Key takeaways

• The economy slowed more than expected, and hot inflation remains sticky. 
• Tightening financial conditions, a slowing economy, political turmoil, and poor consumer sentiment are a volatile mix. 
• The market shake-up repriced assets and presents opportunities for bargain hunters. 

The second quarter was ugly as investors learned there is no good place to hide when inflation takes hold

With its inflation-fighting credentials in question, the Federal Reserve (Fed) got serious, setting the stage for a tightening cycle at the same time the economy is already slowing. Investors are hoping for the best but preparing for the worst as recession worries emerge. However, the shake-up presents opportunities for bargain hunters to find value, and fixed income ended the quarter offering yields that are quite interesting. 

Markets were highly volatile, stocks entered a bear market, and fixed income did not provide a safe haven as all major asset classes ended in the red. Commodities, one of the few asset classes to benefit from inflation, continued to be the best performer of the year, but even that asset class struggled in the quarter as growth concerns grew. After the big move in rates in the first quarter, treasury yields continued their rise across the curve, reaching nearly 3.5% in mid-June. From 2-10 years, treasury rates ended the quarter clustered around 3% as the curve shifted approximately 50-60 basis points (bp) during the quarter. Spreads widened and, along with higher rates, yields rose to a more attractive level than seen in some time. The Bloomberg Corporate Index now yields 4.70% (the highest level since 2009) and the Bloomberg High Yield Index ended the period at 8.89%, providing new alternatives for yield-hungry investors. The S&P 500^® total return index lost 16.1% over Q2 and finished the second quarter in bear market territory. The growth-oriented NASDAQ’s total return was even worse, ending the quarter down almost 30% YTD. Despite terrible performance across the board, the slide was orderly, without the panic selling that investors fear.    

Yields are more attractive than they have been in some time

Investors entered the year with hopes that 2022 would be another above-trend growth story

While the big miss in Q1 (-1.6% vs. 1%, expected) could be explained by inventory normalization after the huge build in the prior quarter, recent data point to a fast deceleration in growth. Expectations had been trending down since peaking in Q321, but the consensus for the year declined sharply in Q2, falling from 3.5% to 2.5%. Even this may prove too hopeful as inflation erodes consumer spending power, the ongoing fight in Ukraine affects food and energy supplies and raises uncertainty, the fiscal purse remains closed, and supply chain uncertainty persists. While the labor market remains strong, inflation is outpacing wage growth. Consumers have dipped into savings and leaned on credit to continue spending, but sentiment – and the desire to buy at these prices – has plunged. The gloomy outlook, despite unemployment of only 3.6%, reflects inflation’s toll.  Personal spending has begun to lag inflation, and without better wage increases, the consumer may not be a tail wind much longer.

Consumer Sentiment is at an all-time low

Inflation continues to come in higher than expected

The most recent prints for Consumer Price Index (CPI) and Producer Price Index (PPI) at 8.6% and 10.8%, respectively, are way too high in the context of average hourly earnings growth of 5.2%. Even the core Personal Consumption Expenditures (PCE), the Fed’s preferred measure that excludes food and energy, at 4.7% is well above policymakers’ 2% target. Chairman Powell acknowledged the pressure on the economy as homes, autos, and a summer vacation become out of reach for average consumers. Board members’ commentary has become increasingly hawkish, and the fact that rates are off their peaks means the message is getting through for now. So far, the Federal Reserve has raised the federal funds rate 3 times this year, starting with a 25bp increase in March and ending the quarter with 50bp and 75bp increases in May and June. Investors are pricing in 175bp-200bp of additional tightening before they think the Fed will have to lower rates in response to the slowing economy sometime in the first half of next year. By the end of the summer, the Fed will be allowing $95billion of its holdings to mature monthly, a program better known as quantitative tightening. Already tight financial conditions are likely to squeeze borrowers more if the Fed tightens in line with expectations which is our base case.

The Fed’s inflation fighting credibility is on the line, and it is likely that policymakers will accept slower growth if that is what it takes to bring prices down. Reality is more complicated, and the Fed is walking a fine line. Workers want higher wages to rebuild purchasing power, and policymakers will see any gains that exceed inflation as too hot. Monetary policy is a blunt tool with lagged results. It is, at best, a potentially counterproductive tool to rebalance markets where more supply is the real answer (like housing). Policymakers will have to balance the lagged effects of tightening with major demand and supply dynamics that are already at work. The glide path to a soft landing is so narrow that one can think of far more reasons for a recession than a happy ending. The good news is that both the consumer and corporate America have reasonably strong balance sheets. If a recession does occur in the next 12 to 18 months, the default cycle may be on the less severe side despite the need to tighten financial conditions aggressively.

Against this backdrop of uncertainty with plenty of negatives, analysts are still in “buy the dip mode” and have not cut earnings estimates in aggregate. Full year 2022 estimated earnings per share (EPS) growth for the S&P 500^® reported by FactSet grew to 10.4% (up from 9.6%) during the quarter with very modest slowing to 7.6% growth next year. This is inconsistent with markets pricing a Fed easing in mid-2023, input cost pressure, and rising fears of a slowdown.

Optimistic earnings estimates, an aggressive Fed, an unhappy consumer, and political risk all add up to a volatile mix. While the repricing we have seen so far is impressive, valuations aren’t extreme in a historical context, nor have we seen panic take hold of the market. The silver lining to the quarter is that there are more opportunities for investors to add value. While we are mindful of the uncertainty going into the second half of the year, this is a good time to hunt for bargains and make sure positioning accounts for the risk of the market hitting an air pocket.