Although no major new development drove the narrative during the second quarter, the economy and financial markets struggled. And while last quarter’s big concern, the Russia-Ukraine conflict, continues, it no longer appears at the forefront of investor thought. Rising inflation, domestic tension, and political divide also appear concerning, but predominately rising inflation.
Indeed, inflation continues to be problematic, with the Consumer Price Index reporting an 8.6% annual increase in prices for the 12 months ending in May. This was the highest rate of inflation reported in 40 years. Within the CPI, food and energy prices rose most significantly, thus amplifying the headline statistic. However, ignoring food and energy prices, core prices rose by an equally concerning 6%, a far cry from the Fed’s target of 2%. With inflation of food and energy appearing to be mostly supply-driven, one must wonder how quickly or effectively Fed policy can affect prices. And how does the Fed keep the inflationary pressures delivered by food and energy from filtering down to other consumer goods?
The Fed has made fighting inflation its top priority. To this end, they raised the Fed Funds rate by 75 basis points to 1.75% at their June meeting, while signaling that more restrictive rates are likely in the future. In addition to increasing rates, the Fed has also indicated that they will begin a quantitative tightening program. This involves the unwinding of nearly $9 trillion from the Federal Reserve’s balance sheet, which had been accumulated over many years. Accumulation of these assets, which accelerated in 2020, involved the buying of securities to pump additional liquidity into the markets. Although this quantitative tightening will be done gradually, the impact of reduced liquidity may well be significant to both the economy and to financial markets.
Labor markets remain steady, with the unemployment rate at 3.6% for May, the same level reported in March. Hourly earnings reported in May were up 5.2% year over year. Despite the apparent strength in employment numbers and wages, consumer confidence continues to decline. The Consumer Confidence Index fell to 98.7, from last quarter’s reading of 107.6. Given this, it may not be surprising that retail sales also fell during the quarter. It’s quite possible that the consumer, the stalwart that has willingly spent, propping up the economy through thick and thin for the past several years, is finally growing wary.
The manufacturing sector is also showing some signs of weakness, as payroll growth slows and confidence among manufacturers declines. Manufacturing payrolls grew by 18,000 in May and although it is still expanding, that growth was less than half the expected total. Other indices, which measure sentiment among domestic manufacturers, remain slightly positive as well, yet show similar weakness or decline. For example, the ISM Manufacturing survey dropped to 53 in June, its lowest level in two years, indicating declining confidence within the manufacturing sector.
With first-quarter GDP contracting by 1.6% and our economy facing considerable headwinds this quarter, continued contraction in GDP is possible. Rising prices, higher interest rates, and a wavering consumer will provide plenty of friction against renewing forward momentum. Most pundits expect the economy to have resumed expansion, albeit at a slight pace, in the second quarter. However, these expectations are trending downward. Definitions of recession vary but most would agree that negative economic growth, as defined by the GDP, for consecutive quarters would signal a recession, which is now a distinct possibility.
Responding to increased concerns about inflation, the Fed’s determination to tame it, and subsequent Fed rate hikes, bond yields moved significantly higher during the second quarter. Yields on the 2-year Treasury Note rose by 62 basis points to 2.95% while 10-year Notes rose 58 bps to 3.04%. Subsequently, returns on most bond indices were negative as bond prices generally move in the opposite direction of interest rates.
Spreads (additional yield paid over Treasury yields) on corporate debt, both investment-grade and high-yield, expanded, leading yields for these issues to grow even higher and causing indices representing these bonds to lag the general bond market. Broad indices for investment-grade and high-yield corporates fell by 6.71% and 6.81%, respectively, while Treasuries, as measured by the ICE BofA US Treasury Index (not shown) fell by 3.85%.
Municipal securities, riding the tailwinds of reduced issuance of new bonds and subsequent reduction in supply, performed much better than the other fixed income indices shown here.
As the Federal Reserve continues to hike short-term lending rates to fight inflation, rates on shorter bonds will likely follow suit and trend higher. However, rates on longer maturities will more likely reflect bond market investors’ opinion on how effective these rate hikes will be on the fight against inflation.
