The second quarter of 2022 saw a continuation and acceleration of the trends witnessed in financial markets in the first quarter of the year. The S&P 500 lost 16.11%, pulling it into bear market territory for the first time since the height of the pandemic-fueled selloff in March 2020. Inflation was the story of the quarter, with all three monthly Consumer Price Index readings coming in over 8%. This was the first time inflation has reached these levels since 1981, prompting the Federal Reserve to move faster than anticipated on their rate hiking schedule. The Fed’s 0.75% rate increase in June was the largest single increase in over 25 years. Amid this tightening monetary backdrop, all sectors ended lower in the quarter. Retailers were some of the biggest underperformers after reporting disappointing earnings, guiding lower, and announcing that they were overstocked due to tangled supply chains throwing off shipping schedules. Much like the first quarter, value outpaced growth, though it still saw double-digit declines. This was evidenced by the 20.92% decline in the Russell 1000 Growth Index, while the Russell 1000 Value Index saw a narrower decline of 12.22%. Companies with some of the highest valuations were once again the hardest hit. For example, the ARK Innovation Fund, which is comprised of high-growth, low-earning companies, experienced a 39.84% decline.
International equities managed to beat out domestic equities in the quarter. The MSCI EAFE Index ended the period down 14.32% as central banks broadly began to take action to fight off inflation, albeit less aggressively than the Federal Reserve. The war in Ukraine dragged on, leading to continued worries over food and energy supplies. China enforced strict lockdowns as a result of its “Zero Covid” policy but did begin to open back up as the quarter went on, easing the pain in global supply chains. Emerging markets more broadly also saw double-digit declines. Finally, the U.S. dollar appreciated significantly due to the Fed’s hawkish policy moves and the dollar’s safe-haven status amid geopolitical uncertainties, weighing further on unhedged international positions.
Fixed income also had a poor quarter but outperformed equities, with the Bloomberg U.S. Aggregate Bond Index ending the period down 4.69%. The Fed ramped up the pace of their rate hikes and signaled that future hikes would come at a more accelerated pace. This caused bond yields to continue their climb higher across the board and led to the U.S. 10-Year Treasury yield topping 3% for the first time since 2018. The Fed is fully committed to taming inflation, which means that the rate hikes will continue until there is a convincing sign that inflation is easing. As far as the balance sheet goes, the Fed has begun its balance sheet reduction, allowing maturing Treasuries to accumulate in cash rather than reinvesting the proceeds. Overall, municipal bonds generally fared better than corporates and investment-grade debt outpaced high-yield.
Outlook
While the selloff in financial markets over the last six months has been painful, it is important to remember to look beyond near-term volatility and adhere to a long-term plan. Corrections are a normal part of the market cycle, and markets have never failed to recover from selloffs in the past. To put it into perspective, the S&P 500, while down 16.11% this quarter, is still up 35.23% over the trailing three-year period, a time frame that also includes the initial Covid selloff. On an annualized basis, that represents an average 10.55% gain over the past three years.
In fact, with domestic equities having sold off significantly over the last two quarters, stocks today look much cheaper than they have been in some time. Quality stocks have fallen alongside some of the higher-flying growth names, leaving behind opportunities for investors to find some bargains. The Fed’s continuing tightening is keeping pressure on equities, but they have generally done a good job issuing forward guidance, taking some of the uncertainty out of the market.
The fixed income market is now seeing its highest yields dating back to 2018. We look for the Fed to continue raising near-term rates at an accelerated pace as they have signaled. While inflationary pressures, such as the war in Ukraine, still exist, there are now some hopeful signs, such as China beginning the reopening process. Increased levels of interest income on bond portfolios resulting from the higher yields have created an attractive entry point relative to the trailing three years.
The Fed tightening is beginning to show its impact on the economy. Housing has seen a slew of data come in over the past couple of months indicating that the market is finally beginning to cool off. Commodities have come off their highs. Beyond the Fed actions, China is focused on factory output, and retailers are well stocked, indicating supply chains are beginning to normalize. All these things in combination bode well for the fight against inflation. Despite the effects of the Fed’s actions, the labor market remains strong, with unemployment near all-time lows, job openings near all-time highs, and wages continuing to rise. On top of this, consumer balance sheets remain in a better position than they were pre-pandemic. This gives us hope that the Fed may yet be able to engineer a soft landing.
There are still areas of uncertainty in the market and economy. The war in Ukraine is still ongoing, Covid is still a risk, and the Fed is still tightening. It is also entirely possible that the U.S. economy could soon enter a technical recession with a negative Q2 GDP reading in late July. However, not all recessions are created equal, and we expect any dip in the economy to be brief. A technical recession at this point, when the labor market is extremely strong, consumers still largely have money on hand, markets are already trading cheaper, and the Fed has room to pivot monetary policy to a more accommodative stance may sound scary but would have little in common with the deep recessionary period of 2008-09. Just as importantly, with markets being forward-looking, it is highly likely that much of this fear is already priced in.
Throughout the recent volatility, though, we have taken steps to best service our clients including tax-loss harvesting, maintaining our disciplined focus on profitable companies, and tactically underweighting some of the areas of the market that have most underperformed. Moving forward, we will remain vigilant in search of opportunities as they present themselves in the near term, while maintaining our broader focus on your long-term needs and financial plans.
