When I sit down to write the quarterly commentary, I often have past commentaries handy as a reference. This quarter, I could practically copy and paste the commentary from the first quarter of this year, because we are facing many of the same concerns. I won’t, because that would be boring. Financial markets around the globe faced extreme pressure in the first half of 2022. When the stock market closed on June 30th, it marked the worst start to a year in over 50 years, with the S&P 500 down 20.6%. The Barclays Aggregate Bond1 Index was down 10.35%. This index has been around for over 40 years, and the largest calendar-year decline ever was 2.92% in 1992. Suffice to say, I could give more examples of declining markets, but I will stop with these two data points.
The declines in both fixed income and equities have made 2022 especially painful. When one goes up, the other often goes down. During these times, you hear the term “return of capital, not return on capital.” How come this has not occurred in the first half of 2022? There are three main reasons (and numerous subsets of these reasons): inflation, rising interest rates, and a deteriorating economic outlook around the globe. Let’s review these in more detail.
Since the end of the Great Recession, between 2010 and 2020 the average U.S. annual inflation rate was 1.7%, and exceeded 3% only once (3.2% in 2011). Inflation accelerated in 2021 to 4.7% and has been above 8% since the start of 2022. Why are we experiencing this inflation, and why does it matter?
There are numerous reasons for the rise in inflation. First and foremost is COVID-19 and the global response to it. The pandemic created massive supply chain disruptions, which increased the costs of many goods. Next, the U.S. government’s pandemic response through Federal spending and support programs such as CARES Acts 1, 2, and 3, designed to combat pandemic-induced economic turmoil, flooded the economy with fresh capital. All told, around $5 trillion of fiscal stimulus was provided to the U.S. economy. This is seven times the stimulus used to combat the Great Recession of 2008. More money in the economy can cause inflation.
In addition, the Russian invasion of Ukraine took already high energy and food prices and catapulted them even higher, as discussed in last quarter’s commentary. A few other contributors to inflation have been the shift to “work-from-home,” increased consumer spending (even as prices started to rise), a lack of semiconductors, increased wages, the Federal Reserve Policy (did they wait too long to raise rates?), tax cuts, the infrastructure bill, and crypto. I read an article that stated Lamborghinis have been sold out for two years, and crypto profits are funding a lot of it.2 Additionally, Redfin (a large, nationwide real estate brokerage firm), found that 11.6% of first time home buyers used crypto profits as a down payment.3
Housing needs a little more explanation. The U.S. has underbuilt single-family homes since we came out of the Great Recession. This, coupled with historically low interest rates, sent home prices soaring, rising 14.6% in 2021. There appears to be some slowing of the rise in home prices as mortgage rates have increased from around 3% at the start of 2022 to around 5.75% today.
Inflation has increased, which is important because the Federal Reserve (the “Fed”) must raise the federal funds rates to slow down the increasing inflation. The federal funds rate serves as a basis for the pricing of savings instruments, like savings accounts or CDs, and borrowing rates for consumers and businesses alike — everything from credit cards and home equity lines to small business loans. As rates increase, consumer demand and business spending begin to weaken, and inflation should start to slow down.
As of this writing, the Fed has already increased rates by 1.5% in 2022. By the time this commentary is published, the Fed will have met again and likely raised rates by 0.75% or 1.00%, with future increases likely. Rising rates are typically done during periods of red-hot economic growth to slow down the economy. This is why the stock market typically performs well during times of increasing rates. Going back to 1962, there have been 14 periods during which we saw rising interest rates, and the average S&P 500 return was 17% during those periods. Only three of the 14 cycles saw negative returns. As noted last quarter, rising rates depress the value of existing fixed income. This helps explain why fixed income is down, but why are equities suffering when the Fed is raising rates?
There are a few reasons why equities have pulled back to start the year. One reason I believe, but I have not seen discussed, is profit-taking. Investors have done well over the last ten years and are taking profits. Even with the substantial pullback this year, the S&P has averaged a 13.25% return over the last ten years. That is an outstanding return, which has likely caused individuals nearing retirement to evaluate their risk exposure. Aside from profit-taking, the stock market is suffering from fears of an economic slowdown or even a recession. Economists are mixed as to whether we are in a recession, will have one in the next 18 months, or will barely miss formally entering recession territory. What is not debatable is that the rapid economic recovery we saw coming out of COVID-19 is slowing.
Is it possible to find any good news in all this gloom? The markets are facing a lot of headwinds. The triple threat of inflation, interest rate hikes, and recession risk may cause consumers and businesses to cut back on spending. This likely will hurt corporate profits and could continue to weigh on stocks. With this in mind, it is virtually impossible to call a market bottom. If there is a recession, the depth of a recession will play a key role in determining if the market has found a bottom. But…stocks are priced much cheaper than they were six months ago; this cannot be argued. Even if corporate earnings are lower in the third quarter than in the first quarter, the Price to Earnings Ratio4 of stocks is more favorable now than at the start of the year. Additionally, much of the damage to fixed income has likely already been done, and fixed income holders should start to see higher interest payments from funds. The final piece of good news is that as I write this, the Atlanta Braves have won 75% of their games since June 1st and appear poised to defend their World Series title.
What is an investor to do in times like this? First, don’t overreact. The investment plan you already have in place should not need significant changes due to six challenging months in the market. Market pullbacks present an opportunity. If you have cash not needed in the next five years, now might be a good time to put some money to work. Also, analyzing your portfolio might present an opportunity to harvest some losses or rebalance the portfolio. If you have any questions, please do not hesitate to reach out.
1Index is composed of different types of bonds, such as government bonds, corporate bonds, mortgage-backed securities, and asset-backed securities.
2Phemex. (2022, March 4). When Lambo? Bitcoin & Lamborghinis: What does it mean? Phemex Blog. Retrieved July 19, 2022, from https://phemex.com/blogs/when-lambo-bitcoin-lamborghinis
3Hansen, S. (2022, January 7). A surprisingly large number of first-time homebuyers are funding their down payments with Crypto profits. Money. Retrieved July 19, 2022, from https://money.com/first-time-homebuyers-crypto-down-payments/
4The P/E ratio is simply the stock price divided by the company’s earnings per share for a designated period. It conveys how much investors will pay per share for one dollar of earnings.
The views and opinions expressed are of Persium Advisors, LLC. This commentary is provided for educational purposes only and should not be construed as investment advice. Persium Advisors is an investment advisor firm located in Atlanta, GA.
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