Second Quarter 2022 Market Update
July 14, 2022
It feels redundant to advise caution in a market where the macro challenges are so plain to see. It turns out that waiting is not so hard when every headline is about inflation, war, or recession. Waiting feels… comfortable. Unfortunately, the best opportunities in investing are usually uncomfortable. – Hedge Fund Manager
Second Quarter 2022 Market Update
The second quarter of 2022 continued where the first quarter left off, with heightened volatility in markets and continued pressure on risk assets. Global markets and economies continued to face the headwinds of elevated and persistent inflation, rising interest rates, and the growing risk of economic recession, leading both equity and fixed income markets to experience one of their worst starts in many years.
Domestic equity markets finished the quarter in negative territory, down -16.1%, leading to year-to-date (“YTD”) returns of -20.0%, as measured by the S&P 500 Index. Performance was negative across all sectors. Sectors including Consumer Discretionary (-26.2%) and Communication Services (-20.7%) fared worst, while Consumer Staples (-4.6%), Utilities (-5.1%) and Energy (-5.2%), held up more favorably. Energy remains the only sector with positive performance on the year, up +31.8% YTD, as commodity prices surged, exacerbated by the ongoing war in Russia and Ukraine. Growth stocks continued to underperform, dragged down by interest rate hikes and valuation pressure, as well as heightened uncertainty around corporate earnings. Coming into the year, equity market valuations were elevated from a historical perspective, however, as of quarter-end, the forward price-to-earnings (“P/E”) ratio of the S&P 500 Index was 15.9x, slightly below its 25-year average of 16.9x.
In U.S. dollar terms, developed international equities were down slightly less than domestic equities, finishing the quarter down -14.5%. On a YTD basis, performance has been largely in line with domestic markets (-19.3% YTD), as measured by the MSCI EAFE Index. Emerging markets fared slightly better, down -11.4% for the quarter and down -17.5% YTD, in U.S dollar terms, as measured by the MSCI Emerging Markets Index. Both international and emerging market equities have performed significantly better than U.S. equities in their local currencies this year, however, as nearly all their relative outperformance has been negated by the strength of the U.S. dollar, which has appreciated +8.9% YTD, as measured by the U.S. Dollar Index.
Fixed income markets experienced another challenging quarter, down -4.7% for the period, as measured by the Bloomberg U.S. Aggregate Index. When combined with the first quarter, YTD returns for the index are down -10.3%, the worst start to a year since the index was formed in the mid-1970s. Inflation remains a key concern for the Federal Reserve (“Fed”), who has strongly pivoted its policy stance, targeting more aggressive interest rate hikes to battle inflation. In June, the Fed raised its benchmark interest rate another 75 basis points (0.75%), its most aggressive rate hike since 1994. The Fed has previously raised rates 25 basis points and 50 basis points in March and May, respectively, with most market participants anticipating additional increases over the remainder of the year. Across the fixed income universe, virtually all returns were negative, with long-dated U.S. Treasury and high yield bonds faring worst, both down more than 10% over the period.
Bear Market Statistics
While uncomfortable, it’s worth acknowledging that sustained drawdowns such as these are actually common throughout history. The dearth of down markets over the past decade is actually the exception and not the norm. – Domestic Equity Manager
Through the second quarter, equity market indices had eclipsed the 20% sell-off threshold that most industry participants use to classify such periods as a “bear market”. While volatility started to escalate near the end of 2021, the most recent peak in the price of the S&P 500 Index occurred in early January, more than six months ago. Unfortunately, a decade of accommodative monetary policy from central banks has conditioned investors to think that all market drawdowns are short-lived in nature, that “buying the dip” is a fail-safe investment strategy, and that market recoveries occur exclusively in V-shaped patterns.
While no two bear markets are the same, on average, they tend to last about ten months and include peak-to-trough price declines of approximately -34%. Important to note, however, is the fact that there has been a high degree of variability around bear market durations and drawdowns. History suggests that recessions typically occur around bear market sell-offs, but not always (approximately 65% of the time). Unsurprisingly, bear markets associated with a recession tend to be longer in duration (by approximately 10 months) and include more severe peak-to-trough declines (by approximately 8 percentage points) than non-recession bear markets.
The Prospect of Peak Inflation
Inflation today is not transitory, but instead structurally embedded in many segments of the developed world’s economy. While the rate of change in consumer and producer inflation will decelerate, both are likely to remain unacceptably high. – Hedge Fund Manager
As we close the books on an ugly first half of 2022, inflation remains a key concern for capital markets. What the Fed was originally adamant was “transitory”, we now know to be anything but. The level and rate of change in inflation have caused global central banks to tighten monetary conditions. The culmination of the aforementioned actions has led to swift and severe re-ratings across equity markets, significant turbulence in fixed income markets, and candidly, very few places to hide.
