Q-2, 2022 MARKET REVIEW:
The second quarter was exceptionally challenging. In US Dollars (USD) the Bloomberg Aggregate Bond Index lost 1.6%, US Fixed Income Government Bond returns were down 3.8%, and the Standard & Poor’s 500 declined 16.1%. International market performance was no better. The Bloomberg Barclays Global Aggregate declined 3.2% and the MSCI Equities World plummeted 8.6%.
What was behind this disturbing performance? Many factors contributed.
Rising inflation in developed economies is in large part a function of supply chain disruptions, opening of post COVID-emergency economies, and associated dislocation in labor and manufactured product availability. The Ukraine war disrupted the flow of agricultural fertilizer, agricultural products. Western country sanctions imposed on Russian energy and raw materials increased instability. China’s zero COVID pursuit within its geographic borders shuttered manufacturing. Reduced consumer demand in several large cities, including Shanghai with its population of 24.9 million, further contributed to economic instability. Fluctuating demand for metals, minerals and crude oil impacted prices exacerbating inflationary pressure. An example is the price of crude oil. Brent crude rose from around $108 at the start of the quarter to $120 in June 2022. Central banks exhibited a commitment to tamp down inflation and constrain inflationary pressures, increasing short-term borrowing cost and reducing financial liquidity. This proved destabilizing to both the bond and equity markets.
Rising yields unmoored the market’s multiyear extended low borrowing cost environment causing price loss to bonds purchased in that more predictable yield environment. Rising interest rates increased the discount rate for valuing the future performance of established companies, particularly those with investor appeal because of their earnings growth potential. The share price punishment was most severe for companies commanding investor interest because of yet unrealized potential, and lacking positive cash flow and little retained earnings to easily a changed economic environment where there will be a higher cost for borrowed funds and reduced consumer demand.
Between April 2022 and the end of June 2022, market watchers and economist monitored labor, economic and real time indicators of changes in economic activity (high frequency data) in an attempt to discern how intractable inflation was becoming. This informed expectations of the direction and speed of Federal Reserve Bank interest rate tightening. Statements of federal bank board members were carefully examined to better understand whether the Bank was truly committed to reducing liquidity to interdict the growth of inflation or would be more restrained, hoping to forestall a possible recession by pushing interest rates upwards too aggressively. What became clear over the months was how committed the Federal Reserve was to doing whatever the data suggested needed to be done to bring the inflation range within a 2% annual level. With base inflation running at above 6% throughout the quarter it was clear that interest rates would climb sharply and quickly.
In June 2022, the Federal Bank raised its benchmark short-term borrowing cost to 1.75%. In January 2022, that rate was 0.25%. Market observers now believe that rates will probably continue to be raised to an amount just shy of 4%. The good news is that the financial market’s anticipation of continued rate increases has gotten ahead of actual rate increases and is contributing to the slowing of economic activity. Of significant concern is whether the federal reserve can engineer a soft landing for the economy. There is limited positive history of a central bank’s ability to reduce inflation by pushing interest rates up and at the same time precluding a recession. Economic activity is in large part a function of consumer sentiment- the consumers’ willingness to spend across the various components that contribute to a complex and dynamic economy. Consumption can change based on sentiment. In contrast, changing borrowing cost, the tool most readily available to central bankers to slow economic activity, is not a precise tool for combating inflation. Interest rate increases cannot address differing supply and demand dynamics at play in an economy; once deployed, changes to interest rates take time to produce demonstrable results.
The challenge central bankers face in an already slowing economic activity environment is exactly what level of interest rates will slow the economy to the desired target rate of growth without tipping that economy into recession accompanied by a loss of employment, production and economic activity.
Markets have contracted significantly in the past six months making it the worst half-year for developed markets in over fifty years. Equity valuations are below their average since 1990 in every major region other than the US. Though the risk of recession is increasing divesting diversified and quality US equities at this stage would require the ability to time the bottom of the market for reentry. Successfully accomplishing that objective is more a matter of chance than informed judgement and skill. As such maintaining positions in a well-diversified portfolio and waiting through this market turmoil is the preferred investment strategy.
The following illustrate the breadth of change in the domestic equity and debt markets over the past three months.
|US S&P 500**
|Growth (MSCI World Growth)**
|Value (MSCI World Value)**
|Small cap (MSCI World Small Cap)**
|Barclays US Aggregate Bond Index (USD)
**Asset Class Data: JP Morgan, Quarterly Review of Markets
We have for the most part stood apart from these volatile markets anticipating clearer indication of direction. Investments when made have been in index-based holdings to deploy excess cash. We have divested portfolios of positions that targeted disruptive industries, believing these investments will take time to recover. Clients with holdings in bond, dividend and income investments will see paper losses in these portfolios. An environment of rising interest rates makes these investments, regardless of the projected return, less attractive until the terminal interest rates is known. Investors in these securities should, however, continue to receive their interest or dividend returns expected at the time the investments were made. The share price of these portfolios, similar to those of equity investments, will correct themselves over time.
 JP Morgan Asset Management, Mark Bell, Review of markets over the second quarter of 2022,