Plum Street Advisors
2022 Q2 Commentary
Inflation has become a primary concern for US consumers. In the Boston area, where several of us at Plum Street Advisors live, the average price for a gallon of milk has gone from $3.54 in January to $4.27 in June – more than a 20% increase. The price of gasoline has increased from $3.14 per gallon at the start of the year (national average) to $4.71 as of June 27th – a 50% increase.
Inflation has become the primary concern for stock and bond markets too. Inflation hurts stock markets because investors fear that the Federal Reserve has to slow the economy – or even push it into a recession – to curb rising prices. The Federal Reserve has been doing this in several ways, the most obvious one being by raising interest rates, which also hurts the current value of future company earnings. The rise in rates has also been a negative for bonds – not because investors are concerned about companies defaulting on their debt, but because the lower fixed rate bonds held in portfolios are now relatively less attractive than the newly issued bonds at higher interest rates.
Inflation has been caused by a strong rebound in consumer demand after the Covid crisis, as Americans have accumulated significant cash savings and our lives begin to return to a pre-COVID normalcy. Also, as demand shifted from goods back to services, there hasn’t been enough labor to fill the need. At the same time, lingering supply chain disruptions from COVID shutdowns and the Russia-Ukraine war have continued to hit manufacturers. For example, General Motors announced that it had almost 100,000 cars that it couldn’t deliver in the second quarter because it lacked computer chips and other parts.
Overall, inflation hit a year-over-year high of 8.6% in March (as measured by the Consumer Price Index).
Fortunately, the rate of increase seems to be slowing down according to several more recent figures. Even the price of oil, which hit $122 per barrel as recently as June 8th, ended the month back down at $106 per barrel (as measured by WTI Crude). The Federal Reserve is widely expected to continue to hike interest rates at its upcoming meetings to get the better of inflation, but the worst fears of runaway inflation are abating. The question that lingers is how far the Fed’s rate increases will take us towards a recession.
Despite concerns about a possible slight GDP decline in the second quarter, the economy seems to be showing continued strength and resilience. There are signs that the supply-chain bottlenecks are easing (lower shipping rates/faster delivery times). Employment remains strong, as the economy added 390,000 jobs in May and unemployment is at just 3.6%. Manufacturing growth slowed a bit, but the growth numbers are still positive.
Overall corporate earnings are expected to grow 10% compared to 2021. The expected S&P 500 earnings in 2022 are being led by the energy sector which is estimating a whopping 120% growth in earnings in 2022 over 2021 due to soaring oil. Financials are the only sector expected to see earnings decline year-over-year, with analysts anticipating an 11% drop for financial companies.
The S&P 500 declined by -16.1% this quarter, which means it has fallen -20.0% year to date. This represents a significant whipsaw compared to the 2021 return of 28.7%. While most asset classes experienced declines this quarter, there were significant differences in the degree. Value stocks on the equity side, and shorter-term bonds on the bond side, held up best in the second quarter.
Value stocks, such as Merck, Exxon Mobil, AT&T, IBM, Dollar General, and Cigna continued to do much better than growth stocks (including Meta Platforms – formerly Facebook, Amazon, Snap, Coinbase, Netflix, and Tesla). Last year, technology stocks, and growth stocks overall saw significant gains as the Russell 1000 Growth Index gained 28% (compared to 25% for the Russell 1000 Value). This year, value stocks have weathered the storm better in the downturn. The Russell 1000 Value Index was down less than -13% year to date, while the Russell 1000 Growth index was down -28% for the year to date (it is often the case that value stocks fall less during a major market downturn).
International stock returns fell less sharply than US stocks, with the MSCI EAFE index of developed market international stocks declining -14.5% in the second quarter compared to the US S&P 500 index decline of -16.1%. The MSCI Emerging Markets Index declined -11.5% in the second quarter and has done relatively better than developed countries this year, despite the war in Eastern Europe.
The Federal Reserve has raised rates by 1.5% so far this year (0.25% in March, 0.50% in May, and another 0.75% in June). We expect to see another increase of 0.50% or 0.75% in July, and more increases before the end of 2022. The future trajectory of interest rates beyond that is quite uncertain. If the Fed succeeds in taming inflation this year, we could see rate declines again as early as 2023.
The 10-year Treasury rate ended the quarter at 3.1%, as mentioned above, up from 2.3% as of the start of the quarter. It had been as low as 0.5% at the low point in 2020. The sharp spike in interest rates from historically low levels has resulted in falling bond prices. Long-term bond price declines of this magnitude have not been seen in several decades.
Bond returns were negative across the board in the second quarter. The Bloomberg Aggregate Bond Index declined -4.7% and the Bloomberg Global Bond Index fell -4.3%. Shorter term bonds tend to be less volatile, but still declined -0.7%. Treasury Inflation Protected Bonds have held up better than the aggregate bond index year to date, but fell a bit more for this quarter, and declined -6.1% (as measured by the TIPS index).
Commodities jumped up in the first quarter, but fell off during the second quarter. After gaining 25.6% in the first quarter, the Bloomberg Commodity Total Return Index declined -5.7% this quarter. Oil still rose slightly over the full quarter, from $100 to $106 per barrel. Gold declined in the second quarter by 6%, ending up close to even for the year.
Financial reporters like to get attention – the more alarmist they can be, the better. The Wall Street Journal recently wrote that 2022 was “the worst first half of the year since 1970”. This is, at best, highly misleading. It makes it sound like this is the biggest downturn since 1970, or at least the biggest downturn in such a short time, but in fact that is not even close. The S&P 500 was down about 20% year to date. This pales in comparison to the 49% decline of the S&P in the 2000 dot com crash, the 57% decline in the 2008 financial crisis, and even the 34% drop within just one month in 2020 at the onset of COVID. It just happens to be an accident of timing that this decline started near the beginning of a calendar year, and the recovery hadn’t started yet after 6 months (hence the “worst half-year” headline). Usually, market declines aren’t that nicely synched up with the calendar. It is irrelevant, misleading, and unhelpful not to put the current decline into proper context.
Volatility is to be expected for long-term investors, and the current stock market downturn is not historically large. Underlying economic indicators remain strong – much better than in past downturns – as we explained above. Stocks are cheaper (the S&P 500 is trading at 16 times the expected coming year of earnings instead of 21 or so at the peak last year), so rebalancing portfolios should prove helpful when markets do recover.
The Covid pandemic has led to a highly unpredictable 2+ years so far. Markets initially fell sharply, then steadily rose for a year and a half, only to give back some of the gains this year. Overall, the US stock market remains well ahead of where we were before it all started (comparing S&P 500 levels at the end of 2019 versus the end of the second quarter of 2022), so we encourage investors to stick with a long-term diversified portfolio which rebalances back to target allocations along the way. The stock market is not like a leaf that blows up and down with the wind – it’s more like a person climbing a mountain where sometimes you have to go back down to find the path that leads to new peaks.