Quarterly Market Review and Outlook
2022 Q2 Market Re-Cap
If you thought the economy and financial markets in 2020 were confusing and difficult, then 2022 just said “hold my drink.” So far, this year is a year of worsts—the worst bond market, the worst first half for the U.S. stock market, and the worst inflation in 50 years.
We will not nitpick the fine details other than to say it’s ugly. Depending upon which index you are tracking, U.S. stocks are down between 15%-30%.[i]
The U.S. bond market, on a relative basis, has been worse. Consider that the worst calendar year for the U.S. bond market since 1976 was -2.92%.[ii] For the first half of 2022, U.S. bonds have declined 10%.[iii] Unless bonds have a dramatic performance in the second half of the year (we do not expect that), the U.S. market is set to have its worst performance in modern history times three.
2022 Q3 Outlook & Beyond
Rock and A Hard Place: Reduce Inflation Without Causing a Recession
We will not dwell on the inflation data other than to reiterate that inflation is running a pace not seen in four decades. For sure, people are feeling the high fuel and food costs.
How did we get here? COVID-19, policy mistakes in Washington D.C., The Federal Reserve Board, and the Ukrainian conflict all, in our view, played a role.
A sizable portion of the blame rests in the historic flow of money in the aftermath of COVID as well as, in our opinion, policy mistakes in Washington, D.C. It turns out there are implications of the U.S. government printing and spending unprecedented amounts of money! The total spent exceeded $5.2 trillion. We are thankful other “proposed” stimulus packages failed to pass—that would have been throwing fuel on the fire.
Many will point to continued supply chain challenges and the Ukrainian conflict, and while those have had an impact, inflation was increasing prior to Russia’s invasion of Ukraine and supply chain challenges have existed since the beginning of COVID.
The Federal Reserve Board, in our view, must take a good bit of the blame. The Fed has many roles to play in our financial system, but one of the most important, is to control inflation. Early on, the Fed insisted that inflation was “transitory.” Later, many criticized the Fed for not raising interest rates sooner. Some argue the Fed has shown their true colors and are simply a “political animal” much like the D.C. swamp.
The blame is important to some, but the real question is how does the problem of high inflation get fixed?
The Administration and Congress could have a role to play. We don’t see this Administration changing their policy on U.S. energy production and regulation. They are too entrenched in green energy and climate change. If that is their singular focus, we don’t see a significant reduction in price of fuel. The recent Supreme Court’s EPA ruling should provide long term benefits to the energy sector in the U.S., but probably will not provide short term cost relief. Congress isn’t likely to pass any meaningful legislation because of where we are in the upcoming November election cycle. After November and until 2024, we are likely to have “gridlock” and not have anything meaningful pass.
With that being said, The Federal Reserve Board, will need to take on the primary role in battling inflation. One of the Fed’s primary tools to bring down inflation is to raise interest rates. So far this year, they have raised rates three times, taking the rate from 0%/.25% to 1.50%/1.75%. They have clearly laid out the plan to raise rates five additional times this year to somewhere around 2.75%/3.00%.
The knife edge the Fed is walking is whether or not these rate increases will stall the economy so much, that we will actually go into recession.
Technically a recession is where we have two consecutive quarters of negative GDP growth. First, we would remind everyone that Q1 2022 GDP was negative. Further, according to the Atlanta Federal Reserve’s GDPNow indicator, recent second quarter projections look like the possibility of negative growth. If that is the case, by the traditional definition, we may already be in a recession.
There are, however, several positive contrarian indicators to being in a current recession. U.S. Corporate earnings were, in large part, at or exceeding expectations in the first half of this year. Also, we would typically see rising unemployment numbers as the economy weakens. There is some evidence of hiring freezes and layoffs in a few sectors, but generally speaking unemployment is not the problem as employers can’t seem to find enough employees to meet their needs. In March 2022, job openings were at a record high of 11,855,000.[iv] There was a slight decline in April, but there were still 11,400,000 job openings.[v] This is not the type of unemployment data that we would traditionally expect from an economy in recession.
Financial Market Situation
As we discussed above, 2022 has been, so far, a year of worsts.
Generally speaking, our clients have navigated these challenging market conditions better than the market averages would suggest by holding a higher-than-normal level of cash, focusing on alternative rather than traditional bond allocations, and through a shift away from growth stocks to value stocks. These have all helped limit the “damage” delivered by the broad market averages.
In the short term, we would not be surprised to see the stock market move sideways as data confirms the impact of inflation on Americans and by extension the U.S. economy. Companies will begin to report second quarter numbers shortly. Just as we’ve seen this year, any company missing estimates or issuing bleak forward guidance will see their stock price get punished. Investors will simply have little tolerance for missing on earnings targets in the current landscape.
