“Now is the winter of our discontent” --William Shakespeare
Perhaps a better way to start this article would be by rephrasing the Bard’s famous quote as a question:
“Is now the winter of our discontent?”
We have no way of knowing, but there are plenty of cold winds blowing out there.
What we do know is that, at the start of the year, our expectation was that global economies would continue to recover from the effects of the COVID-19 pandemic, but at a more modest pace than in 2021. While that holds true, the pace of change in macroeconomic fundamentals such as inflation, growth, and monetary policy has failed to live up to expectations.
Labor and supply-chain constraints were already fueling inflation before the year began, but Russia’s invasion of Ukraine and China’s zero-COVID policy exacerbated the situation. Central banks have been forced to play catchup in the fight against inflation, ratcheting up interest rates more rapidly and possibly higher than previously expected. But those actions risk cooling economies to the point that they enter recession and thus possibly lead us to a season of discontent.
A doubling of interest rates from the beginning of the year (+1.52% on December 31, 2021 to +2.98% on June 30, 2022) along with stubbornly high inflation caused mayhem in stock and bond markets, resulting in one of the worst 6-month periods on record.
The U.S. stock market, as measured by the S&P 500, lost -20.0% for the year through June 30. Value stocks outperformed growth stocks, returning -12.9% vs -28.1% for the year (Russell 1000). Small cap stocks underperformed large cap stocks for the year -23.4%, while international stocks (MSCI ACWI xUS) modestly outperformed U.S. stocks (-18.4%).
The best performing sectors year-to-date in the U.S. were energy (+31.7%), utilities (-0.6%), and consumer staples (-5.3%). The worst performing sectors were consumer discretionary (-32.5%), technology (-26.6%), and communications (-29.8%).
Rising interest rates hurt bonds as well and the only silver lining is that bonds lost less than stocks in the first six months of the year. In aggregate, the U.S. fixed income market lost -10.4%. Short duration credit dropped -6.0% for the year while long duration Treasury bonds lost -22.0%.
The American economy contracted at an annualized rate of -1.6% on quarter in Q1 2022, the first contraction since the pandemic-induced recession in 2020. Imports surged 18.9%, led by nonfood and nonautomotive consumer goods and exports dropped (-4.8%). Consumer spending growth was 1.8% as an increase in spending on services, led by housing and utilities was partly offset by a decrease in spending on goods, namely groceries and gasoline.
Labor market trends are likely to keep downward pressure on the unemployment rate through year-end, though increases in 2023 are likely as the impacts of Fed policy and slowing demand take hold. Analyst consensus is that the probability of recession remains low at about 25% over the next 12 months, and then climbs over 65% over 24 months. The rationale is that a period of high inflation and stagnating growth is more likely than an economic “soft landing” of growth and unemployment rates around or above longer-term equilibrium levels.
As you have heard us say many times in the past, periods of poor asset performance like this one have definite long-term benefits. Lower current equity valuations and higher interest rates will reward patient investors with higher expected long-term returns. While the markets are likely to remain volatile and frustrating in the second half of this year, they have already largely priced in a global recession.
It is important to remember that the fall in bond and stock returns in the first half of 2022 follow on the heels of impressive positive portfolio returns for a decade or more and especially over the last three consecutive years. Consolidations, corrections, and higher volatility are emblematic of uncertain markets and a normal part of how markets function, which cannot be avoided.
Achieving inflation-beating long-term returns and your financial goals means having an effective investment process that includes effective diversification and prudent rebalancing, especially during times like this.
Summer is in full swing now and our best advice is to enjoy what is left of it. We will continue to our job of watching over the markets and your portfolios.
Sources: Stockcharts.com, Conference Board, Vanguard 2022 Mid-year Outlook, Trading Economics. Featured image courtesy of Wall Street Journal Notable & Quotable 2016.