Authored by :
Michael G. Dow, CAIA, CFA, CPA, Chief Investment Officer
Julien R. Frazzo, Director of Risk Management and Securities Research
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The Quick Facts
- A miserable first half of the year for investors with the S&P 500 posting its worst first half (-20%) since 1970
- Large Cap Value beats Large Cap Growth by more than 15% through 1H 2022
- Bonds also post their worst half year in decades
- May CPI (published on June 10) reached a new 40-year high of 8.6% year-on-year
- June saw the first Federal Reserve (Fed) 75 bps rate hike since 1994
We decisively entered a bear market in June, as stubbornly high inflation, higher interest rates, and a slowing economy pushed the market down over 20% from the S&P 500 peak reached on January 3, 2022 (4,796).
U.S. equities posted their worst first half performance since 1970 with the S&P 500 down 20.0% – much of it coming during the 2Q (-16.1%). Value, dividend-focused, and low volatility strategies outperformed, signaling the market’s continued emphasis on defense.
The growth-heavy Nasdaq declined in five of the first six months this year, which marked both its worst first half (-29.2%) in 20 years and its worst quarter (-22.3% in 2Q) since 4Q 2008. Soaring inflation, increasingly hawkish global central banks, the Russian war, China lockdowns, food and energy shortages, and growing recession fears continue to be the primary headwinds driving the risk-off price action and record low sentiment.
Most investment asset classes posted negative returns in the first half of 2022, with the notable exceptions of crude oil (+46%), natural gas (+45%), and Energy equities (+31%). No S&P 500 sector beyond Energy generated a positive return in 1H 2022. The current bear market has been entirely driven by decompressing earnings multiples rather than the result of reduced earnings estimates. However, it is now fair to expect consensus profit margin forecasts to fall from peak levels, which will likely lead to downward EPS revisions, whether the economy falls into recession or not.
June Asset Class Performance
The Russell 1000 Value outperformed the Russell 1000 Growth by 15.8% through 1H 2022, highlighting the market’s focus on defense. The ESG segment of the market as measured by the MSCI USA ESG Select Index was down 23.5% in 1H 2022, 3.5% more than the S&P 500. However, over the last three years, the ESG index is up 38.9% and approximately 3.7% ahead of the S&P 500 on a total return basis. Investing outside of the U.S. helped somewhat; the MSCI Emerging Markets Index posted a 17.9% loss in 1H 2022 and the MSCI EAFE (Europe, Australasia and the Far East) Index was down 19.2% in 1H 2022, both outperforming the U.S. Large Cap equity benchmark.
The 2Q earnings season is on the horizon. Reported earnings and management guidance are likely to have a significant impact on the stock market. A key question is whether companies can continue to enjoy the record operating margins seen over the past few years in a recessionary environment.
Since the start of this year, Fed officials have turned increasingly hawkish in their discussions of the outlook for monetary policy. Rate hikes began on March 16 with a +25bps move, followed by a +50bps hike on May 4, and a +75bps hike on June 15 to take the Federal Funds rate to a 1.50%-1.75% range. At the start of the year, markets were pricing in three +25bp rate hikes for all of 2022. At the recent peak on June 14, they were pricing close to twelve +25bp hikes. Over this period, the U.S. 10-year Treasury yield rose as much as 199bps from 1.51% to 3.50% before settling at 3.01% on June 30, 2022. Now that the Fed is “unconditionally” committed to bringing inflation down to its stated average target of 2%, the risk is it will do so even if that produces a policy-engineered recession.
Bonds also posted their worst half year in decades. The Bloomberg U.S. Aggregate Bond index, the U.S. fixed income benchmark, has delivered total year-to-date losses of 10.3%, setting fixed income on course for the worst year on record. While the Municipal Bond index did slightly better with a 9.0% negative return in 1H 2022, both the U.S. Corporate Investment Grade and U.S. High Yield closed more than 14% lower. Many global central banks are behind the curve, which has contributed to the worst inflation in over 40 years. They are now being forced to catch up with rapid tightening that is negatively impacting global economies and capital markets, reducing the likelihood of a soft landing, and increasing the probability of a recession. A recession could trigger a credit crunch, exacerbating the downturn, even though the global banking system is in good shape compared to the 2008 financial crisis. We are watching the yield spread between corporate bonds and the 10-year U.S. Treasury bond, an indicator of default risk – it has widened but not to alarming levels.
