Our breakdown of the markets in the second quarter followed by a look ahead to the third.
Coming up, a review of the quarter that was and predictions for the quarter to come.
From Thrivent Asset Management, welcome to episode 33 of Advisor’s Market360™. A podcast for you, the driven financial advisor.
As you’re probably aware, the second quarter was a tale of two conflicting trends. The first trend was the labor market which remained strong throughout the first two quarters of 2022. And then there is the trend of rising inflation – and monetary tightening policies by the Federal Reserve, or Fed, that have continued to drive down stock and bond prices throughout the second quarter.
Will these conflicting trends continue in the third quarter? Our outlook will provide answers. Also on tap, a primer on bear wrestling.
Before we look to the future, let’s begin by looking back to the second quarter. To help us break it down, we tapped into Thrivent Asset Management’s team of experts led by Steve Lowe, CFA, Chief Investment Strategist.
The S&P 500® Index ended the quarter down 16.45% – and was down about 20% through the first two quarters. Meanwhile, the bond market experienced its worst quarterly performance in years, with the Bloomberg Aggregate Bond Index (which tracks the high-grade bond market) declining 10.35% year to date. The Fed raised rates a 0.25% in March, 0.5% in May, and 0.75% in June which was the largest single rate hike since 1994.
The Fed’s monetary tightening policy is intended to combat rising inflation. The Consumer Price Index, which is a commonly cited index used to gauge inflation, was up 8.6% through the 12-month period through May 2022. Excluding food and energy, the index rose 6% during that period. The food index was up 10.1% and energy prices were up a whopping 34.6% during that 12-month period.
On the bright side, employment growth continued to surge in the second quarter, as employers added nearly 1.2 million new jobs. The unemployment rate remains steady at 3.6% – the lowest level since the pandemic began in February 2020.
With more Americans returning to work, personal income has continued to increase each month since February, with income increasing by half of a% in both April and May, according to the Bureau of Economic Analysis. Disposable personal income also increased by 0.5% in April and May.
Personal consumption expenditures have also been rising in the second quarter, up 0.6% in April and 0.2% in May. However, when adjusting for inflation, personal consumption expenditures were up only 0.3% in April and down 0.4% in May. The personal savings rate as a percentage of disposable income was up 5.4% in May.
Manufacturing has also remained solid, with economic activity in the manufacturing sector improving in June for the 25th straight month, according to the Institute for Supply Management. While there were signs of a softening in demand – and continued supply chain issues – 15 of the 18 industries tracked reported growth for the month.
Those are the highlights, if you can call them that, for the quarter. Let’s look at those numbers a little closer, starting with equities.
The S&P 500 Index dropped 16.45% in the second quarter – including an almost 8.4% decline in June. The total return of the S&P 500, including dividends, was down 16.1% for the quarter. Year to date, the total return was negative by almost 20%. As a reminder, the S&P 500 is a market-cap-weighted index, representing the average performance of a group of 500 large-cap stocks.
The NASDAQ Index, an electronic stock exchange with more than thirty-three hundred company listings, fared even worse, down about 22.5% in the second quarter. Year to date, the NASDAQ is down just over 29.5%.
On the retail front, sales were up 7.7% over the three-month period from March through May, as consumers continued to recover from the pandemic slow-down, according to the June 15th Department of Commerce retail sales report. But sales slipped 0.3% in May, with inflation and concerns over the economy weighing on consumer confidence. Compared with the same period a year earlier, retail sales were up 8.1% in May.
Getting a bit more granular, auto sales were down 4% in May and down 4.9% from a year earlier. Building material sales were up 0.2% for the month and up 6.4% from a year earlier. Department store sales were up 0.9% for the month and 0.9% from a year earlier. Non-store retailers, primarily online, were down 1% for the month but up 7% from a year earlier. Restaurants and bars continued to recover, with sales at food services and drinking establishments up 0.7% in May and 17.5% from a year earlier.
When we look at unemployment, we see that in the second quarter, the economy added almost 1.2 million jobs according to the Department of Labor. The unemployment rate in June remained steady at just 3.6%, which is generally considered full employment.
The slump in stocks affected every sector of the S&P 500 in the second quarter, with all 11 sectors in negative territory. Consumer Discretionary fared the worst, down over 26% for the quarter. Technology stocks were also hammered, with Information Technology dropping 20.2% and Communication Services falling 20.7%.
While still negative, the best performers included Consumer Staples, down 4.6%; Utilities, down just over 5%; and Energy, down 5.3%. But if we look at the first six months of 2022, Energy is still up close to 32%.
And now, a lightening round of vital statistics from the second quarter:
Bond yields continued to move up in the second quarter as the Fed raised rates a total of 1.25%, following a 0.25% hike in March. The yield on 10-year U.S. Treasuries rose 0.66% in the second quarter, from 2.32% at the end of March to just shy of 3% at the June close. The Fed is expected to continue to raise rates throughout the remainder of 2022 in an effort to curb inflation.
Despite inflationary pressures, corporate earnings expectations continued to rise in the second quarter. The 12-month advanced earnings per aggregate share projection for S&P 500 companies climbed 2.85% in the second quarter. Year-to-date, earnings projections have increased 7.39%.
