Capital Markets Highlights
In Q2, 2022, the U.S. stock market[1] entered a bear market, falling by 16.10% in the quarter and breaching the down 20% threshold from its recent high. After declining 4.6% in Q1, the market continued its slide in April, stabilized in May, and then moved sharply lower in June after a higher-than-expected inflation number.
It was the worst quarter for the stock market since March 2020 and the worst first six months start to the year since 1970. No market sector was spared in the decline. On a relative basis, the Consumer Staples, Utilities, Energy, and Health Care sectors held up the best, all down mid-single digits, with Consumer Discretionary, Communications Services, and Technology showing the largest declines of 20% or more.
Most areas of the market were down sharply in the quarter with Small Cap, Mid Cap, and International, down in the mid to high teens. After years of market leadership, Growth was among the worst performing areas of the market in the quarter, down more than 20%. Year-to-date through June 30, the declines in many areas were greater than 20%. Value and Dividend strategies were far more protective than Growth strategies in the quarter and year-to-date.
It was also another tough quarter for fixed income investments with interest rates rising across the yield curve. Even lower risk, shorter-term Treasuries showed a loss in the quarter while the Bloomberg U.S. Aggregate bond index (U.S. Treasuries, highly rated corporate bonds, and mortgage-backed securities) was down 4.7% in the quarter, bringing its loss to 10.3% year-to-date through June 30.
Oil prices were volatile in the quarter, running up to over $120 a barrel in early June but ending the quarter only modestly higher from March 31. Concerns over oil’s impact on inflation, something the Fed cannot control, weighed heavily on both the stock market and fixed income prices during the quarter.
Our Thoughts Going into Q3
At the risk of sounding Pollyannaish, we think the economy is in better shape than the latest consumer confidence numbers indicate and that the stock market will likely end the year far better than its midyear levels. As the market sell-off accelerated in June we have become more optimistic about the prospects for stocks for the next 6 to 12 months. Stock and bond prices have come down a lot and the recent economic data, while showing signs of slowing, looks OK to us.
We think the Fed is getting what it is hoping for: some moderation in the economy’s growth that should bring supply and demand into better balance while still showing good job numbers and modest economic growth. If this continues to play out, the rate of inflation should start to decline without causing a severe recession (a soft landing). As evidence of the decline in inflation builds, we think the Fed may surprise investors later in the year by slowing or pausing its rate increases, giving a lift to stock prices.
Though growth in the economy is slowing (and hitting companies that benefitted disproportionately from the Covid economy, particularly hard) recent earnings calls in late June from three large companies representing a broad cross-section of the economy with real-time economic data, Accenture (ACN), Federal Express (FDX), and Paychex (PAYX) all reported good results and expressed confidence in their businesses outlooks[2]. Many super-regional banks conveyed a similar message in their June analyst meetings.
Below are excerpts from the ACN, FDX, and PAYX calls:
From Accenture on June 23:
“We see continued strong demand going into the next quarter with another strong bookings quarter and another strong revenue quarter.”
From FedEx’s earnings call, on June 23:
“Let me take a moment to discuss 2023. We anticipate consumers will keep spending and their spending will continue tilting toward services from goods. We expect more consumers to return to stores. Our fiscal ’23 forecast assumes a normalized economic environment”
From Paychex, June 29:
“Macroeconomic trends have been positive this year but with inflation at the 40-year high, there are concerns for the potential of a recession in the near future. We continue to monitor key leading indicators for any signs of a change in the macroeconomic environment but have not seen any signs of deterioration at this time.
Typically, the first signs of a macroeconomic recession would be a decline in employment levels at existing clients, an uptick in non-processing clients, or a slowdown in sales activities. These indicators continue to trend in a positive direction. Job growth at U.S. small businesses remained strong…”
We believe a recession, if we have one, may be mild. Technically, we may already be in one. The old but still common definition was two consecutive quarters of negative GDP. However, as reflected in the comments from ACN, FDX, and PAYX, even with all the current headwinds, the underpinnings of the U.S. economy are still healthy. Consumer and business spending, while moderating, remains positive. Unemployment is near historic lows and individual and business balance sheets remain solid with credit quality exceptionally high.
