Inflation remains the major theme so far in 2022 impacting daily habits, long term plans and financial markets. With inflation readings setting 40-year highs, both bond and stock investors had to adjust quickly to reprice securities in a high inflation environment.
2nd Quarter 2022 Returns
- S&P 500: -16.4% (measured by ticker SPY)
- International stocks: -13.9% (measured by ticker IXUS)
- Emerging stocks: -12.1% (measured by ticker IEMG)
- US bonds: -4.4% (measured by ticker AGG)
- US high yield bonds: -6.6% (measured by ticker HYG)
The stock correction in 1Q22 developed into a bear market on June 14th. The selloff centered on high-priced tech stocks. Facebook, Amazon, Apple, Netflix, Google (referred to as FAANG during the 2021 run up) have experienced pullbacks of 28%, 35%, 21%, 53%, 22% respectively, in just the 2nd quarter.
Our decision to remain underweight to these high-priced tech stocks has supported performance across all models. We remain more constructive on value stocks as compared to growth companies, like Netflix and Facebook.
Interestingly, this pullback marks the third bear/near-bear market we’ve experienced in the past 4 years. Even with the frequency of these bear markets, the US stock market has returned +52% since 1/1/2018.
For bonds, the challenges continued as rising Fed interest rates exceeded initial expectations. Entering the quarter, the market expected a 0.5% rate increase in June, but inflation news caused the Fed to increase rates by the most in decades with a 0.75% rate increase.
The Fed is clearly playing “catch-up” in the inflation game. To do so, they must quickly raise rates and likely to higher levels than previously necessary. This will present challenges for growth stock investors and opportunities for bond investors.
Looking at the chart below, we see how quickly interest rates have risen across all bond durations. Investors who bought 30-year bonds on 12/31/2021 purchased at a yield cheaper than a 1-year bond today.
The speed and frequency of these rate increases has caused the US bond market to experience its worst intra-year drawdown in nearly 50 years.
Inflation remains the fundamental story to markets in 2022. Investors are simultaneously concerned about inflation’s impact on prices today and the rate increases required by the Federal Reserve.
Markets are currently pricing Fed rate hikes of 0.75% in July, 0.50% in September, 0.50% in November and 0.25% in December. This would make the peak Fed interest rate at 3.50% - 3.75%.
However, that’s not the entire story. Markets are also forecasting that economic growth will slow down in 2022, with a 60-80% chance of a recession. Bond markets are now expecting interest rate cuts in 2023. This would be consistent with prior interest rate tightening phases, where the Fed averages a rate decrease just four months after the last rate increase.
What’s Next? —Stocks
At last quarter’s market update, we outlined our enthusiasm for value and smaller sized US companies. We continue to hold this enthusiasm, as long-term tailwinds support both segments of the stock market.
Our decision to diversify outside of the S&P 500 into international and small- and mid-sized US companies has supported performance in the first half of 2022.
When looking at the prior worst starts to the year, each time the market’s first half performance ended with a bear market, the market rallied in the second half.
Regarding the 3rd quarter outlook, we continue a more defensive approach to the stock market. With a likely recession in store for the US economy, we expect to see a decrease in the growth of corporate earnings. We also expect consumer sentiment to weigh on multiples in the US stock market.
Over this next quarter, we will look to make opportunistic buys across the stock market. We expect to increase our exposure to quality, value, and small US companies. These segments of the market have proven to outperform when exiting a bear market.
What’s Next? —Bonds
Unquestionably, this year’s bond market is the most challenging on record. With rising interest rates and now widening corporate spreads (how much more interest a company pays compared to the US Treasury), the bond market faces a multitude of headwinds.
We are beginning to see the initial stages of corporate spreads significantly widening in the high yield bond market.
We will look to lower our exposure to this part of the market, replacing the exposure with increased Treasury bond purchases.
These Treasury bonds typically act as a ballast during difficult markets. They will also provide a yield of approximately 3% and remain ultra-liquid for when we choose to re-enter the high yield bond market.
On June 13th, we noticed that short-term Treasury bonds were yielding abnormally high rates compared to similar, long-term Treasury bonds. The next morning, we quickly moved to purchase these bonds that have since appreciated in value.
With the significant volatility in the bond market, we expect to be able to seize on opportunities over the next 3-4 months. We expect these opportunities to be most available in the high yield bond market.
2022 is proving to be one of the most challenging years for investors. With economic news indicating recessionary pressures, we will be de-risking our bond positions and looking to further diversify away from expensive growth stocks. Trading activity will continue to increase in the 3rd quarter as opportunities quickly present themselves.