This article is brought to you in collaboration with our colleagues at Laird Norton Wealth Management from their post, Economic Flash: Job Market Is Key to What Happens Next.
U.S. Economy: Inflation Stings
Despite some bright spots such as the ongoing strength of the U.S. labor market, inflation and tightening by the Federal Reserve are throttling growth with weakening across manufacturing, real estate and a continuing drop in consumer spending. Mortgage applications and home sales fell in June, as consumer sentiment hit an all-time low to 50.0 on the index and retail sales slowed by -0.3% at last reporting.
U.S. Stocks: Earnings a Concern
U.S. equities stabilized in the second half of June but finished down, nearly matching the worst monthly return so far in 2022. Earnings growth has cooled, and forward earnings guidance has turned generally negative. With a potential recession top-of-mind for investors, commodity-sensitive energy and materials were the weakest sectors, dropping by -16.8% and -13.9% respectively.
Foreign Stocks: China Rebounds
Emerging market stocks were buoyed somewhat by a 6.6% rebound in China following its emergence from COVID-19 lockdowns and less concern about a crackdown on tech companies. China is unique among the major global economies in its implementation of pro-growth policies such as tax cuts, infrastructure spending and lower interest rates.
Fixed Income: Fed Tightens More
The Fed surprised markets by raising its key interest rate 75 basis points, with more such increases possible. After the Fed announcement, the 2-year U.S. Treasury yield surged from 2.5% to 3.5% before falling back to 2.9%. That rates came back down suggests investors believe the Fed will get inflation under control, even at the cost of recession.
Real Assets: Commodities Dive
On recession concerns, commodities were the worst-performing sector across financial markets and the real asset category. Losses were broad, with industrial metals, energy and agricultural commodities falling 16%, 15% and 9%, respectively. U.S. gas prices remain elevated but are down 15 cents from the mid-June high of $5.47/gallon.
Alternatives: Softening the Blow
Hedge fund exposures have continued to benefit portfolios by dampening losses. That said, 2022 has been a modest reprieve for managed futures strategies, which generally benefit from persistent market trends in a broad array of commodity and financial derivatives. Such strategies may struggle, and generally have, for years before posting an outsized gain.
Equities Total Returns
Fixed Income Total Returns
The first half of 2022 was one of the worst starts to the year in stock market history. The high-profile stocks of the pandemic era, including Netflix, Nvidia and Meta, are each down more than 45% in the past six months. In fact, 40% of the drop in the S&P 500 in the first half was due to the ten largest stocks on the index, highlighting both the value of diversification and how yesterday’s winners can turn into losers as market expectations change.
Investors’ focus has shifted over the last few months from the causes of inflation, such as tight labor markets, supply chain shocks and accommodative monetary policy, to the impact of inflation on U.S. consumers. The data on that front do not paint a rosy picture. As noted earlier, inflation and the Fed’s response have started to take a toll on consumer spending. Even potential positives, such as falling real estate prices, are not likely to make housing more affordable, given the highest mortgage rates since the 2008 global financial crisis and low vacancy rates driving up rents.
We would not be too surprised if the U.S. economy is actually in the midst of a recession, defined as two consecutive quarters of negative GDP growth, given that first quarter GDP shrank and could also be negative for the second quarter. The severity of recessions can and does vary, notwithstanding the deep downturns that followed the bursting of the dot com bubble in 2000 and real estate bubble in 2008. In any case, recessions are a natural part of the business cycle. Since WWII recessions have typically lasted less than a year and aren’t necessarily marked by long-lasting negative returns in the stock market. Over the last 100 years, the equity market has peaked around six months before a recession began, as recessions are typically priced in advance.
If not recession, the U.S. economy could be facing stagflation in the near term. Two of the three elements of stagflation are already in place — relatively high inflation and low GDP growth – with rising unemployment withstanding. We are long-term investors who structure portfolios to navigate through full economic cycles, both expansionary and recessionary. If stagflation does turn out to be the path, we expect real assets to remain a core component of our positioning thanks to their potential to capture inflation as positive returns. Within equities, we expect our managers to become more defensive, focusing on essential goods and services that consumers buy even when they cost more.
