Crosscurrents challenged the global economy and financial market in Q2 2022. Persistently high inflation, exacerbated by energy-price shocks from the Russia-Ukraine conflict, spurred the Federal Reserve (the Fed) to hike interest rates more aggressively than anticipated.
High inflation and tighter financial conditions weighed on consumer and business confidence, and growth fears helped send the S&P 500 down 20%, into bear-market territory, and to the lowest level since 2020.
Outflow of Liquidity from the Global Financial System
After adding trillions of dollars of liquidity into financial markets the past two years, global central banks pivoted towards monetary tightening. As of publication, 24 central banks raised interest rates to combat inflation.
The European Central Bank is tapering its quantitative easing program, while the Fed started to reduce the size of its balance sheet in June. This decrease in global liquidity contributed to elevated market volatility.
Labor markets in the United States remain tight, with the 3.6% unemployment rate near multidecade lows. Consumers report jobs are plentiful.
Nominal wage growth is the highest in decades, although high inflation has rendered real-wage growth negative, which weighs heavily on consumer confidence and real income expectations.
Global Earnings and Equity Valuations
Global earnings growth continued to slow in Q2 from the decade-high rates registered during the profit recovery in 2021.
Forward earnings-growth expectations for stocks ticked down some but remained positive across all major categories of global equities—US, non-US developed markets, and emerging markets.
The US dollar is stronger compared to most major developed-market currencies so far this year. This should provide additional headwinds to US-based companies that sell their products abroad.
For equities, the continued broad sell-off caused valuations for all categories of global stocks to fall and the S&P 500 now trades near its historical average of 16 times forward earnings. Valuations in other developed countries and emerging markets are broadly trading below their historical averages.
Bonds traded lower in price and higher in yield during the quarter due to expectations for further Fed tightening.
A silver lining to rising rates is that after several years of extremely low bond yields, fixed income assets now offer relatively better income with more attractive valuations.
Unlike most other countries, China continued to enforce a zero COVID-19 policy early in Q2. Small outbreaks were met with city- and province-wide lockdowns. During a recent COVID-19 outbreak, an estimated 46 separate cities and provinces shut down—impacting nearly 300 million people and representing 80% of China’s economic output—compounding global supply chain problems.
However, by quarter-end, China’s recovery appeared to gain traction, as industrial activity ticked up amid the lifting of COVID-19 lockdowns. Fiscal and monetary policy easing picked up steam, including measures targeted to support manufacturing, property, and consumer spending. The continuation of zero-Covid -19 policy, however, remains a risk to economic activity in that region
Inflation and the Federal Reserve
On June 10, the May consumer price index (CPI) report showed inflation rose 8.6% year-over-year, the highest reading since 1982. Following that, the Fed increased interest rates by 75 basis points at the June meeting, the biggest rate hike since 1994. This brings the Fed Funds range to 1.50%–1.75%.
The high CPI reading combined with the greater-than-expected rate hike pressured stocks again and in mid-June the S&P 500 dropped to its lowest level since December 2020.
During the last two weeks of the quarter markets stabilized as commodity prices declined and the most extreme supply-related pressures appeared to ease, particularly for manufacturing supply chains.
Economic readings showed a clear moderation in activity, rekindling hope that a peak in inflation and an end to the rate hike cycle might come sooner than feared. Those factors, combined with the fact that markets became near-term oversold, resulted in a modest bounce late in the month, but the S&P 500 still finished with a solidly negative return for June.
Foreign markets declined in the second quarter as the Russia-Ukraine war continued with no signs of a ceasefire in sight.
However, foreign markets relatively outperformed US markets as foreign central banks are expected to be less aggressive with future rate increases compared to the Fed. Emerging markets outperformed foreign developed markets thanks to high commodity prices, for most of the quarter, despite rising global recession fears.
Oil and Commodities
Commodities registered slightly negative returns in Q2 due mostly to steep declines in late June. Fears of a global recession hit most commodities at the end of the quarter and erased what was, up to that point, a solidly positive performance for the broader commodity complex.
Oil finished the quarter with a small loss. Prior to late June, oil prices were sharply higher for the quarter, but rising fears of reduced future demand and increased supply weighed on the oil market into the end of the quarter.
In sum, the factors that pressured stocks in the first quarter, including high inflation, the prospect of sharply higher interest rates, geopolitical unrest, and rising recession fears, also weighed on stocks in the second quarter.
Markets will likely remain volatile until investors get relief from these headwinds.
Opportunities in 2022
The S&P 500 just realized its worst first-half performance since 1970. Those declines are understandable given inflation reached a 40-year high, the Fed raised interest rates at the fastest pace in decades, the world’s second-largest economy effectively shut down, and the Russia-Ukraine conflict saw no signs of resolution.
While the volatility and market declines of the first six months of 2022 have been unsettling and painful, the S&P 500 now sits at much more historically attractive valuation levels. A lot of negatives have been priced in at current prices, opening the possibility of positive surprises moving forward in 2022.
History Points to Rebound
There are signs that inflation is peaking, such as commodities and oil rolling over, inventories rising, supply chain pressures abating.
If price pressures reverse in coming months, it’s possible the Fed will hike rates less than currently feared. This could be a positive catalyst for markets.
Recession fears are on the rise in the United States, however stocks are no longer richly valued and, as such, aren’t as susceptible to an economic slowdown as they were at the start of the year. As a result, there’s opportunity for positive surprises.
To that point, the S&P 500 only declined more than 15% through the first six months of the year five previous times since 1932. In all those instances, the S&P 500 registered a positive return for the final six months of those years.
Clearly, past performance isn’t necessarily indicative of future results, but market history provides a clear example that positive surprises can and do occur even in difficult markets such as this. More importantly, through each of those declines, markets eventually recouped the losses and moved to considerable new highs.
Diversification and Long-Term View
A strong strategy to achieve long-term success is to remain in the market with a diversified asset allocation that’s appropriate for your specific risk tolerance, objectives, and time horizon.
While market downturns can be unsettling, they’re also part of the investing process. Some risks always remain, but macroeconomic fundamentals remain strong for the long term. It’s important to remember that a well-executed and diversified, long-term financial plan can overcome bouts of volatility.
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