With the stock market tumbling about 20% this year, the forward price-to-earnings ratio, or P/E, of the S&P 500 dropped significantly in the second quarter. The forward P/E of the S&P 500 declined from 19.79 at the end of the first quarter to 15.8 at the end of June. The P/E has dropped nearly 5 and a half from the 2021 closing level of 21.33.
The forward 12-month earnings yield for the S&P 500, which is the inverse of the P/E, moved up from 5.1% at the end of the first quarter to 6.3% at the June close. The 12-month forward earnings yield can be helpful in comparing equity earnings yields with current bond yields. Although the yield is about 1% lower than it was two years ago, it is still significantly higher than the 2.98% market rate of 10-year U.S. Treasuries.
The dollar has reached a 20-year high relative to the world’s other major currencies. The dollar appreciated just over 6% versus the Euro in the second quarter, as the war in Ukraine – and the Russian sanctions that have accompanied it – took a toll on the European economy. For the year, the dollar has appreciated just over 8% versus the Euro.
The dollar has also appreciated significantly versus the Yen, up almost 12% versus the Yen in the second quarter and up just shy of 18% versus the Yen through the first six months of 2022.
Oil prices continued to climb in the second quarter, due primarily to two factors: Global demand had already been on the rise as the pandemic receded, a situation that was exacerbated by the boycott of Russian oil in response to the Ukraine war.
West Texas Intermediate, a grade of crude oil used as a benchmark in oil pricing, surged to more than $123 per barrel in early March before slipping back down to about $100 at the end of March. Year to date, oil prices are up just over 40%.
Gas prices at the pump also continued to spike in the second quarter, up almost 18%. Through the first six months of 2022, gasoline was up just over 51%, from a national average of $3.38 per gallon at the end of 2021 to $5.11 at the June close.
Despite rising inflation, gold prices moved nearly $150 per ounce lower in the second quarter, ending June at nearly 18 hundred dollars. Year to date, gold is down about 1.2% from its 2021 closing price.
And finally, international equities mirrored the U.S. market in the second quarter. The MSCI EAFE Index, which tracks developed-economy stocks in Europe, Asia, and Australia, dropped about 15.4% at the June close. Year to date, the index is down just shy of 21%.
That wraps up our review of the second quarter. Now, let’s look through our fingers to the third quarter.
What’s the market outlook for the third quarter of 2022? We asked Steve Lowe to share his thoughts with us.
Lowe cites accelerating inflation, war in Europe, and aggressive monetary tightening policies by the Fed as the major contributors to one of the worst quarters in decades for financial assets.
Major stock market indexes moved decidedly into bear market territory in the second quarter – dropping more than 20%. Even the bond market, which typically provides some diversification as a bulwark against declining stock prices, failed to provide any protection as interest rates increased.
Unfortunately, if it looks like a bear, walks like a bear, and roars like a bear, then it probably is a bear… market.
Surging and widespread price increases throughout the economy remain the major issue for both the stock and bond markets. Inflation is clearly the biggest issue facing consumers, businesses and the Fed.
Unrelenting price increases are causing a growing number of consumers to be more cautious in their buying behavior. They are also increasing their credit card balances to keep up. Businesses are more reluctant to expand as they continue to grapple with supply challenges and costs. The Fed finally acknowledged it misread the inflationary environment and is now trying to get in front of the problem by accelerating its move to raise interest rates. This is a concerning combination which could trigger a recession.
There are, however, some positive signs regarding the direction of inflation: one, commodity prices have finally turned lower with some falling significantly. Two, retailers have been caught with far too much inventory and are scrambling to cut prices to clear their aisles. Three, freight rates are now declining, and there is evidence of improving supply chain issues with supplier delivery times falling. And finally, Treasury bond yields have declined from their recent peak of about 3.5%, and the real yield in the Treasury Inflation-Protected Securities, or TIPS, market has moderated. Remember, real yields are yields after considering the impact of inflation.
However, these are early developments. The Fed has made it clear that it will want to see substantial and sustained evidence that the smoldering fire of inflation is being extinguished.
Although first quarter profits for the market overall were reasonable, second quarter profit reports will be extremely important in determining how well businesses are doing in maintaining profit margins and real growth.
Current analyst earnings expectations seem high given all that has happened in the past few quarters, especially the impact that rising labor and input costs will have on profitability. Additionally, businesses face persistent and costly logistical challenges brought on by Covid, the war in Ukraine and snarled supply chains. Furthermore, if consumers pull back due to the inflationary environment, revenues could be negatively impacted – providing another headwind to earnings.
With the significant decline in stock prices thus far in 2022, valuation – as measured by P/E multiples – has fallen to levels that look more reasonable from a historical standpoint. The forward P/E multiple for the S&P 500 had reached as high as 23 times earnings in 2021. It has now declined to approximately 16 times forward earnings. However, forward earnings estimates are likely to be proven too optimistic as second quarter corporate profit reports are released.
