THE SECOND QUARTER of 2022 ended with a whimper and entered rare historical territory. The period marked the worst first calendar half of S&P 500 performance (fueled mainly by horrific 2Q performance, down 16.1%) since 1970. From a rolling six-month perspective, the period ranks in the worst 3% since 1926. Bonds weren’t much better as U.S. Treasuries were down more than 9% and high yield down 14.9% in the half. From a 60/40 asset allocation perspective, rolling six-month returns were in the bottom 2% since 1926. It also marked just the fourth time in the past century that stocks and bonds were both down two quarters in a row and the first time since 1974.
Looking at asset categories, large cap (-16.7% in the quarter) outperformed small cap (-17.2%) and international equity (developed -14.5%, emerging -11.5%) outperformed the U.S. markets, despite the soaring U.S. Dollar (up 6.5% in the quarter) reaching parity with the Euro recently. The good news? This horrific performance (and hopefully the worst quarter for a long time) is behind us. The bad news? There is likely still more downside to come, at least in risky assets like equities and high yield, in our view.
THE FED, INFLATION AND ECONOMIC ACTIVITY
Despite many claiming there is no recession in sight or even that this is the strongest economy we’ve ever seen, it is likely that the U.S. and many economies around the globe are already in recession. And if not currently, the Fed’s expected actions in the coming months will certainly bring a recession to fruition later this year. U.S. real GDP contracted 1.6% in the first quarter of 2022 and, despite starting the second quarter with a growth estimate of 2.5%, the Atlanta Fed GDPNow forecasted another decline of 1.2% as of July 8.
While the National Bureau of Economic Research won’t make it official any time soon, and economic drivers like employment still show strength, the negative signals from GDP and leading indicators show that economic momentum is fading quickly. Not to mention, the Consumer Confidence Expectations Index is at its lowest point in the past nine years as a stock market decline and raging inflation hit consumer sentiment and purchasing power. Recent data from retailers also suggest a trading down from brand names and fewer gallons of gasoline purchased per transaction. What’s more, credit is expanding rapidly, most likely as consumers borrow to meet rising living expenses. Credit card debt is up 22% annualized over the three months ending in May. This does not paint a pretty picture, with unsustainable credit-fueled spending and GDP still contracting. The consumer debt-to-income ratio is higher now than all but one cycle peak dating back 60 years. The economic risk is to the downside.
Adding concern and uncertainty is the Fed, notable followers of lagging economic data. The interest rate futures market is currently priced for another 75 bps hike on July 27, 50 bps in September and another 50 bps in November. This will potentially occur while the U.S. economy is likely already in a recession, the yield curve is inverted (10s and 2s), and equites and most commodities are in a bear market. Add to this, the tightening impact of the Fed balance sheet reduction of up to $100 billion per month, and the headwinds remain stiff. Certainly, the financial markets discount a solid portion of this, but we think it is not enough just yet.
Many of our current problems are self-inflicted by an extended period of negative real rates. With recovering economic growth in late 2020 and 2021, low unemployment, and the stock markets at all-time highs, why the Fed continued quantitative easing and kept interest rates at zero is anyone’s guess. The Fed began raising interest rates with inflation significantly higher than seen during prior hiking cycles. Over the past 70 years, the first-rate hike came to the median, when the Consumer Price Index (CPI) reached 2.5%. The first increase this year occurred in March when CPI hit 8.5%. Certainly, part of the cause for delay were concerns around a fragile recovery after the pandemic and the supply side shocks that were expected to abate and lessen inflation. Perhaps it was its backward-looking nature. But what is clear to us is that the Fed is quickly heading toward a policy mistake if it does not look at the current data or project ahead. We are of the view that inflation will not be the primary concern in the back half of the year and into 2023, but weak economic growth and lower equity prices.
Looking at inflation, the five-year breakeven TIPS inflation expectation measure has declined nearly 100 bps from the March peak, while the commodity futures markets have seen massive pullbacks in many commodities—including oil, wheat and natural gas—ranging from 20-30% from recent May/June peaks. Will these rates hold or even continue to decline? We think it is likely, albeit certainly not a lock with ongoing uncertainty with Russia and Ukraine. However, the demand destruction from higher interest rates and consumer prices is spreading throughout the economy and is likely to suppress inflation in the coming six months.
