Investment performance was negative across all major asset classes in the second quarter. Three related factors were the primary catalysts for the declines: high inflation, Fed policy tightening, and rising interest rates. While the risk of recession has increased, most current economic data continues to indicate growth.
Is Economic Growth Decelerating?
During the first quarter, the U.S. economy contracted 1.6% after adjusting for inflation. This was the first decline in real economic activity since mid-2020. However, these quarterly results were impacted by a nearly 18% rise in imports as shipping congestion eased.1 Meanwhile, exports fell. This trade gap subtracted 3% from overall GDP in the first quarter, offsetting growth in other areas.
Personal spending continued to be strong due to low unemployment, rising wages, and a significant stockpile of savings from past COVID relief payments. But with the significant spike in prices this year, necessities such as energy, food, and housing now account for a much larger share of household budgets. This threatens to slow economic activity, leaving consumers with less discretionary income to spend elsewhere.
Inflation increased to a 40-year high of 8.6% in May, causing the Federal Reserve to raise short-term interest rates more than expected during the quarter. Bond yields and loan rates rose even faster, on the expectation that the Fed will continue to aggressively hike rates in the second half of the year. This has been the key catalyst for the decline in asset prices so far in 2022.
Given the headwinds of higher inflation and interest rates, most economists agree that the chance of recession has increased. But for now, the economy appears to be slowing but still growing. Here is some recent evidence of this:
- The unemployment rate is down to 3.6%, back to pre-pandemic levels
- The increase in payrolls was strong in the second quarter, culminating with a surprisingly high 372,000 job gains in June
- While the ISM manufacturing and services indexes weakened, both remain solidly in expansion territory through June
While economic risks have increased, recession is likely not imminent. Most of the indicators monitored by the National Bureau of Economic Research to identify turning points in the economy (employment, retail sales, industrial production, real income) continue to increase.2 If a recession does materialize in the next 12 to 18 months, it should be milder than the Great Recession of 2008 or the pandemic downturn of 2020. This is because the financial condition of banks, corporations, and households is healthy, helping to limit the extent of any downturn.
|MARKET SCOREBOARD||2Q 2022||2022 YTD|
(Large U.S. stocks)
(Developed international stocks)
|Bloomberg Aggregate Bond
(U.S. taxable bonds)
|Bloomberg Municipal Bond
(U.S. tax-free bonds)
|Wilshire Liquid Alternative
Source: Tamarac Advisor View, Morningstar as of June 30, 2022.
What Caused Markets to Drop in the Second Quarter?
Financial market performance in the second quarter can best be described as awful. Both U.S. and international stocks posted declines in the mid-teens, bonds struggled as interest rates rose, and alternative investments fell. Stocks posted their worst first-half performance since 1970, crossing the 20% bear market threshold in June. Bonds had the most difficult start to a year ever, dropping about 10%.
The significant rise in inflation and interest rates (aggravated by Russia’s invasion of Ukraine) caused a massive resetting of asset prices during the first half of the year. This is the primary reason behind the negative returns for both stocks and bonds.
The rise in rates caused a meaningful contraction in the price-to-earnings (P/E) multiple for stocks. The S&P 500 P/E multiple declined from over 21 times forward earnings at the beginning of the year to just under 16 times by the end of June. Stock valuations are now slightly below the 25-year average. Meanwhile, corporate profits rose 11% in the first quarter and are expected to rise 5% in the second quarter, an indication that underlying fundamentals are in decent shape.
Similarly, price declines in bonds were largely due to the rise in interest rates. When interest rates rise, bond prices fall. Credit quality has not been an issue in 2022; corporate and municipal finances are strong, and default rates low and stable.
Why Has Inflation Remained So High?
The U.S. is currently experiencing the highest inflation since 1981. The May Consumer Price Index (CPI) registered an increase of 8.6%. Supply shortages and surging demand have combined to rapidly push prices up. Supply has been unable to meet demand due to bottlenecks, worker shortages, and a general lack of capacity. The latter has been most evident in the energy markets, particularly in gasoline refining. The good news is that some of the supply chain issues are starting to dissipate, particularly in the shipping industry. Worker shortages continue to be an issue but are becoming less acute, according to recent surveys. However, the lack of capacity is harder to solve as it will require a multiyear commitment to investment in new facilities.
