Q2 2022 Market Update

THE QUARTER IN BRIEF

Following financial markets in 2022 has only been fun for history majors. The highest inflation in 40 years, the largest interest-rate hike since 1994, and the most severe European conflict since World War II all contributed to the worst first half for equity markets since 1970 and the steepest bond market losses since the Reagan presidency. Meanwhile, crashes in the tech sector and cryptocurrency have drawn comparisons to the dot-com bubble, the Ponzi scheme, and even the Dutch tulip mania.

Very few investors remember such a horrid first half of a year. The Morningstar Global Markets Index, a broad gauge of equities across developed and emerging markets, officially entered bear-market territory, with a decline of 20.1% in the first half of 2022. The Morningstar US Market Index, the largest contributor to global equities, was down 21.3%, the Morningstar Europe Index fell 23.3%, and the Morningstar Asia Pacific Index was off 17%.

Bonds, which typically cushion losses during times of equity market stress, provided no refuge. The Bloomberg Global Aggregate Bond Index fell more than 13% over the first six months of 2022, while the Morningstar US Core Bond Index declined roughly 10% for the same period.

 

Major Asset Class Returns

 

 

7/18/2022

Index

3 Month

Year to Date

1 Year

S&P 500 Total Return

-12.41%

-18.95%

-10.16%

S&P GSCI Total Return – Commodity Index

-7.03%

33.43%

43.76%

Russell 2000 Total Return

-12.32%

-22.03%

-18.67%

Russell 1000 Value Total Return

-11.55%

-12.63%

-5.85%

Russell 1000 Growth Total Return

-14.10%

-26.32%

-17.84%

MSCI World Ex USA Total Return

-11.88%

-18.53%

-16.13%

MSCI Emerging Markets Total Return

-10.13%

-18.80%

-24.50%

Dow Jones US Real Estate Index Total Return

-14.62%

-20.11%

-11.10%

Bloomberg US Treasury

-1.09%

-9.12%

-9.69%

Bloomberg US Aggregate

-1.22%

-9.93%

-10.47%

Bloomberg Municipal Bond

0.12%

-7.62%

-7.85%

©2020 YCharts, Inc. All Rights Reserved.  Returns through 7/18/2022

 

DOMESTIC MARKETS

US equities fell in Q2. Investor focus was trained on inflation and the policy response from the Federal Reserve (Fed) for much of the period.

The Fed enacted its initial rate hikes during the quarter and signaled that there would be more to come. Even so, the central bank admitted the task of bringing inflation down without triggering a recession would be challenging.

The US economy looks robust, but signs of a slowdown are emerging. The ‘flash’ US composite purchasing managers’ index (PMI) eased from 53.6 to 51.2 in June. The services component eased from 53.4 to 51.6, but the manufacturing output deteriorated from 55.2 to a two-year low of 49.6. Only twice has this fallen by more than 5.6 points; during the pandemic in 2020 and the financial crisis in 2008. (The PMI indices, produced by IHS Markit, are based on survey data from companies in the manufacturing and services sectors.) PCE inflation, the Fed’s preferred price gauge, was unchanged at 6.3% y/y in May.

Declines during the quarter affected all sectors although consumer staples and utilities were comparatively resilient. There were dramatic declines for some stocks, most notably in the in the media & entertainment and auto sectors.

ECONOMY

While markets were anticipating a hot headline CPI reading, the June CPI report showed even hotter-than-expected inflation, with core inflation most surprisingly exceeding expectations. Headline CPI rose by 1.3% m/m and Core CPI rose 0.7% m/m, translating to year-over-year gains of 9.1% and 5.9%, respectively. Sharply higher energy and food prices once against propelled headline inflation higher, while within core inflation, the lagged “bad news” of higher costs of inputs and labor is broadly pushing prices higher. We still expect that the Fed will hike interest rates by another 0.75% later this month. Thereafter, the broad-based impact of higher food and energy prices across core components may add pressure on the Fed to hike interest rates even further this year.

On the bright side, we see promising signs of inflation coming off its highs in July. Oil and gas prices have dipped meaningfully (down 11% and 4% from June), as have airline fares (down 8%), and this should lead to a deceleration of price pressures in the coming months. Consumer 1-year and 5-year inflation expectations also came down in the University of Michigan’s preliminary July results, dropping from 5.3% to 5.2% and from 3.1% to 2.8%, respectively. If these trends continue, June may mark the last hot month of headline inflation, with stickier components taking the baton going forward. This should provide some inflation relief to the Fed and consumers. However, the question remains whether the Fed will exercise the patience for this lagged “good news” to flow through, or race to stomp out demand before it does.

LOOKING FORWARD

As investors look to the second half of 2022 and beyond, they must reckon with an altered market complexion.  While we remain cautiously optimistic, we do believe we have entered a new market regime, marked by rising rates, high and non-transitory inflation, increased market volatility and growing fears of recession.  This new regime will require further diversification outside traditional equity and bond asset classes, and active management within the portfolio.

Drew Corradetti   

 Chief Investment Officer