Glossary of Indices
U.S. Large Capitalization = S&P 500 Index
Tracks the performance of a representative sample of 500 leading companies in the major industries of the U.S. economy.
U.S. Small Capitalization = Russell 2000 Index
Tracks performance of the 2,000 smallest companies in the Russell 3000 Index, representative of the U.S. small capitalization equity market.
U.S. Growth Equities = Russell 3000 Growth Index
Tracks the performance of those Russell 3000 companies that have higher price-to-book ratios and higher forecasted growth values.
U.S. Value Equities = Russell 3000 Value Index
Tracks performance of those Russell 3000 companies that have lower price-to-book ratios and lower forecasted growth values.
International Equities (Developed Countries) = MSCI EAFE Index
A float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. Consists of the stock market indices of these 20 developed countries: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.
Emerging Market Equities = MSCI Emerging Markets Index
A float-adjusted market capitalization index designed to measure equity performance in the major emerging markets. Consists of the following 25 emerging-market -country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
U.S. FIXED INCOME, TAXABLE
U.S. Aggregate Bond = Barclays Capital U.S. Aggregate Bond Index
Covers U.S. dollar-denominated, investment-grade, fixed-rate, taxable bond market consisting of SEC-registered securities. Includes U.S. Treasuries, U.S. agency bonds, U.S. corporates, mortgage-based securities (MBS, CMBS) and asset-backed securities (ABS).
TIPS (Treasury Inflation-Protected Securities) = Barclays U.S. Treasury Tips Index
Measures the performance of TIPS of various maturities issued by U.S. Treasury.
INTERNATIONAL FIXED INCOME
International Developed Bonds = BofA Merrill Lynch Global Government Bond II ex U.S.
Measures the performance of non-U.S. developed-market government bonds on an unhedged currency basis.
Emerging Market Bonds = BofA Merrill Lynch Emerging Markets Sovereign
Bond Index Measures the performance of emerging markets government bonds on an unhedged currency basis.
U.S. FIXED INCOME, TAX-EXEMPT
Intermediate Municipal Bonds = Merrill Lynch Municipals, 3-7 Yrs Index
A subset of The Merrill Lynch U.S. Municipal Securities Index, including all securities with a remaining term to final maturity of between 3 and 7 years.
Municipals, Broad Market = Merrill Lynch Municipal Master Index
Tracks the performance of U.S. dollar denominated investment-grade tax-exempt debt publicly issued by U.S. states and territories, and their political subdivisions.
Absolute Return Funds = HFRX Absolute Return Index
Tracks the performance of hedge funds aiming to provide stable performance regardless of market conditions. Such funds tend to be less volatile and less correlated to market benchmarks. Data is based on estimates for the most recent months, may not include performance for the last business day of the indicated month and is subject to revision.
Market Directional Funds = HFRX Market Directional Index
Tracks the performance of hedge funds that add value by participating in the direction of various financial markets. Such funds characteristically have higher expected volatility than Absolute Return strategies (see above). Performance data is based on estimates for the most recent months, may not include performance for the last business day of the indicated month, and is subject to revision.
Equity Volatility = CBOE VIX Index
Aims to measure investor expectations for near-term stock-market volatility as conveyed by the pricing of stock options on the S&P 500 index that mature within 30 days.
Implied Inflation = 10-Yr TIPS Implied Inflation
Gauges investor expectations for future U.S. inflation based on the difference between the yield on a 10-year TIPS (Treasury Inflation Protected Security) and the yield on a nominal 10-year Treasury.
Gold Spot $/oz.
An index intended to measure the current price of gold, based on futures contracts deliverable in the following month priced in U.S. dollars per Troy ounce.
Oil = Brent Crude Oil Spot Price $/bbl
Brent Crude Oil refers to a particular grade of crude oil often quoted in financial reports as the global benchmark for the price of oil. It typically trades at a premium to the West Texas Intermediate price.
U.S. Dollar = Trade-Weighted U.S. Dollar Index
Value of the U.S. dollar relative to a composite of 26 currencies of major U.S. trade partners, weighted based on trade data