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 2^nd 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 2^nd quarter and 11% in the first half of the year.   

Within the equity market, 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 2nd 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, 2^nd 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 2^nd 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.  

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.

It may be helpful to consult with your financial professional before making any changes in your portfolio during these volatile times.

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