Accelerating inflation, war in Europe, and aggressive monetary tightening policies by the Federal Reserve (Fed) were the major contributors to one of the worst quarters in decades for financial assets.

Major stock market indices moved decidedly into bear market territory in the 2nd quarter. The S&P 500^®, Russell 2000 small cap, and NASDAQ indices have all dropped 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, with the Bloomberg Aggregate Bond Index (which tracks the high-grade bond market) declining 5% in the 2nd quarter and 11% in the first half of the year.

Within the equity market, the very divergent sector trends that began at the start of the year continued throughout the 2nd quarter. Large cap growth stocks, especially technology, were down 20%, while the value sector continued to perform dramatically better on a relative basis, down about 11%.

However, one long running trend that reversed somewhat in the second quarter was the relative performance of international stocks, especially emerging markets. MSCI emerging market indices were down approximately 8% while developed markets were down about 13%.

Over the past few years, international stocks, including emerging markets, generally have trailed the performance of U.S. stocks. But through the first half of the year most international markets posted returns in local currency terms that were ahead of U.S. markets. In U.S. dollars, however, returns have been much closer, due to the strong dollar.

Rising prices threaten profits and P/E valuations

Prices. 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 more consumers to be more cautious in their buying behavior and to increase 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:

• Commodity prices have finally turned lower with some falling significantly.

• Retailers have been caught with far too much inventory and are scrambling to cut prices to clear their aisles.

• Freight rates are now declining, and there is evidence of improving supply chain issues with supplier delivery times falling.

• Finally, Treasury bond yields have declined from their recent peak of about 3.5%, and the real yield in the TIPS (Treasury Inflation-Protected Securities) market has moderated. (Real yields are yields after taking into account 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.

Profits - 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 the consumer begins to pull back due to the inflationary environment, revenues could be negatively impacted, thus providing another headwind to earnings.

Price to Earnings (P/E) multiples - 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 an 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, as mentioned previously, forward earnings estimates are likely to be proven too optimistic as 2nd quarter corporate profit reports are released.

Corporate profit margins, which are near record highs, will be dented by rising costs and uncertain revenue growth. Furthermore, P/E multiples almost axiomatically decline when interest rates go up.  Thus, declining P/E multiples should be expected when interest rates rise, as they have this year.

Bear markets in the current context

The current economic and market environment remains extremely challenging, as the stock market entered bear market territory in June. Historically bear markets last for about a year, and since 1946 (post World War II), the average market decline has been approximately 32%.

However, this average is somewhat negatively distorted by three major events which 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 quarter end, the S&P 500 was down about 20% after six months in a downward trend.

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 indices 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.

In the stock market, historically an investor who buys into the market and holds for 10 years when the valuation multiple of the S&P 500 is at 16 times earnings – approximately the level at quarter end - is rewarded with returns that have averaged in the mid- to high-single digits on an annualized basis. Sectors of the equity market that are valued at even lower valuation levels than historical averages, such as small cap and international stocks, could generate even more attractive returns over that same 10-year time span.

A look ahead

Looking forward in the near term, risks remain that the stock market could decline further, approaching typical bear markets in terms of duration and overall decline. The Fed has been clear that it intends raise rates until inflation is quelled. It likely would take a more severe market downturn or a meaningful recession for the Fed to pivot to an easing stance before inflation falls.

Given this market environment, here are our views on economic and market prospects:

Volatility. We expect volatility to remain high until there is greater clarity on inflation and the economy.

Inflation. There are tentative signs that inflation may be peaking, which if sustained, 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.

Recession. Estimated probabilities of a recession are increasing but vary, with most estimates in a range of about a 30% to 60% probability, which appears 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.

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.

Interest rates. Interest rates 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.

Yields. Yields in the corporate and municipal bond market look significantly more attractive, particularly if inflation continues to soften over time and rates fall.

Real estate. With mortgages rates up, the housing market should continue to cool off. Longer-term, strong demand and a shortage of housing should support the market.

In terms of asset allocation, we’re close to our normal allocation of modestly overweight 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.

Also, 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.  

For an in-depth look at economic and market performance in the 2nd quarter, see: 2nd Quarter Market Review: Despite strong employment, markets rattled by inflation and recession concerns