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Q2 2022 Market Commentary: Don't Fight the Fed

August 27, 2022
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Key Takeaways:

1. The Federal Reserve raised interest rates by 0.50% in May, 0.75% in June, and is expected to raise rates again by 0.75% in July.
2. U.S. stocks were down by -21.6% through the first half of the year, and bonds were down by -9.6%.(1)
3. Inflation has risen, but expectations for future increases have fallen. Commodity prices such as oil, corn, wheat, and soybeans are down over -20%.(1)(2)

Through the end of June, markets experienced their second worst start to a year in history. A higher-than expected May inflation reading further exacerbated this decline and triggered a broad selloff to end the quarter, with the Russell 3000 down -21.6%, international stocks down -26.4%, and bonds declining -9.6%.(1)

However, beneath the surface of these broad declines, not all stocks and bonds performed equally. Speculative stocks, including the flood of IPO’s from 2021, are down anywhere from -60% to -80% from their highs. Companies with more established businesses, in sectors such as industrials and consumer staples, fared better but are still down -11.5% so far this year. This divergence is also apparent in the bond market. Long duration bonds, which mature in 20+ years, and are more sensitive to interest rate moves, were down -19.8% through the first half of the year. Conversely, short maturity bonds with terms of 1-3 years, are down a more modest -2.9%. The wide range of returns within stocks and bonds demonstrates that proper portfolio diversification is more important now than ever, and that sticking with a long-term investment plan can help investors navigate volatile markets.

There were a number of headlines in Q2, but most analysts were rightfully focused on inflation. On May 4th, the Federal Reserve raised interest rates by 0.50%, and announced plans to raise rates by 0.50% again in June.  That day stocks roared higher, as investors gained clarity on the Fed’s plan to fight inflation. But shortly after May’s surprise inflation reading, the Federal Reserve was forced to adjust course and increased their telegraphed rate hike from 0.50% to 0.75%. Following this move, investors received a mixed bag of macroeconomic data, further complicating the Fed’s path through the end of the year. Multiple Wall Street analysts have now increased the odds of a global recession and speculation on slower economic activity is causing commodity prices to fall. Oil is thelatest example, which has dropped by 20% to pre-Russia Ukraine war levels. Other commodities such as copper, corn, wheat, and soybeans are down -23%, -30%, -37%, and -27%, respectively, from their 2022 highs.

The rising probability of a recession is not only generating fear across commodity markets but in asset prices overall. Generally, a recession is defined as two consecutive quarters of negative GDP growth. Despite the record economic growth of the past two years, economists are seeing signs of slowing growth across various industries. Whether it is manufacturing data or new home sales, consumers are beginning to spend less and have become historically pessimistic about the economy. In addition, the Atlanta Fed’s GDP predictor is now forecasting a second consecutive quarter of negative growth. As investors, we would like to see these indicators be positive, but in a “bad news is good news” inflationary environment these negative indicators are what the Federal Reserve wants to see.

Signs of slowing growth puts less pressure on rising prices, and signals that the Federal Reserve’s policy is beginning to make a dent in inflation. If the Fed continues to see signs of slowing growth, we can
expect inflation to slow too, and investors will stand to benefit going forward as further rate hikes will not be necessary.


JFG Outlook


We enter the second half of 2022 with a high level of uncertainty. With little resolution in Ukraine, and stubbornly high inflation, it is likely that markets will remain volatile until a catalyst emerges.

The expression “Don’t fight the Fed” came from the post financial crisis era of expansionary monetary policy and government stimulus. During that time, the government’s injection of money into the economy created a windfall for both stocks and bonds. But now, as the Federal Reserve doubles down on their commitment to fight inflation by raising interest rates and shrinking their balance sheet, the Fed has served as a headwind to bond and stock investors. In our Q4 2021 commentary, we cautioned that bonds would be at risk against rising rates, and while we believe that the Fed is making progress against inflation, investors must tread carefully when adding to their bond allocation. This is evident within investment grade corporate bonds, which now yield 4.27% versus 1.67% a year ago. This is their highest yield since 2010, and the higher yield represents a silver lining for investing in bonds during this rising rate environment. The FedWatch tool from the Chicago Mercantile Exchange is now predicting the Federal Reserve will stop raising rates, and possibly even begin lowering rates, in 2023. The removal of restrictive monetary policy would be a welcomed sign for investors, and serve as the catalyst we are looking for.


According to JP Morgan Asset Management, in the previous eight consumer sentiment lows dating back to 1971, the average subsequent 12 month return of the S&P 500 was +24.9%. In June, the consumer sentiment index reading was 50.0, lower than readings during both the 2008 financial crisis and in 1980 when inflation was near 14.5% and unemployment was over 7.5%. (3) It is nearly impossible to predict the lows, but history has shown that buying during uncertainty has benefitted investors in the subsequent
months.

In Q4 2021, it was our view that clients should remain invested in high-quality stocks to weather rising rates and inflation. One sign of high-quality companies is their ability to return profits to shareholders in
the form of dividends. In the second quarter, companies in the S&P 500 paid out a record $140.6 billion in dividends according to S&P Dow Jones Indices. (4) These companies have also seen their share prices significantly outperform the broader equity market this year. While the Russell 3000 was down -21.7%, the SPDR High Dividend ETF was only down -3.4%.(1) We believe select growth companies could outperform in the coming months, but allocating to high quality stocks in your portfolio has led to relative
outperformance so far this year. After numerous rate hikes, the outlook for the bond market has improved, and stocks with solid fundamentals should be well positioned to navigate a challenging economic environment. But as long as inflation remains stubbornly high, “Don’t fight the Fed.”


Thank you for your continued trust in the Juno Financial Group


Sources
1. FactSet
2. https://fred.stlouisfed.org/series/T5YIE
3. https://am.jpmorgan.com/content/dam/jpm-am-aem/global/en/insights/market-insights/guide-to-the-markets/mi-guide-to-the-markets-us.pdf
4. https://www.wsj.com/articles/dividend-payouts-hit-record-despite-rocky-stretch-in-markets-11657618381?mod=djemMoneyBeat_us