In our opinion, it is a fool’s errand to time or predict the bottom of a market decline—it just cannot be done consistently and accurately over a long period of time. However, it is prudent to examine history as a guide to obtain a sense of where value could begin to emerge. Currently, we’d suggest that the overall U.S. stock market is about fairly valued now—not overvalued, but not significantly undervalued either. As evidence of that, price to earnings ratios for U.S. stocks have fallen since the beginning of the year but are currently at the historical market average of just under twenty.
If U.S. stocks, however, fall much more than they already have and assuming bond yields do not increase significantly, then we would suggest that the potential for a real buying opportunity may emerge. Many have heard us say this before, we make money when we buy, not when we sell. At some point, the risk of not buying stocks will be greater than buying.
To be clear, we are not advocating for a dramatic increase in stock or traditional bond exposure at this point. We think for now, clients should hold their current positions and for clients with new cash, use a dollar cost averaging strategy to enter the markets slowly. There will be a time for bold action later when either clarity emerges or, in our judgement, we see value return to the markets.
The Political Landscape and The Media
We do not think it is much of a stretch to say that the political climate in the U.S. is toxic. No matter where you fall on the political spectrum, civility and reasonableness seem to be in short supply. Confidence in our national institutions is at an all-time low.
We don’t have a lot of faith that the real day to day problems that Americans face will get solved anytime soon by our elected officials. We think a substantial part of the problem is the fact that few in D.C. have actually had a real job. Almost all are career politicians or bureaucrats. How can people who have never worked in the private sector, made payroll, or gone to the bank to risk their future on a business venture fix the nation’s economic problems?
The media could be even worse—we would even characterize the media as poisonous. We have little faith in the national media reporting “just the facts.” The ship has sailed on the idea that the media is objective and without bias.
What do we have confidence in?
We have confidence in our system of government. We have said before that we think the Founding Fathers were near genius in crafting our founding documents. They weren’t perfect, but when judged through the lens of the time they were in, they put together a system of checks and balances that have endured the test of time for 250 years. They have allowed this country to prosper to become the greatest economic power in the history of the world where people have freedom and fundamental rights. Our founding and history are not without blemishes, but we invite anyone to make a comparison that shows another system of government that is superior to ours.
We also believe in capitalism and our economic system. U.S. companies are good innovators and good corporate citizens. Have you ever thought about why the great technology companies of the world are all U.S. companies? Apple, Microsoft, and Google all originated on the U.S.—why? Because our system allows for risk and innovation to be rewarded. No government could have ever created these great companies. It was private enterprise and the risk and reward dynamic that allowed these companies to flourish.
It is certainly not our intention in any of this writing to come off as bleak or pessimistic. We believe that we can be optimistic and realistic at the same time. We believe in the American people, our system of government, and in our capitalistic system to revive and restore the economy.
While the short-term may look uncertain, the longer-term picture offers some silver linings. Several of our favored economists tend to concur—
Kiplinger: “Inflation 6.7% at end 2022”.[vi] (Still high but trending the right way.)
First Trust: “Even more unlikely is the notion that the U.S. is on the cutting edge of a recession like the one in 2008-09.”[vii] (Their take is the next recession, whether it is now or later, will be mild.)
First Trust: Average S&P 500 Intra-year pullback during mid-term election year is 16.3%. Average return 1 year after low date is 37.2%.[viii] (The stock market often dips in a national mid-term election, like we are having in November, but has a significant bounce in the 12 months after.)
Bob Brinker: “Based on our expectation that a slower economic growth track will reduce pressure on long-term interest rates, we continue to favor our 18 to 20 times forward operating earnings price/earnings multiple range, which should enable the S&P 500 to challenge the 5000 level during the first-half of 2023.”[ix] (With a current S&P 500 at 3831, that implies a 30% gain if his expectation is true.)
We continue to be unwilling to bet against the long-term potential of the U.S. economy and innovative companies within our great country. Recessions and bear markets are scary, but the U.S. economy or stock market has a history of recovering and reaching new heights.
Finally, and most importantly, we will continue to review client accounts to ensure that they are properly and prudently positioned relative to your financial goals and objectives. We cannot control the stock market, the economy or who is in Washington D.C., but we can adapt and adjust where appropriate.
As always, we thank you for your continued trust and confidence. Our relationship with you means a great deal to us. If you have any questions that you would like to discuss, please do not hesitate to contact us.
We hope that you and your family have a wonderful summer!
[vi] “The Kiplinger Letter.” Volume 99, Number 23. June 9, 2022. 1100 13th Street NW, Washington, DC 20005. Kiplinger.com.
Securities offered through First Heartland Capital ®, Inc., member FINRA/SIPC. Advisory Services offered through First Heartland ® Consultants, Inc. Walker, Higgins & Associates, LLC and Walker, Higgins & Associates Wealth Management, LLC are independent of First Heartland Capital ®, Inc. and First Heartland ® Consultants, Inc.