An Unusual Downturn

2Q 2022

By Ryan Bouchard with Cliff Aque

Markets have been in a brutal tug-of-war since the end of 2021 due largely to the aftershocks of the COVID pandemic. When the pandemic first hit, the global economy came to a standstill. At the time, governments and central banks did a lot (too much, in hindsight) to try to mitigate the damage. While this may have helped at the time, the combination of shutdowns and assistance would have ripple effects on the economy, contributing to the inflation we see today.

Early in 2022, the Federal Reserve pivoted to a more aggressive stance on fighting inflation, signaling that they would begin to raise interest rates and reduce their massive balance sheet. That was the beginning of a sustained move higher in rates (the 10-year Treasury yield was 1.52% at the end of 2021, and nearly doubled over the next 6 months), which wrung out some speculation in the markets. Many of the most expensive bets in the market – stocks trading at massive valuation multiples with very little (or even nonexistent) earnings and cryptocurrencies – lost more than 50% of their value.

As the year has continued to unfold, China’s sustained pursuit of a zero-COVID policy has restrained global manufacturing output. In late-February, Russia’s invasion of Ukraine prevented Ukrainian grain exports, and coordinated global sanctions against Russia removed a large supplier of energy. All of this added more inflationary pressures to an already tenuous situation.

With inflation appearing to accelerate, and showing no signs of letting up, Fed rhetoric became increasingly more aggressive, ultimately raising rates 0.25% in March, 0.50% in May and 0.75% in June. At the beginning of the year, the market estimated the Federal Funds Rate (the overnight bank lending rate which is the primary rate the Fed controls) would end the year at 0.75-1.00%, but by June, that estimate had risen to 3.25-3.50%. This put upward pressure on all interest rates, which hurt bond prices (when rates rise, bond values fall). While the S&P 500 finished the first half of the year -20.0% (officially qualifying as a “bear market”), bonds – as represented by the Bloomberg US Aggregate Bond Index – were -10.3%.

That was the unusual thing about this downturn: both stocks and bonds fell. Normally, when stocks fall, interest rates drop as investors flock to “safe haven” investments like Treasury bonds which causes bond values to rise and offset some of the portfolio decline. But, because interest rates were on a steady push higher until mid-June (owing to the Fed’s focus on fighting inflation), that neutralized the ability of bonds to mitigate portfolio volatility.

We are finally at a point in the cycle where the hikes in interest rates are having some of the intended effects. Speculation in crypto and “expensive” stocks has fallen, while higher mortgage rates have begun to cool the housing market. Commodities have also started moving lower as some investors fear the Fed might tighten too far and send the economy into recession. West Texas Intermediate Oil, which was above $120 per barrel a month ago, is now trading near $100, and the Bloomberg Commodity Index, which hit an all-time high on June 9th, is down about 15% in less than a month.

While the rate hikes have reduced the market’s inflation expectations, rising interest rates have also driven the dollar higher which has hurt exports. With some economic figures softening, we seem to be back in a “bad news is good news” regime, where the market thinks if the data worsens, there’s a higher probability the Fed might stop tightening and potentially move back to easing.

Nobody knows how the situation will ultimately shake out, when this bear market will end, or even the catalyst to break us out of the bear market, but we are encouraged by a few things. The 20% drop in stock prices has led to more attractive valuations. The forward price-to-earnings ratio was 21x at the start of the year, and is now at 16x, compared to the 25-year average of 17x. Historically, returns following a bear market are some of the best on record (see above) because you can buy stocks “on sale”. Additionally, we use periods like this to potentially enhance client situations down the road by capturing “tax assets” by tax loss harvesting where appropriate. Investing is a long-term activity, and playing the long game means staying diversified, rebalancing, and taking advantage of opportunities when they come along. If you have questions about your portfolio or your financial situation, give us a call. We’re here to help any way we can.