Being decidedly behind the curve in the fight against inflation, the Fed has now stepped up aggressively with increasing interest rate hikes this year of 25, 50 and most recently, two 75 basis point increases. Most market participants expect further increases in the months ahead. While headline inflation (as measured by the Consumer Price Index or “CPI”) showed a very slight downtick in April (8.3% versus 8.5% in March), recently released June data included a year-over-year increase of 9.1%, a 40-year high.
The question on the minds of investors is how and when does inflation finally peak, and when it does, how does the market react? Unfortunately, the Fed’s monetary policy tools are blunt instruments and can only address the demand side of the inflation problem. The war in Ukraine, supply chain bottlenecks, an ongoing pandemic, and an energy crisis are problems that cannot be fixed by aggressively raising interest rates. We believe, however, that the rate of change in inflation will likely peak in the near-to-intermediate term, as the Fed now seems to have adopted a “do whatever it takes” mindset to tame it. Unfortunately, such a shift means that the risk of collateral damage (i.e., a recession) is increasing. Given the structural issues above, we believe that even after peaking, inflation will likely remain above its long-term trend, and above the Fed’s ultimate target, for some time.
Corporate Earnings, Recession Risk and Soft Landings
The Fed needs to bring down inflation quickly and will continue to act accordingly. We expect them to continue lifting short rates aggressively until something in the economy breaks. Further, the speed with which conditions are changing and the lagging impacts of monetary policy will make it very difficult to achieve a soft, or even soft-ish landing. – Global Fixed Income Manager
Real GDP growth turned negative in the first quarter of 2022, and the U.S. faces a risk of a “technical recession” (typically defined as two consecutive quarters of negative growth in real GDP). Whether the current environment qualifies as a technical recession or not, almost all market participants agree that economic growth is slowing, and the range of potential outcomes is wider than it was a few months ago. As such, we continue to believe volatility will remain elevated in the near-to-intermediate term, as markets digest economic and corporate data, and adjust to a changing environment. Importantly, nearly all of the S&P 500 Index’s decline YTD has been driven by multiple compression, and not earnings revisions. As second quarter earnings season has just begun, only now are analysts starting to meaningfully revise earnings forecasts lower. This will remain a key data point for investors to closely monitor over the next few weeks and months. History suggests that in the last 15 recessions earnings fell an average of approximately 30% (again, with a wide range of outcomes). If we are indeed in a recession, and if corporate earnings follow historical norms and decline in line with historical averages, the lower “E” in P/E ratios (price-to-earnings, a common market valuation metric) could make equity valuations continue to look more expensive today relative to long-term averages.
The key question on the minds of investors today is whether the Fed can tame inflation without causing a severe economic recession (i.e., engineer a “soft landing”). As we have written in the past, we believe that the probability of this proverbial soft landing is low. As one manager recently put it, the Fed is tasked with “landing on an aircraft carrier in a choppy sea”. Their recent (and longer term) track record would suggest that they have a low probability of achieving their inflation goals without leaving a trail of economic wreckage in their wake. The market is also displaying similar sentiment, and now projecting meaningful interest rate cuts in 2023, signaling that interest rate hikes YTD and forecasted over the next six months will likely cause significant economic pressure, and the Fed may have to reverse course next year.
This year’s investment environment continues to be very challenging. Equities are officially in a bear market, fixed income returns have been some of the worst on record, and outside of commodities, there have been very few places to hide in the first half of the year. While client portfolios have not been entirely immune from market drawdowns and volatility, our conscious positioning towards higher-quality equity exposure, shorter duration fixed income, and thoughtful incorporation of alternative investments has helped. In addition, while market declines and elevated volatility can be stressful, they can also present opportunities for disciplined investors. As one manager recently reminded our team, resets work in both directions, and the seeds of future bull markets are planted in periods like the one we find ourselves in today. Most market participants agree that economic growth is slowing, the range of potential outcomes is wider, and we will likely continue to see volatility in the near-term as markets digest economic and corporate data and adjust to a changing environment. However, for those willing to take a longer-term outlook, we also believe there are places to allocate capital that are likely going to generate attractive returns going forward. We believe that a disciplined and thoughtful investment plan is vital, and that a diversified approach is warranted to set the stage for strong risk-adjusted returns going forward over full market cycles.
As always, we welcome the opportunity to discuss your portfolio in detail and appreciate the trust and confidence that you have placed in Prairie Capital.
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