Corporate profit margins, which are near record highs, will be dented by rising costs and uncertain revenue growth. Remember, P/E multiples almost always decline when interest rates go up. So, declining P/E multiples should be expected when interest rates rise, as they have this year.
The stock market entered bear market territory in June. Not surprisingly, the current economic and market environment remains extremely challenging. Looking at it historically, bear markets typically last for about a year. And since 1946, the average bear market decline has been approximately 32%.
However, the average decline is somewhat negatively distorted by three major events that crushed markets: the oil embargo of 1973, the Dot-com crash of 2000, and the financial crisis of 2008. The median decline of bear markets over this time frame was approximately 27%. At the quarter’s end, the S&P 500 was down about 20% after six months in a downward trend.
Unfortunately, it’s not just the stock market. The significantly negative performance of the fixed-income market has added to the pain. In addition to the overall bond market being down approximately 11% through the first half of the year, corporate and high yield bond indexes were down around 14% and the municipal bond market fell approximately 9%.
Currently, valuations, as measured by yields in the bond market and P/E multiples in the stock market, are at levels not seen since 2018. In the bond market, after years of paltry returns, fixed income investors can obtain yields of approximately 5% in investment grade corporate bonds, more than 8% in high yield bonds, and 3 to 5% in municipal bonds, depending on credit quality. If the Fed is successful in bringing inflation down to its 2% long-range target, current market yields will likely be rewarding for long-term investors.
Historically, an investment into the market held for 10 years when the valuation multiple of the S&P 500 is at 16 times earnings – about where we are now – has returns averaging in the mid- to high-single digits on an annualized basis. And sectors of the equity market that are valued at even lower levels than historical averages, such as small-cap and international stocks, could generate even more attractive returns over that same 10-year time span.
Given this market environment, our views on economic and market prospects can be summarized by seven themes. If you listened to our previous episode, you’ll likely notice some overlap, but know that the following segment represents our latest thinking.
Theme one: volatility. We expect volatility to remain high until there is greater clarity on inflation and the economy.
Theme two: inflation. There are tentative signs that inflation may be peaking. If sustained, this would provide a foundation for markets to first stabilize and then begin to recover. We expect inflation to peak in the second half of this year. Forward market inflation expectations already have fallen due to an expected economic slowdown. A wild card is commodity prices, which are somewhat hostage to geopolitical risks, such as the Ukraine war.
Theme three: recession. Estimated probabilities of a recession are increasing but vary, with most estimates in a range of about a 30–60% probability, which seems reasonable. If the economy does tip into a recession, it’s likely to be moderate given the underlying strength of both consumers and companies, including low household debt levels, high consumer savings, strong business balance sheets, and a solid employment market.
Theme four: equity markets. Markets already have priced in an economic slowdown, but more downside likely remains in a recessionary scenario. Valuations and market prices, however, have reached levels that are more attractive to long-term investors, even if there are more near-term declines. The S&P 500 is at levels where the probability of long-term gains is high. Historically, once the market hits bear market levels – down 20% – average performance of the next 12 months has been 16%, with a 17% chance of a loss. Additionally, some of the sharpest upward rallies tend to be coming out of bear markets.
Theme five: interest rates. They have fallen from peak levels as markets have started pricing in Fed rate cuts next year in response to recession risks. In the near-term, we expect interest rates to trade within a range below peak levels seen in June. What could break this range? A recession likely would lead to significantly lower rates, while higher than expected inflation could trigger a renewed surge in rates.
Theme six: yields. In the corporate and municipal bond market yields look significantly more attractive, particularly if inflation continues to soften over time and rates fall.
Theme seven: real estate. With mortgage rates up, the housing market should continue to cool off. Longer-term, strong demand and a shortage of housing should support the market.
Lowe offers these closing thoughts on the third quarter outlook around strategies that the team is employing moving forward. In terms of asset allocation, we’re close to our normal allocation of a modest overweight to equities, with an overweight to domestic equities. Once we feel comfortable that inflation is sustainably starting to decline and economic risks are priced in, we intend to start adding to risk assets – both equities and credit, such as high yield bonds. We have been positioned for higher rates all year but recently moved close to neutral given increasing concerns over an economic slowdown, which typically pulls down interest rates.
In closing, it’s important to remember that bear markets eventually do come to an end. Patience and discipline are required to not only wait out these difficult periods, but to also start allocating capital to risk assets when the environment still seems negative, and valuations are attractive.
Thanks for listening to this episode of Advisor’s Market360™. All episodes are available on Apple Podcasts, Spotify, and Google Podcasts. We’d like to hear from you! If you’ve got questions or comments about this episode, or if you have an idea for a topic, email us at firstname.lastname@example.org. You can also learn more about us at thriventfunds.com and find other items of interest to you, the driven financial advisor. Bye for now.
All information and representations herein are as of July 8, 2022, unless otherwise noted.
Any indexes discussed are unmanaged and do not reflect the typical costs of investing. Investors cannot invest directly in an index.
Past performance is not necessarily indicative of future results.
Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.
Thrivent Asset Management, a division of Thrivent, offers financial professionals a variety of investment products to help meet their clients’ needs. Thrivent Distributors, LLC, is a member of FINRA and SIPC and a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans.