As one market observer noted, the best news about the 1st half of 2022 is that it has ended. The S&P 500 posted a 16.4% decline for the 2nd quarter as nagging inflation compelled the Federal Reserve to raise their target rate a cumulative 1.25%, including the largest single move since 1994. Elevated inflation also pushed market interest rates higher. The yield on the 10-year US Treasury rose to 3.0% and the price of the safe-haven asset fell 5.5%. The rate on a 30-year home mortgage rose 1.0% to 5.7%. As has been the case historically, higher interest rates have coincided with lower price-earnings ratios, and the stock market decline in 2022 can be almost entirely explained by investors’ willingness to pay less for each dollar of earnings. Meanwhile, 1st quarter earnings were almost 5% higher than analyst forecasts, at a 9.3% year-over-year growth rate. The 13.1% growth in revenues topped projections by 2.2%.
The U.S. economy contracted 1.6% during the 1st quarter, though consumer demand grew a comparatively stronger 1.8%. Weaker defense spending, exports and inventory building explained the bulk of the overall weakness. Uncertainty stemming from the Ukraine conflict weighed on foreign demand for U.S. goods and services, and continued supply chain impediments hampered companies’ ability to restock warehouses. Despite headline economic weakness, the labor market continues to post strong job gains, and the unemployment rate remains near historic lows. These dynamics suggest some support for resiliency in consumer spending. While inflation remains elevated, meaning additional Federal Reserve policy adjustments to come, data indicates inflation may have already peaked. Recent double-digit retreats in oil, lumber, copper and agricultural commodity prices fit with a narrative of moderating inflation. Prudent policy moves and lessening pressures in areas the central bank can’t directly control could set a backdrop for more benign inflation and friendlier market returns.
Stock price performance was negative across all S&P 500 sectors, as the benchmark posted its worst quarterly return since 2008. Share prices in the historically defensive sectors of Utilities, Consumer Staples and Health Care held in better, as households can’t curtail spending much in those categories, regardless of economic growth trends. Energy qualifies as a highly cyclical sector, but changing dynamics in global energy markets helped support shares. Global energy demand remains quite strong, while constrained production and refining capacity also support the sector. Consumer Discretionary lagged all other sectors, as slower economic growth would likely present obvious headwinds for bigger ticket, less necessary purchases. Communications Services performance tends to follow consumer spending trends, as consumer-oriented firms often cut ad budgets in challenging times. That link likely explains the sector lagging the broader market. Seeing Technology trail the market is less intuitive, as the increasing alignment between a firm’s tech agenda and business agenda could make Tech less sensitive to a potential slowdown than history has shown. Even in an unfavorable overall market environment or within market sectors that are out-of-favor in the near-term, investors are typically well-served by remaining committed investors in companies whose management teams exhibit the ability to consistently execute and deliver on long-term strategic plans.
Economists define a recession as two consecutive quarters of contraction in output. The causes will vary from episode to episode, and some causes are more problematic than others. Recessions will occur as surely as the sun will rise. Such is the nature of the business cycle. The good news is that periods of economic contraction end, typically in under a year. No one can predict the onset or the end of such periods with certainty. Markets price in probabilities rather than absolute outcomes, and asset markets currently price in a higher-than-typical chance of a recession in the next 12 to 24 months. As ever, the stock market isn’t the economy, and vice versa. The job market is strong, and consumer and corporate balance sheets are healthy. There are no obvious excesses to purge. If a recession does occur, stocks have already priced in quite a bit of bad news. The stock market is as ever a forward-looking mechanism, and currently sees the proverbial glass as half-empty. The irony is that once “half-empty” is confirmed, the mindset typically turns to looking toward a glass half-full with eyes on the eventual recovery.