While the price portion of the valuation calculation has fallen in 2022 (P/E multiples are down from 20-plus to 16), surprisingly forward earnings estimates have not. Consensus expectations through 2023 actually increased in June and remain well above the long-term trend. Consensus estimates also forecast earnings growth in 2024. Consensus expectations do not currently forecast an earnings recession despite significant recessionary signs, which gives us cause for concern as we assess the short-term future of equity prices.
During the past four recessions, the typical earnings revisions ranged from -6% to -18%, with a median of -10%. Assuming no more multiple contraction (probably not overly likely as we are just back to historical norms, not bear market/recession averages), broad equity prices could see additional downside in the aforementioned range or even more considering the removal of market liquidity via quantitative tightening.
We will assess the data as it comes in, but for now we see at least double-digit declines in earnings forecasts and equity prices in the coming six-month period, needing to get through both the July and October earnings seasons. The good news is that the revisions are finally beginning to happen. During one recent week, there were more than 500 analyst downgrades to either stock price targets and/or EPS estimates. This does not happen frequently, so it is a good sign. But unfortunately, there is likely more to come.
While the Supreme Court’s overturning of Roe vs. Wade has ignited the Democrat base, we can still forecast a flip of the House to Republican control. Even the Senate is looking like it could morph red. Economic concerns and horrifically low approval ratings for both President Biden and Vice President Harris are likely to weigh heavier on voters’ minds come November.
Talk of the mid-terms is about to heat up. We think gridlock, achieved by a Republican win in either the House or the Senate, will benefit the economy in 2023, perhaps providing a boost after the economy bottoms. This would not be from massive government spending, at least we’d hope not, but from more energy-friendly policy, if not broader opportunities.
As we look outside the U.S., risks still abound. While the financial markets seemingly no longer react daily to war news out of Ukraine or COVID concerns in China, the longer both issues persist, the more damage we expect to the supply chain, most notably in the food sector out of Ukraine. We expect inflation to ease in most goods categories in short order, but believe there is heightened risk for food prices to retest recent highs once the fall harvest concludes and the market discounts the output and future projections.
We are beginning to wonder if greater exposure to international equities makes sense, given the recent outperformance despite a strengthening U.S. dollar. We remain cautious about Europe given the ongoing energy crisis there and think there is probably better timing to be had following China’s recent equity rally, but more and more opportunities around the globe appear to be opening.
Despite a terrible second quarter and more reasonable valuations, our forecast for the equity markets remains lackluster, albeit likely to include decent short-term rallies at times. Valuations are not attractive enough to us to overcome the significant Fed headwinds (even if they pause after September, we’re still looking at 100-125 bps in hikes) and earnings overhang in July and October that could amount to double digit percentage declines in forecasts. While sentiment is extremely weak, positioning remains skewed toward risk, suggesting more selling pressure ahead. Once we get through the July and September Fed meetings and the aforementioned earnings seasons, and likely have lower equity prices, we’d look to get more aggressive. Whether this will be a tactical purchase or a shift in long-term positioning remains to be seen and will be dependent on our economic outlook at the time.
From a fixed-income perspective, we think the next big move in long-duration bond rates is lower, perhaps significantly so. We think this asset class is finally beginning to act like the risk-off asset that it is, and when equity prices take that next leg down, Treasuries will provide the ballast its owners expect. Sentiment remains weak here while allocators are underweight and speculators remain short, meaning that if inflation rolls over (which recent commodity prices indicate), there will be a significant rally in long duration bonds. Looking at corporates, we continue to favor quality over high yield as the recession is not yet factored into high yield prices or spreads and the sector has significant energy exposure, which is under pressure. We expect the next selloff will be a solid purchase, given our current outlook. The stronger U.S. dollar, coupled with the international bond market selloff, has made for some interesting yield opportunities in the emerging markets, which we are currently digging into.
Certainly, our outlook is not a positive one, at least not for the next four to six months. However, we do see conditions shifting during this time to provide the basis for a more optimistic view and healthier investing climate during the next quarter or two.
QUESTIONS AND COMMENTS
Clifford T. Walsh, CFA®
Chief Investment Officer
American Portfolios Financial Services, Inc.
631.439.4600, ext. 277
Samuel J. Rozzi, CFA®
Manager of Due Diligence
American Portfolios Financial Services, Inc.
631.439.4600, ext. 136
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