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Cash was king during the second quarter as both the stock and bond markets suffered significant declines. With inflation and interest rates rising, shorter maturity bonds outperformed those with longer maturities. All 10 stock sectors declined during the quarter. For the S&P 500, it was the worst first half of a year since 1970. Energy is the sole sector with positive year-to-date appreciation. For the Aggregate Bond Index, it was the worst start of a year ever according to the Wall Street Journal.
The Fed remains determined to bring down the rate of inflation. After three interest rate hikes this year (0.25%, 0.50% and 0.75%), it appears another 0.75% hike in July is likely. This monetary tightening has produced fears of an economic slowdown. Fed Chairman Powell told Congress that the Fed will keep raising rates until it believes inflation is under control, even if that causes a recession. A higher Fed Funds rate drives up other short-term interest rates which, in turn, reduces liquidity in the economy, depressing corporate investment and consumer borrowing.
This is a reversal of a long-term trend where Fed policies provided a strong wind at the back of the investment markets. Now we are seeing interest rates going up and liquidity going down, the reverse of the conditions that began with the economic bailout of the Great Recession and accelerated with the unprecedented stimulus package and massive expansion of the Fed’s balance sheet following the Covid outbreak.
One argument against falling into a recession is the labor market. We added 1.6 million jobs in the first quarter, while inflation-adjusted "real" GDP declined by an annualized 1.6%. Normally in true economic downturns, we are shedding hundreds of thousands of jobs each month. Instead, even in April and May hiring has proven remarkably strong, with gains of around 400,000 per month--stronger than almost any months we'd seen in the entire expansion before the pandemic hit.
There are no guarantees in the investment world, of course, but history suggests that market downturns represent a buying opportunity for the long-term, and that markets tend to overshoot the actual underlying conditions on the upside and also on the downside.
One of the reasons for a downside overshoot is that human psychology seems to be inverted when it comes to our investments. In the general marketplace, when something goes on sale, people flock to buy. But when stocks and other investments go on sale, people seem to regard it as a selling opportunity.
Second quarter earnings reports and accompanying guidance for the rest of the year will be forthcoming over the next several weeks. The current consensus calls for a 5.1% increase versus the same period last year. For the full year, analysts still anticipate operating earnings for the S&P 500 companies will advance 10.9%, but those estimates have started to be reduced as inflation and supply chain constraints squeeze profit margins.
The first half of the year has not been kind to most investors, but staying invested with an appropriate asset allocation remains important to long-term investment success.