July 18, 2022

There were very few places to hide during the year’s first half as both equity and fixed income markets suffered heavy losses. With companies and consumers facing the highest inflation since the early 1980s, the U.S. Federal Reserve recently, and perhaps belatedly, raised interest rates aggressively to combat inflation. Rapidly rising interest rates swiftly brought down bond prices, and as rising interest rates and global growth fears worried equity investors, U.S. stocks suffered their sharpest first-half drop in over 50 years.

With inflation running hot across many parts of the world, central banks outside the U.S., concerned about their fragile economies, are taking a less aggressive approach toward suppressing inflation. For their part, the Federal Reserve recently demonstrated its resolve by signaling an additional half-to-three-quarters-point rate increase in July. While markets, as do we, question whether central banks will remain resolute in their efforts to fight inflation, there is some evidence inflation may be moderating as commodity prices have backed off and rising new car inventories are bringing down car prices.

A hawkish Federal Reserve, combined with an end to pandemic-related fiscal stimulus, an overvalued dollar, and record-low consumer sentiment, is weakening domestic economic growth. Real gross domestic product (GDP) decreased at an annual rate of 1.6% in the first quarter of 2022. The Atlanta Fed’s latest GDP estimate for the second quarter is a further decline of 1.9%. Two quarters of shrinking economic output often signal an economy entering a recession. In a recession, GDP, jobs, income, and spending all usually decline in concert. While GDP has contracted, the labor market continues as a potential bright spot for the economy. The U.S. economy added 372,000 jobs in June, and 11.4 million jobs remain open—both at odds with a recession. Recognizing the tightening cycle has just begun, and interest rates are still relatively low, it is hard for us to envision a deep recession starting this year.

In the U.S., the corporate earnings outlook for 2022 and 2023 remains essentially unchanged, meaning the stock market correction thus far has been driven by changes in investor sentiment rather than changes in business fundamentals. Valuations on stocks, generally, are much more reasonable than at the start of the year. Indeed, the S&P 500 forward Price-to-Earnings (P/E) ratio is now below its 25-year average of roughly 16.9x. Higher wage, input, energy, and interest costs will eventually begin to erode profit expectations so we will be keenly focused on the corporate earnings releases and future guidance provided in the coming weeks.

Looking forward, the abundant financial conditions of the last few years are behind us—borrowing costs are higher, and the Fed is shrinking liquidity in the economy and from financial markets. Corporate management teams and investors are attempting to get a better feel for future economic and political conditions. Accordingly, we expect heightened volatility in the fixed income markets as governments work to keep inflation in check while not inflicting too much damage on end demand. Stocks may take some time to fully factor in the risk of recession, but we believe that a significant portion of the speculative air has already been released from the bubble.

While it is difficult to remain dispassionate when markets are retreating and headlines are bleak, it is essential to maintain a rational approach. Successful investors attend to crucial signals and tune out the noise. As the year progresses, the tea leaves for some key indicators should become easier to read. Chief among these is whether inflation will persist and how the economy responds to aggressive Fed tightening. Our combined quality and price discipline helped buffer our clients as the stock market went into bear territory. We believe that more attractively priced stocks and potentially higher interest rates will help us meet our clients’ long-term investment goals.

The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.

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