Demand has been driven by massive government stimulus and strong wage gains as the economy has reopened. Wage increases have stabilized around 5%, but the gap between job openings and available workers should keep them elevated for some time. Government stimulus created a stockpile of savings, allowing consumers to keep spending despite high inflation.
In summary, a confluence of extraordinary events over the past two years caused the spike in inflation, and relief from high prices will likely be a gradual process.
How Is the Federal Reserve Reacting to Recent Inflation Trends?
The continued increase in inflation has changed the tone of Federal Reserve policy. May’s higher-than-expected CPI reading, combined with long-run inflation expectations hitting a 14-year high, led the Fed to raise rates by 0.75% in June. This was the largest Fed Funds rate hike since 1994. The Fed expects rates to be much higher by year-end. Their current forecast is for the Fed Funds rate to reach 3.375%, significantly higher than the March estimate of 1.875%. Since the June 15 meeting, Federal Reserve officials have reiterated that their primary focus is to reduce inflation toward the 2% goal.
The Fed does not want a recession to occur but admits this is a possible outcome of its effort to tame inflation. The Fed raised the rate by 0.75% at the July 27 meeting, but the path for rates for the remainder of the year is less certain. Commodity prices have fallen in recent weeks. Oil ended June down 13% from its earlier high. Other commodities like lumber and copper also have fallen sharply. If inflation continues to trend downward in coming months, the Fed may soften its stance on rates.
What Is the Outlook for the Remainder of the Year?
Interestingly, the 10-year Treasury note yield peaked at 3.48% in mid-June, just ahead of the Fed’s sizable rate hike. Since then, the yield has declined to 3.05%. Fed Funds futures also have fallen since then, an indication that upcoming interest rate increases may not be as severe as previously thought. The reason for the decline in rates is that the markets have in some respect done the Fed’s work by reducing demand. Market rates had risen significantly in anticipation of the Fed’s planned hikes, causing consumers and businesses to defer purchases because of higher borrowing costs. As a result, inflationary pressures have started to ease.
If inflation falls through year-end and interest rates stabilize, then the worst of the asset repricing should be behind us. While recession odds have increased, the market has already priced in a mild economic downturn. Stock prices are forward looking and reflect investor expectations; therefore, markets normally bottom before the economy does.
Corporate earnings are the key driver of stock prices in the long run. Despite significant share price declines in the first half of the year, earnings continue to rise. Corporate profits are expected to reach a new, all-time high this year, growing about 9%. Combining profit growth with improved valuation results in much better forward return potential for stocks.
As a proxy for bond rates, the yield on the benchmark 10-year Treasury note has doubled in 2022. This means the expected return from bonds going forward also has improved. Over time, interest income accounts for most of the return produced by bonds. Today’s bond yields are the highest in several years; therefore, this asset class is poised to make a more meaningful contribution to balanced portfolio returns going forward.
The above factors point to a greater probability of improved returns in the second half of the year. A significant amount of uncertainty still exists, so markets may continue to be volatile in the near term. But remember that uncertainty also breeds opportunity. The future return potential of most asset classes has improved, positively impacting our planning assumptions across every allocation. In times like these, maintaining portfolio discipline is key to being positioned for a more favorable market environment and the eventual recovery of value.
As always, we appreciate the confidence you have placed in the FORVIS Wealth Advisors team!
Jeffrey A. Layman, CFA® – Chief Investment Officer
Andrew L. Douglas, CFA® – Senior Portfolio Manager
FORVIS Wealth Advisors, LLC is an SEC registered investment adviser offering wealth management services for affluent families and investment consulting services for institutional clients and is a wholly owned subsidiary of FORVIS, LLP. The views are as of the date of this publication and are subject to change. Different types of investments involve varying risks and should not be assumed that future performance of any investment or investment strategy or any non-investment related content, will equal historical performance level(s), be suitable for your individual situation, or prove successful. A copy of FORVIS Wealth Advisors' current written disclosure statement is available upon request.