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The Markets at Halftime 2022


Richard Barnett, CFA

The Markets at Halftime 2022

As we head into halftime 2022, with a six-month perspective, it's hard to be optimistic about markets and investments, with the worst first half for stocks since 1970, and bonds fell by 10% or more. Adding to the pain is that we are not getting the usual diversification from holding stocks and bonds, since investors experienced big declines in both asset classes. This is highly unusual. In fact, this was the second time in the last two decades that both stocks and bonds posted losses for two consecutive quarters. 

We don’t have to look far to find the reasons for the precipitous decline in risk assets, which include:

  • Spiking inflation
  • Weak consumer and investor confidence 
  • Falling corporate earnings 
  • Fed pivot to higher rates
  • Quantitative Tightening
  • Tightening financial conditions, which include, exchange rates, credit spreads, and equity valuations, which restrict credit (see “Capital Markets Face Difficult Test”)
  • War in Ukraine

The result was a classic bear market for stocks and bonds. Through June 30, the S&P 500 was down 20.6%, the Dow was down 15.3%, and the NASDAQ was down 29.5%, as growth stocks got hit the hardest. And the US wasn’t singled out for a bear stock market. The MSCI world stock index, which includes 47 countries, had the largest first-half drop since it was started in 1990. 

Bond prices are inversely correlated to interest rates, and the US 10-year treasury yield, the go-to benchmark for world credit markets, doubled from under 1.5% at the start of 2021 to 2.9% at the end of the quarter, after peaking at 3.49% on June 14. This allowed bonds to rally back some of their losses, but the Bloomberg US Treasury index ended the quarter at -9.2%, after a -11.5% return on June 14.

Digital assets fell even harder than stocks and bonds, with Bitcoin down 70% since its all-time high in November 2021, and 60% of that drop occurred in the second quarter. Prices for popular NFTs dropped, some of which were hundreds of thousands of dollars last year, dropped through the floor. Cryptocurrencies have gone through their own “Lehman moment”, as a dele verging event in Decentralized Finance (DeFi) occurs during the final few weeks of the quarter, leading to the failure of several big-name funds and Cryptocurrencies.

Even commodities, which had been on a tear earlier this year due to supply chain disruptions and war, started to roll over. Copper, which is closely watched as a leading indicator of economic growth, finished Q2 at a 17-month low. The GSCI commodities index, which includes metals, grains, and energy, is down about 7% since the recent high on June 9. 

As the second quarter got underway in April, the Fed made it increasingly clear that they would stick to an aggressive interest rate increase and QT policy, even at the risk of pushing the US into a recession. As the weeks went on, market analysts and investors increasingly priced in the possibility of a recession, and by the end of June, some said that we have already entered one. Several Fed governors, and even Fed chief Jerome Powell, have countered that a recession is not baked in the cake. 

One relatively bright spot is that the credit markets have held up better than during the big market selloffs in 2020 and 2008, in spite of falling prices for bonds. Functional and liquid credit markets will be a key factor in the Fed pulling off its QT plans. The next big test for the markets may be the second-quarter earnings season, where we are not convinced that the rapid deceleration of corporate earnings is fully priced in.  While we are not fully convinced that a US or global recession is fully baked in the cake, it does seem likely, with recent recession probabilities from major Wall Street banks ranging from 35 - 85%. 

While markets are easy to explain with the benefit of hindsight, they are much harder to predict. We learned in 2020 how quickly markets can bounce back once investors start to discount a more positive economic environment. What that environment could look like would be the Fed cooling inflation, getting through most of their rate hike and QT programs, deflationary pressures in commodities, and a resolution to the war in Ukraine.   At Highline, we don’t believe market timing is a successful investment strategy, which is why we build diversified portfolios that are in line with our client's risk and return preferences and financial goals.

Zooming out, with a longer time horizon in view, it's easy to be optimistic. Even with this year’s drop, the three-year annualized return of the S&P 500 is 10.7%, and the five-year annualized return is 11.5%. The S&P hit its all-time high of 4818 on January 6 of this year, after fighting through the impact of the COVID economy,  broken supply chains, and countless other problems. History tells us that risk assets have positive returns most of the time during higher interest rate regimes. The current storms driving asset prices will pass, and we will be there to benefit from healthy long-term returns in the capital markets. 

Sources: Morningstar, Reuters, YCharts

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