last two weeks of June and longer-term inflation expectations declined slightly.
Yields on Treasury reflect investors’ expectations for short-term rates set by the Fed. As noted above, the federal funds rate now sits in a range between 1.50% and 1.75%. Median projections from the Federal Open Market Committee (FOMC) show the effective federal funds rate reaching 3.25% to 3.50% by the close of 2022.
Credit spreads widened in the quarter, indicating investors required a higher yield for bonds that have more significant perceived default risk. For years investors had pushed up prices on riskier bonds as the thirst for yield was substantial. However, with the risk of a recession increasing, yields on riskier bonds have increased toward more normal levels.
U.S. GDP declined at an annual rate of -1.6% over the first quarter of 2022, the latest period for which data is available. In general, second-quarter GDP estimates are positive, but a few larger financial institutions are projecting very modest growth—raising concerns that a recession is still possible. Since 1950, the U.S. has experienced 11 recessions, with the most recent recession occurring in early 2020.
The consumer price index (CPI) rose at an annual rate of 8.6% in May, its fastest rate of increase since December 1981. Core CPI, which removes inflation in volatile food and energy prices, rose at an annual rate of 6% in May. Meanwhile, the Fed’s preferred gauge of inflation, the core personal consumption expenditures (PCE) price index, rose at an annual rate of 4.7% in May. Regardless of the measure evaluated, inflation is too high and is negatively impacting economic growth and consumer sentiment dropped to its lowest level on record. Inflation reduces consumers’ purchasing power and persistent inflation can lead to a dramatic decline in economic growth.
To curb historically high inflation, the Fed moved to increase its federal funds rate twice during the quarter, by a total of 1.25%. After starting the year at a range between zero and .25%, the federal funds rate now sits at a range between 1.50% and 1.75%. In addition to its increases, the Fed also initiated a policy of quantitative tightening in June, a process whereby the Fed allows securities on its balance sheet to mature without reinvesting principal repayments.
Halfway through the year, it would be an understatement to say that investors have had a rough go in 2022. The highest inflation in over 40 years has put into question the Fed’s inflation-fighting credibility. Investors are struggling to determine if the Fed’s commitment to fighting inflation will ultimately result in higher interest rates that will dampen demand and push the U.S. economy into a recession. International markets face elevated inflation as well, particularly in Europe, which is now facing surging oil and energy costs related to a reliance on Russian oil. A major disruption in oil supply could kick the region into recession as it will take time to develop new options for energy outside of Russia.
Still, there is reason for optimism going forward. Historically, painful market declines like the one experienced in the first half of 2022, have followed positive rebounds. When the S&P 500 has fallen at least 15% in the first half of the year, it has risen an average of 24% in the second half of the year. U.S. consumer sentiment recently hit its all-time low, however, low levels of consumer sentiment have historically preceded above-average returns for stocks in the 6 and 12 months that follow a bottom. Furthermore, with stock prices declining everywhere, valuations have declined aggressively, and in many regions, they are below their longer-term averages. For example, in mid-January, the forward 12-month price-to-earnings ratio for the S&P 500 was 21.1, above its five and ten-year average. More recently, the forward 12-month price-to-earnings ratio for the S&P 500 was 15.8, below its five and ten-year average.
It appears that investors have priced in a mild recession given the downturn in equity prices this year. Therefore, additional downside appears limited unless a deep recession develops. At this stage, a deep recession seems unlikely given the strength of the U.S. employment market and the current level of reasonable equity valuations. Equities are poised to produce relatively strong returns in the second half of the year, with value stocks and emerging market stocks offering the most attractive upside potential. Bonds, after struggling in the first half of the year, are better positioned to provide positive returns as well. The Fed has been very transparent with its rate hike expectations and the fixed income market adjusted quickly. Interest rates are unlikely to increase sharply from current levels unless the Fed is forced to hike rates faster than expected. Credit spreads have widened, and bond yields are more reflective of the current environment. Overall, both stocks and bond valuations have adjusted to the current risks and returns could turn positive in the second half of 2022 if these risks do not materialize.
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Darin joined the Portland wealth management firm in 2004, bringing more than a decade of investment and financial consulting experience with him. As chief investment officer for Aldrich Wealth, Darin is responsible for developing, and implementing our investment philosophy and leading the investment committee. He works directly with some of our most complex and largest clients and also…
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