Equity markets declined significantly in the second quarter and exhibited heightened volatility in reaction to an increasingly gloomy outlook. It was only several months ago that the world economy was on track for a strong, albeit uneven, recovery from the pandemic. However, supply chain disruptions, the war in Ukraine, and shutdowns in China have dealt a serious blow, and the first half of 2022 has once again tested investors’ resolve, presenting them with one of the worst starts of a year in a decade. The stock market, as it often is, has been the biggest casualty of recent turbulence. The S&P 500 Index has fallen 16% in the last three months, the eighth biggest quarterly fall in 50 years, and every stock market index has declined by double digits. The large capitalization stocks again outperformed their mid and small capitalization counterparts, albeit by a small margin. All eleven sectors of our domestic economy were negative in the second quarter, with only energy posting a positive return for the first six months.
Stocks fell in response to persistent inflation and corresponding rate hikes from the Federal Reserve. In June consumer prices rose by 9.1% year-over-year, the largest increase in forty years. To curb this historically high inflation, the Fed broke from its more normal .25% rate hike pace with oversized rate hikes of .50% at the May 3rd meeting and .75% at the June 15th meeting. The last hike was the largest since 1994, and after starting the year at a range between zero and .25%, the federal funds rate now stands at 1.50%-1.75%. At quarter-end, federal funds futures suggest another .75% at the July 27th meeting was likely and a year target range came to 3.25% to 3.50%. Surging inflation data convinced the Fed to become more aggressive with the pace and magnitude of its rate hikes and Chairman Powell suggested policymakers will be more data dependent as opposed to following previous rate guidance going forward. In addition to its increases, the Fed also initiated a policy of quantitative tightening in June, a process where the Fed allows securities on its balance sheet to mature without reinvesting principal repayments.
Foreign markets also declined in the second quarter as the Russia-Ukraine war continued with no sign of a ceasefire in sight. However, foreign markets relatively outperformed the U.S. markets as the inflation overseas seemed to be more tepid and foreign central banks were expected to be less aggressive with future rate increases.
The fixed income markets did not present a safe haven for investors as it usually does during stock market turbulence as bond indexes registered solidly negative returns, having the worst quarter on record. Only short-term Treasury bills finished the quarter with a slightly positive return.
We close the first half of the year with the odds of a recession rising. Consumer sentiment, a leading indicator, reached a decade low and real personal spending declined in May for the first time this year, suggesting a slowdown in consumption may be around the corner. After shrinking 1.5% in the first quarter of 2022, signs point to the continued weakness of our domestic economy. According to the Federal Reserve Bank of Atlanta, which attempts to track GDP growth in real time, the economy is on track to decline another 2.1% in the second quarter, so it is completely possible that we have already met the basic definition of the recession, i.e., two consecutive quarters of negative economic growth. However, other data tells a different story, as unemployment remains near 50-year lows and June’s jobs report came in stronger than expected. In fact, there were more jobs added in the first half of this year than any six months period during the entire ten-year expansion following the 2008-2009 financial crisis. Unfilled job openings also remain near an all-time high. If this were determined to be a recession, it would be the first one going back to 1950’s where there was not a single month of job loss that coincided with the two consecutive quarters of negative GDP growth.
Halfway through the year, it would be an understatement to say it has been a rough time for investors. Still, there is a reason for optimism going forward. Historically, serious market declines like the one we saw during the first half of 2022 have been followed by equally impressive rebounds. In addition, the falling prices brought down high stock valuations, and, in many cases, they are now close to their long-term averages. Furthermore, the declines in stock prices suggests that the markets have already priced in a mild recession and additional downturns appear limited unless a deep recession develops, which seems unlikely, given the strength of U.S. employment. Therefore, in our opinion, equities are prepared to produce reasonable returns in the second half of the year.
While the start of this year has been one of the worst on record, it only reinforced the importance of diversification and maintaining an investment discipline while keep the focus on a time horizon longer than six months of turbulence. The goal is not to have a portfolio to withstand inevitable recessions and bear markets, but to meet your long-term objectives.
Dumont & Blake Investment Advisors, LLC
June 30, 2022