2nd Quarter Market Insights

Published July 15th, 2022 in Blog, Financial Planning & Investments | No Comments »

Recession, bear market, pullback, inflation, volatility… These are all headline-grabbing words being used to describe economic conditions today in the media. As always, we need to take the media with a grain of salt. In the news business, fear and worry sell news in both the print and digital world. Once we get below these headlines, we can plainly see that the world is not ending, and this too shall pass.

Looking at current economic conditions, we can see employment is still strong. Unemployment continues to run at a 50-year low and there are 5.45 million more jobs open than unemployed workers. Such strong employment can help buffer the U.S. economy from falling into a recession. Even when the employment tide starts to turn, that would stabilize wage growth and potentially reduce inflation and increase corporate earnings over the coming quarters.

Inflation is running hot at an annualized 8.5%. This over-inflation stems from numerous dynamic factors, including the fiscal stimulus provided to many Americans during the pandemic. This prompted outsized spending on goods through the end of 2021, and a subsequent shift to service spending such as travel more recently. Pundits suggest this spending shift is the result of pent-up demand, especially for travel, both for business and leisure. This persistent spending can also help to keep the economy from sliding too much, because once travel is booked, more than likely the trip will be taken, and more money will be spent on dining and shopping.

The only sector of the investment landscape that had a positive return for 2022 so far was commodities, up 18.4%. Commodities includes things such as oil, gasoline, copper, gold, nickel, iron ore, and agricultural items. We know all too well how much the price of gasoline went up in 2022! With the shutdown of mines and factories, there has been a tight supply of all commodities since the pandemic, and the war in Ukraine is not helping to ease supplies. This large jump in commodities should start to level out through the rest of 2022 and individual commodities will start to perform more based on their own supply/demand dynamic instead of the entire sector running hot from geopolitical issues.

The overall equity market as measured by the S&P 500 Index was down 19.96% for the first half of 2022, but it was very unevenly distributed. Growth stocks in the S&P 500 were down 27.6% while value stocks were down 11.4% for the first 6 months of the year. Dividend-paying stocks fared better than the overall market, as the cash dividend helps to offset some of the drop in price of the stock. This scenario is very typical of an end-of-market-cycle scenario where the economy is slowing, but it does not automatically mean we are headed for a recession.

While the S&P 500 Index is a broad measure of large cap stocks, the Russell 2000 is a broad measure of small cap stocks. Small cap stocks did worse than large cap stocks because the companies have uneven earnings, niche markets, and can have less-than-stellar balance sheets. Small cap stocks are down 23% this year, which has led to a valuation gap between large cap and small cap stocks.

Foreign stocks have followed the US markets in lockstep. The MSCI EAFE Index is down 19.2% so far in 2022. This is a broad measure of large cap stocks around the developed world. Just like the US market, when we drill a little deeper into the headline number, we find large discrepancies in overall performance. Part of the reason for the different returns from one country to another are the actions taken by their central banks and how reliant the economy is on commodities. The UK has been one of the most aggressive nations to increase interest rates, with 4 increases since the end of 2021. Meanwhile, the Bank of Japan has maintained ultra-low interest rates. For 2022, the MSCI UK index is down 8.8% while the MSCI Japan index is down 20%. The low interest rate stance has caused the Japanese currency to hit a 24-year low against the US dollar. This large imbalance is having ripple effects through their economy, especially as a large importer of oil and natural resources.

The bond market has been the real thorn in everyone’s side. Often when stocks fall, most investors rush toward the safety of bonds, but that has not been the case so far in 2022. For only the 3rd time in 60 years, stocks and bonds moved in tandem downwards, and more severely than ever before. This is caused by the unwinding of the excessive bond purchases made by the Federal Reserve during the pandemic and the removal of an ultra-easy interest rate policy. Even though many investors are surprised, it should have been expected. When interest rates go up, bond values go down, regardless of what the stock market does. We believe we are starting to see a reversal of this tandem movement. Yields on government Treasury bonds have risen high enough to offer a yield that investors are willing to accept and which are close to the dividend yield on stocks. We believe the worst is behind the most secure parts of the bond market for this year.

As you can see, even though markets have been turbulent and most broad indices have suffered in 2022, there are signs of optimism. It’s also worth noting, the average annual compound rate of total return of the S&P 500 from January 1973 until May 2022—after the Index suffered 3 major pullbacks of 50%—was 10.5%. This is almost exactly what its long-term (1926–2021) average has been.

If you would like to discuss markets, your current investment allocation, or how current market conditions are affecting your portfolio, please feel free to contact me at ted.schumann@dbsia.net or 800-327-2377.