The second quarter was marked by exceptional weakness as the S&P 500® declined by 16.4% with very few places to hide. For the first half of the year, the index is down 20.6% reaching bear market status for the second time in just a little over two years. Market weakness was driven by Fed tightening and raising the Fed Funds rate to cool inflation which has been at multi-decade highs. Inflation as measured by the Consumer Price Index (CPI) rose 8.6% from May 2021 to May 2022, the largest increase since December 1981. The Fed responded by increasing the Fed Funds rate by 0.75% to 1.50% -1.75%, the largest rate hike since 1994. In addition, beginning in June, the Fed started to let $47.5B of securities roll off the balance sheet per month, ramping up to $95B per month In September. Investors are concerned that the Fed’s tightening and rate hikes, though necessary to combat inflation, could lead to a recession. The Atlanta Fed’s GDPNow model is predicting a 2.1% decline in GDP during Q2, suggesting that we may already be in a recession. As a result of the concerns about inflation and the Fed’s ability to control it while avoiding a recession, there were very few places to hide as both stock and bonds declined for two consecutive quarters for the first time in four decades with only one sector in the S&P 500 (Energy) in positive territory thru the first half. One point of optimism may be that the yield on 10-yr treasuries closed the quarter at 3.02% after reaching a 3.5% in June. Commodities also declined from recent highs, with oil closing at $105.97 off its 2022 highs of $130.50 and copper closing down 1.3% in Q2. While commodity declines and the recent decline in 10-yr treasury rates suggest that inflation possibly peaked last month, the declines could also suggest that future demand may be negatively impacted by a recession. Stock performance in the second half will likely depend on a possible moderation in inflation and in the Fed’s pace of rate hikes and quantitative tightening.
Portfolio Equity Positioning:
During the quarter, we maintained our defensive posture further reducing our Consumer Discretionary sector exposure while buying Lockheed Martin which has a solid dividend and is less dependent on the macroeconomic environment. We remain overweight in Consumer Staples and Healthcare relative to the S&P 500® Index.
Outlook:
In the second half, we expect the market will continue to experience elevated volatility in both directions until investors gain more clarity on inflation and the aggressiveness of Fed policy. There is potential for a market rebound later this year if inflation moderates and the Fed becomes more measured in its future rate increases and quantitative tightening. We expect companies to be more conservative in their guidance during the upcoming earnings calls and earnings estimates will likely decline as a result. Equities, particularly dividend payers, should continue to be a good hedge against inflation.
Important Disclosures
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