Appropriately, the market was down again yesterday to mark the end of a terrible quarter due to the increasing fears of a coming recession. Federal Reserve Chairman Jerome Powell and European Central Bank President Christine Lagarde said on Wednesday afternoon that they would keep hiking rates to lower inflation, even if it slowed their economies. This stoked renewed fears of a recession in the near future.
These factors – recession fears, rising rates and global central banks’ fights against high inflation – have driven the market lower for the past six months. Many have wondered when this recession might hit and many have opined that it is likely next year. However, earlier this week GDP for the first quarter was revised down to a -1.6% annualized decline, down from the initial release of -1.4% in April. On Thursday, the Atlanta Fed released its latest estimate for the second quarter of -1% growth. If that turns out to be the case, the economy will already be in a recession. Many have predicted that if/when the economy goes into a recession it will be a mild and short-lived one. The economy is starting from a strong point as fourth quarter 2021 GDP was up over 6%, very strong growth.
On the inflation front, pressure may be beginning to ease as the core Personal Consumption Expenditure Price Index, the Fed’s preferred inflation gauge, moved down to 4.7% in May. It is the third straight monthly decline and the lowest reading since November of 2021. The Personal Consumption Expenditure Price Index, which includes food and energy, rose by 6.3% in May versus last year, but remained unchanged from the previous month. On the flip side, housing prices are still rising as home prices hit another all-time high in May and rose for the 39th straight month in a row. Rents hit another record high as well, up 14% in May. The Fed and other central banks still have plenty of work left to do.
The close to the second quarter and the first half of the year may be a very welcome occurrence for investors as the S&P 500 is off to its worst start of the year since 1970, down 21%. The second quarter saw the S&P 500 return negative 16%, while the Dow Jones Industrial Average was down 11% and the Tech-heavy NASDAQ was down 23%. For the year, the DJIA is down 15% and the NASDAQ is down 30%. This is the worst first half for the NASDAQ since the start of 2002. Outside of the Great Financial Crisis the S&P 500 has been down 20% in six months only seven other times, mostly during periods of financial turmoil like high inflation in the early 1970’s. The biggest six-month loss ended in February 2009, down just under 43%. The more recent selloff due to COVID-19 saw a 13% decline in the six months prior to the end of March 2020. Currently, we are seeing the turmoil from rising interest rates at the fastest level in years, combined with high inflation and the war in Ukraine.
Looking under the covers of the S&P 500 for the second quarter, one can see that not a single sector was up during the quarter. In the first quarter at least the Energy sector was positive. The decline in the quarter was led by the Consumer Discretionary sector, down 25% as many retailers felt the pain of consumers tightening their purse strings and with the possibility of a recession investors moved away from those names. Technology and Communication Services were not too far behind with both sectors down close to 20%. While the Energy sector was not positive for the quarter it still was the best performing sector, down 3%. Other safe havens like Consumer Staples, Healthcare and Utilities were also down less than 7%.
Often in times of equity market turbulence investors will look to the fixed income markets for protection. Investment grade bonds have also had one of their worst starts to the year as well. Over the past few years, with equity markets doing well and bond yields so low, the attraction for bonds has been absent. The yield on the ten-year Treasury bond has increased from 1.51% at the end of 2021 to 2.97% at the close yesterday. It touched 3.51% in the past month, and yesterday was the first close below 3% since the first week of June. In the quarter, the Bloomberg US Aggregate Bond Index was down 5%, while the shorter duration Bloomberg Intermediate US Government / Credit Index was down 2.7%. This was after both indices were down at least 4.5% in the first quarter.
For both bonds and stocks to have negative quarters back-to-back is extremely rare. The last eight times the equity markets were down for the year, bonds finished up for the year, softening the blow. This year does not look to follow suit, with the Bloomberg US Aggregate down 10% so far in 2022. To no surprise, the 60/40 balanced portfolio is easily off to its worst start, down 16% through the end of June. The worst full year for a balanced portfolio was 2008, down 6.7%.
At the start of the second half of the year there are questions aplenty. Is the economy on the verge of a recession? Is it already in one or can one still be avoided? Can the Fed facilitate a soft landing? What would that soft landing look like? How high and fast does the Fed raise rates? Will inflation continue to run hot or roll over like we have seen in some commodity prices lately? What do earnings look like going forward in the second half of the year? These are all things investors will be paying attention to in the coming months. Investors’ answers may be very different three or six months from now than they are today. Today’s sentiment is rather negative with many economists and Wall Street analysts. Consumers think the economy is getting worse. If the economy does fall into a recession next year, it will be the most telegraphed recession of all time. If it is already in a recession, most economists will say they knew it was coming but just got the timing wrong.
There was a term that was thrown around a lot during the financial crisis: “cautiously optimistic”. I am not ready to start using that term yet, but I do begin to think about it when I look a year out. A year from now or less, we will know if we are in or possibly through a recession. The Fed will have either completed a soft landing, or judging by their history, stepped too far and already reversed course. Inflation should be back to normalized levels as commodities like wheat, corn and soybeans are all down 20% or more from recent highs. Cotton is down 40% and actually lower than the start of the year. Earnings estimates should come in, reset lower and be moving back to growth. If those things come to fruition, then the setup should be good for equity markets at that time. In the meantime, now is the time to work on your shopping list. Know what you want to own coming out of a possible recession and what price you are willing to pay for it. Work to find those high-quality growth names that belong in your portfolio for the long run.
The first half of the year has not been kind to most investors, but looking forward there will be buying opportunities at some point. Staying invested with an appropriate asset allocation will be important. Bonds are looking a lot more attractive than at any time in the last 5 years. The S&P 500 set a new low in June before bouncing. It will most likely test those lows and could go lower, but the bear market will come to an end at some point and investors will want to be ready for it. I am cautiously optimistic about being cautiously optimistic.
Have a great weekend and Happy Fourth of July!
Mash’s Jamie Farr turns 88. Dan Aykroyd is 70. Pamela Anderson is 55 and Liv Tyler turns 45.
Daniel Rodan 610-260-2217