Economies here and around the world have reopened and are shifting into a different gear from a stay-at-home Covid world to a more normal demand for services economy. As long as jobs are plentiful, and people have the income to save and spend we believe that consumer behavior will be more supportive of a good economy than recent sentiment indicators suggest.
Further, in recent business updates, many money-center and regional banks all noted that consumer balance sheets currently have more cash and are stronger than their pre-Covid levels. Credit card data shows pent-up consumer demand for activities curtailed during Covid with a strong pick-up in traffic at restaurants, entertainment, sporting events, and travel.
Inflation is a significant near-term problem, but we believe that it is a cyclical problem created by extraordinary fiscal and monetary stimulus during Covid, logistics problems, also a byproduct of the Covid economy, and then inflamed by the war in Ukraine. The Fed’s recent policy actions to increase interest rates and reduce the money supply, coupled with an improving Covid-related labor market and logistics issues, will likely result in lower inflation rates by fall if not sooner.
There are already signs that inflation may have peaked while employment remains strong. Retailers, like Walmart and Target with too much inventory in kitchen appliances, televisions outdoor furniture, and apparel are reducing prices.
Economically sensitive commodities like copper, steel, and lumber are well off their highs and housing price increases are slowing in response to the sharp rise in mortgage rates. Rental prices showed their first slowdown and, in some cases, declined in the past month. Supply chain disruptions are also an issue, but likely will be peaking before year-end. Gasoline and food prices are still high, held up by supply constraints, mostly caused by the war in Ukraine.
If and when that war ends, food and energy prices should decline dramatically. Finally, the U.S. dollar has been very strong versus other currencies which lower the cost of imported goods for U.S. consumers, putting downward pressure on inflation. The powerful secular forces that kept inflation low for so many years, including global competition and rapid technological advancements, will inevitably reassert their gravitational downward pressure on inflation.
The U.S. economy is a very powerful engine of economic growth. Recessions[3] are a normal part of the business cycle, usually short-lived and followed by strong market recoveries. During the post-World War II period, a typical recession lasts about six to 12 months, although some were longer, and one was shorter (the most recent one after Covid lasted two months)[4]. If we have a recession, we expect it to be on the shorter and shallower end of historic norms as we don’t see the excesses in the economy that usually accompany or cause deeper, long-lasting problems.
We think the chances are good that the economic picture may look much sunnier six months from now and the stock market, as it has done historically, will likely rise well before it becomes obvious that inflation is coming down and the worst fears about the economy prove to be exaggerated. The timing of the next advance is unpredictable and sticking with an investment plan and not overreacting to current events or short-term market moves is critical to long-term success.
A lot is being made in the business press about poor consumer sentiment. The inference is that poor consumer sentiment and poor stock market performance are positively correlated. A study of the actual relationship strongly suggests that this is not the case and in fact, there is an inverse relationship and low consumer confidence is often followed by very favorable investment returns.
JPMorgan (JPM) chief strategist David Kelly notes in their quarterly guide to the markets that The University of Michigan Index of Consumer Sentiment [5]stretching back over the past 50 years has eight distinct peaks and troughs. On average, buying at a confidence peak yielded a return of 4.1% in the following 12 months while buying at a trough returned 24.9%.[6] While we wouldn’t look at this history as a forecast for the upcoming year, it does suggest that investors should not be overly concerned about negative consumer confidence headlines.
We do not know when the next bull market will start but it will inevitably begin while the majority of investors are bearish, worrying about another leg down in prices. Our valuation work on our investment strategies have reached levels that historically have been very bullish for the market in general and our portfolio strategies in particular.
Being invested in the early stages of a market rally is critical to good…
Read More: Matrix Asset Advisors Q2 2022 Capital Markets Commentary