If inflation is thought to be under control, then longer-term yields may rise slower than short rates or even decline, leading to an inverted yield curve (higher rates on short-term debt than on long-term debt). If investors believe inflation will remain problematic, then longer rates may move even higher.
Treasury yields of selected maturities for recent time periods are displayed below (data from Bloomberg).
|Treasury Bill||Treasury Notes & Bonds|
|3 mo.||2 yr.||5 yr.||10 yr.||30 yr.|
Total return numbers for various fixed income indices over the past quarter and 12 months are below (data from Bloomberg).
|Fixed Income Returns|
2nd Qtr. 2022
Last 12 mo.
|BBerg US Aggregate Bond Index||-4.69%||-10.29%|
|BBerg Intermediate US Gov./Credit Index||-1.11%||-7.28%|
|ICE BofA US Corporate Bond Index||-6.71%||-13.83%|
|ICE BofA US High Yield Bond Index||-6.81%||-12.66%|
|BBerg Global Aggregate Bond Index||-8.26%||-15.25%|
|ICE BofA US Municipal AAA Securities Index||-0.75%||-5.08%|
Equity markets declined broadly and sharply during the quarter, posting consecutive quarterly losses for the first time since 2009. The NASDAQ, heavily weighted with growth-oriented tech companies and a long-running market-leading index, posted the most significant setback with a 22.27% quarterly loss. The Dow Jones Industrial Average, representing more established companies, has been granted a reprieve from consistently being among the laggards and led all indices displayed below during the second quarter with a -10.78% return. Nonetheless, all major indices shown below were hit with double-digit declines in value in the second quarter. Similarly, all these same indices are down in value over the past 12 months.
Continuing the reversal of a long-term trend, value stock returns dominated growth stocks during the second quarter. While both indices still posted losses, the S&P 500 Value Index lost 11.28% while the S&P 500 Growth Index lost 20.81% for the quarter. Year-to-date returns paint a similar picture, as results for value versus growth for this period are -11.42% and -27.62%, respectively.
During the first quarter, inflation and higher interest rates pressured corporate profits, which fell at a 2.3% annual rate according to the Department of Commerce. Add a newly cautious consumer to the mix, and profits are likely to remain under pressure. The lingering question is, have stock prices already adjusted adequately for potentially lower corporate profits and a slowing economy? Although stock price levels have adjusted substantially in the past two quarters, volatility will likely continue as the market attempts to find firm footing.
Below is a table displaying various equity index returns for the past quarter (data from Bloomberg).
|Equity Indices||2nd Quarter 2022||Last 12 mo.|
|Dow Jones Industrial||-10.78%||-9.05%|
|S&P 500 Growth||-20.81%||-16.41%|
|S&P 500 Value||-11.28%||-4.89%|
|Russell 2000 (small-cap)||-17.21%||-25.24%|
|MSCI/EAFE (developed international)||-14.32%||-17.26%|
|MSCI/EM (emerging markets)||-11.40%||-15.08%|
All 11 sectors of the S&P 500 lost value during the second quarter. Even Energy, riding the wave of higher prices and corporate profits, did not overcome the negative sentiment that swept through second quarter markets. Although all lost value, wide disparity in returns among sectors was again apparent.
Like the first quarter, defensive sectors such as Consumer Staples, Utilities, and Health Care held their value much better than average, posting returns of -4.62%, -5.09%, and -5.29%, respectively. Likewise, sectors that represent more discretionary items like Information Technology (returning -20.24%), Communication Services (-20.71%), and of course, Consumer Discretionary (26.16%) trailed the market over the second quarter for sector returns.
The following table details S&P 500 sector total returns for the quarter (data from Bloomberg).
|Return by Stock Sector||2nd Quarter 2022|
|1. Consumer Staples||-4.62%|
|5. Real Estate||-14.72%|
|7. Basic Materials||-15.90%|
|9. Information Technology||-20.24%|
|10. Communication Services||-20.71%|
|11. Consumer Discretionary||-26.16%|
Learning Center articles, guides, blogs, podcasts, and videos are for informational purposes only and are not an advertisement for a product or service. The accuracy and completeness is not guaranteed and does not constitute legal or tax advice. Please consult with your own tax, legal, and financial advisors.