A First Half to (Not) Remember
The first half of 2022 proved to be the worst first half equity performance since 1970 with the S&P 500 declining by 20.0% and the Nasdaq declining by 29.5%. Prompting the decline has been equity markets pricing in a high likelihood of recession compared to recession not even being on the horizon at the beginning of the year. The main driver of this change in expectations has been the extremely hawkish pivot by global Central Banks as inflation rates continued to rise (exacerbated by the war in the Ukraine). Getting a handle on inflationary pressures and expectations is paramount to the U.S. Federal Reserve. This is prompting the Fed to quickly raise interest rates - even if the consequence is recession. While recessions obviously hurt individuals who lose their jobs, it is how the economy removes imbalances - leading to a healthier overall environment and setting up the next economic expansion. Our current imbalances relate mainly to the supply / demand differentials in goods, services and labor which are producing unhealthy levels of inflation. A recession would likely restore a proper equilibrium between supply and demand which would be desirable in the long-term.
One aspect of the first half financial market decline that has been atypical is that the bond market has not been able to act as a useful hedge. The Barclays Composite Bond Index declined 10.4% over the first six months of the year. This is because interest rates rose dramatically across the yield curve as inflation spiraled and the Federal Reserve started to raise the Fed Funds rate. There is a silver lining. We would expect that bonds will once again resume being a good hedge going forward. With the rise in interest rates, short-term bond yields are now in the 2.5%-3.0% range which might not sound like much, but are considerably better than the sub-1% rates we have experienced for many years.
So, what comes next? Our base economic case calls for a recession. Should this occur, we could see a little more downside in equities. In the near-term, we expect markets to continue to be volatile, highlighted by multiple negative days as well as sharp rallies. For perspective though, the market is already pricing in some portion of that recession. While not our base case, if we do not enter recession then equities would be primed for a large rebound.
When will we see a sustainable equity market recovery? While predictions for economic growth have been coming down, earnings estimates are only just beginning to. This has been very recent and is welcomed as more realistic earnings estimates are a prerequisite for a sustainable market recovery. A sustainable recovery will likely come once a) inflation starts to decline in a convincing fashion giving the markets confidence that b) there is an end in sight to Federal Reserve rate hikes. At the same time c) corporate earnings estimates must come down to more realistic levels. Once this all starts to occur, equity markets will be able to look beyond current economic concerns and start to price in economic expansion. The equity market bottom will likely occur well before economic bottom given the market’s propensity to look forward. The process takes time and patience, however we remain optimistic on the future.