While a growing number of market measures suggest inflation could finally be peaking (one argument supportive of bonds and lower rates), the Fed’s Quantitative Tightening (QT) program and the increasing supply of Treasuries are fueling debate regarding the future path of rates. The Fed will not quit tightening financial conditions until inflation is tamed, using both higher rates and QT.
Measures of inflation remain elevated. The core CPI (which excludes Food and Energy) came in at 6.0% YoY, down slightly from the peak of 6.5% YoY in March. Headline CPI reached a new 40-year high of 8.6% YoY. While economic measures of inflation are at or near multi-decade highs, market measures of inflation – which the Fed is specifically focused on – tell a different story. The forward-looking U.S. 5-year, 5-year Forward Breakeven Inflation rate retraced 46bps from its peak of 2.60% in April to a 2022 low of 2.14% on June 30.
WTI Crude declined 5.5% in June, which ended a streak of six consecutive monthly gains. WTI finished the first half of 2022 up 46.5% at $106/bbl. After peaking in March at $124/bbl., its highest level since 2008, it has since been consolidating in a sideways range following a prior steep uptrend.
The increasingly hawkish Fed, along with the global “risk-off” price action, led to a 9.4% gain in the U.S. Dollar Index (DXY) in 1H 2022. The Euro declined 7.8% in the first half of the year against the Dollar, while the Japanese Yen was down an astonishing 17.9%. While most central banks around the world are tightening monetary policy via rate hikes, the Bank of Japan (BoJ) is an outlier. The BoJ has implemented yield curve control by locking its long rate at 25bps, to the detriment of its currency.
Bitcoin lost 59.1% of its value in the second quarter of 2022, posting its worst quarterly performance since 2011. Ethereum did even worse with a negative 69.4% return in 2Q. The quarter also saw the collapse of algorithmic stablecoin terraUSD, which sent shockwaves through the industry. We believe that the 2022 crypto selloff confirms our view that the most appropriate way to think about crypto assets is as a call option – i.e., a highly volatile asset with a very high beta to the S&P 500 – on the underlying blockchain technology.
The CBOE Volatility Index (VIX) has yet to reflect the amount of pain in the markets – we have not seen the expected spike above 40 that would indicate capitulation, while the S&P 500 saw its most volatile half year since 2009. During the first half of the year, 90% of trading days had an intraday range greater than 1%.
Chart of the Month – Financial Repression and Real Rates
Financial repression remains the long-term operating framework as governments work to reduce the high debt levels accumulated with COVID-19 mitigation efforts. Over our cyclical horizon however, we expect financial repression policies to remain on hold to fight inflation. They will reappear once inflation expectations are affirmed near Fed comfort levels.
Negative real yields are the hallmark of financial repression. Real yields are nominal interest rates minus inflation. In our graph below, we specifically decompose the U.S. Treasury 10-year yield into inflation expectations and real yield. This chart shows that real yields have moved significantly higher – due entirely to the move in nominal yields, inflation expectations remaining stable. Real yields are now positive for the first time since January 2020.
Quote of the Month
“It is better to be roughly right than precisely wrong.” – John Maynard Keynes
Major Asset Class Dashboard
Important Disclosure: This report is for informational purposes only. Opinions expressed herein are subject to change without notice. Beacon Pointe has exercised all reasonable professional care in preparing this information. The information has been obtained from sources we believe to be reliable; however, Beacon Pointe has not independently verified, or attested to, the accuracy or authenticity of the information. Nothing contained herein should be construed or relied upon as investment, legal or tax advice. All investments involve risks, including the loss of principal. Investors should consult with their financial professional before making any investment decisions. Past performance is not a guarantee of future results.
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