June, Second Quarter 2022 Review and Outlook

• The S&P 500 had its worst first half since 1970 
• The 10yr UST Yield gained 199 basis points to a high of 3.5% 
• Economic measures of inflation hit 40-year highs while market measures are in freefall 
• Markets are pricing a 3% - 3.25% FFR by the end of 2022 and rate cuts in 2023 
• Consumer sentiment is at record lows 

Total Returns:

This year has been a painful year for investors, with most U.S. equity benchmarks down between 20% and 35% from their respective 52-week highs. The S&P 500 registered its worst first half (-20%) since 1970 and its 2nd worst 1H since its inception in 1957. The broad large-cap index declined 16% in Q2 2022, which is its fourth-worst quarter this millennium, behind only the worst quarters of the Global Financial crisis (Q4 2008), the Covid crisis (Q1 2020), and the end of the Dotcom bubble (Q3 2002).   The growth-heavy Nasdaq 100 declined in five of the first six months this year which marked both its worst 1H (-30%) in 20 years (Q2 2002) and its worst quarter (-22% in Q2) since Q4 2008 (Lehman Bros.). The small-cap Russell 2000 cemented its worst 1H performance (-23%) since its inception in 1979. The relative outperformer was the Dow which declined 15% in the 1H of 2022; however, June was its worst-performing month this year.   
 
Soaring inflation, increasingly hawkish global central banks, the Russian war, China lockdowns, food and energy shortages, and growing recession fears continue to be the primary headwinds driving the risk-off price action and record low sentiment.   
 
At the start of the year, markets were pricing in three 25bp FFR rate hikes for all of 2022. At the recent peak on June 14th, they were pricing close to twelve 25bp hikes. Over this period, the 10YR U.S. Treasury Yield rose as much as 199bps from 1.51% to 3.50%, while the national 30-year fixed-rate mortgage nearly doubled from the low 3% level towards 6%. The Bloomberg U.S. Aggregate Bond Index declined 11% in the 1H of 2022. In the prior 45 years dating back to 1976, it has only had four annual declines, with the steepest being 2.9% in 1994.

Over the last three FOMC meetings, the Fed hiked the FFR three times in increasing increments of 25bps (March), 50bps (May), and 75bps (June). June marked the first 75 bps rate hike since 1994. Markets were pricing in a 50bps hike until three sessions before the JFOMC when the monthly CPI (May) and consumer sentiment (June) data came in much worse than expected, raising fears that inflation was becoming more entrenched. That same week the Swiss National Bank surprised global markets with a 50bps rate hike, its first hike in 15 years. Brazil’s central bank raised its lending rate by 50bps, and the Bank of England raised its rate by 25bps while simultaneously cutting its Q2 GDP outlook to -0.3%. Many global central banks are far behind the curve, which has contributed to the worst inflation in more than 40 years. They are now being forced to catch up with rapid tightening that is negatively impacting global economies and capital markets, reducing the likelihood of a soft landing and increasing the possibility of a recession.   
 
Economic measures of inflation remain elevated, with the most recent core CPI (May) excluding food and energy coming in at 6% YoY, down slightly from the peak of 6.5% YoY in March. Headline CPI (May) reached a new 40-year high of 8.6% YoY. Core PPI (May) was 8.3% (YoY), down from its recent peak of 9.6% YoY in March, while headline PPI came in at 10.8%, down from its recent peak of 11.5% in March. The PCE deflator (May) was 6.3% YoY, down from a high of 6.6% in March. Core PCE (May) came in at 4.7% YoY, down from the recent high of 5.3% in February.   
 
While economic measures of inflation are at or near multi-decade highs, market measures of inflation tell a different story. 5YR breakevens retraced 120bps from their peak of 3.76% in March to a low of 2.56% in June, while 10YR breakevens gave back 78bps from 3.08% in March to a low of 2.29% in June. The typically less volatile 5YR Forward breakevens, capturing years 6 through 10 of the 10YR breakeven, fell 64bps from a high of 2.68% in April to its June low of 2.03%.   

Total Returns: 

The Russell 1000 Large-Cap Value Index (RLV) outperformed the Russell 1000 Large-Cap Growth Index (RLG) by more than 15 percentage points through 1H 2022. This is Value’s 2nd best outperformance since the inception of the Russell indices in 1978. Value’s record outperformance took place in 2000 when the Value Index outperformed Growth by 28 percentage points. 2000 started a streak of seven consecutive years of Value outperformance. From a technical perspective, the below relative strength chart plotting the ratio of Growth over Value (RLG / RLV, weekly period) depicts a textbook “bearish reversal” pattern (double top), which was confirmed in April of 2022 on the break below the prior low. The ratio is currently trading just below the prior support suggesting Value’s outperformance could still be in the early-to-mid stages of a longer-term trend. 

Total Returns: 

Ten of 11 sectors are in the red YTD. Energy is the lone sector in the green (+32% YTD) despite declining nearly 17% in June. All eleven sectors were lower in both June and Q2. Notable standouts include Consumer Discretionary, with a 26% decline in Q2. its worst quarter since its inception in 1989, while Communications and Technology each declined more than 20% in Q2. The standout in June was the Materials sector which declined nearly 14% and may support the viewpoint that peak inflation is behind us.   
 
The below weekly period chart of the S&P 500 Materials Index shows a convincing breakdown below an 11-month support level which projects a minimum measured move, based on traditional technical analysis, down 6-7% to the 427 level. 

Rates, Commodities and the Dollar 

The chart below plots the U.S. Treasury Yield Curve at the end of 2021 (blue) and the end of 1H 2022 (red). The biggest net advance (lower panel) was led by the 12M, 6M, 2yr, and 3yr maturities, and the 10yr is inverted versus the 3yr, 5yr, and 7yr.   

The long-term chart of the 10YR UST Yield (quarterly period) going back to the late 1970s shows a “bullish breakout” in Q2 above a clearly defined, 40-year downtrend line. Despite reaching a high of 3.50% in June, it closed the month back below 3%, which has been a level that has previously marked major highs and lows going back to 2003. While there are a growing number of market measures suggesting peak inflation could be behind us, which is one argument supportive of bonds and lower rates, the Fed’s QT program and the increasing supply of Treasuries coming down the pipe are fueling debate regarding the future path of rates.

The Bloomberg Commodity Index (BCOM) gained 19% in the 1H, following a 27% gain in 2021. However, it retraced nearly 17% from its highs in March, and June was its 3rd worst monthly decline (-11%) since 2008. WTI Crude declined 8% in June, which ended a streak of six consecutive monthly gains. WTI finished the 1H with a gain of 41%, following a 55% gain in 2021. After peaking in March at $130.50, its highest level since 2008, it has since been consolidating in a sideways range following a prior steep uptrend. Separately, the U.S. Strategic Petroleum Reserve (SPR) is down to its lowest level since 1986.   

Copper declined more than 27% from its March highs and -20% YTD. Over the latter half of June, the copper to gold ratio (chart below), a popular barometer of global economic activity, has broken a 15-month support level and has already retraced most of the parabolic uptrend previously made in Q1 2021. The ratio finished June at its lowest level since February 2021, which favors a bias for continued downward movement.   

The increasingly hawkish Federal Reserve, along with the global “risk-off” price action, led to a 10% gain in the US Dollar Index (DXY). The Euro declined 8% in the 1H vs. the greenback, while the Japanese Yen was down 18%. While most global central banks are tightening monetary policy via rate hikes, the Bank of Japan is an outlier. To the detriment of its currency, the BoJ has implemented yield curve control (YCC) by locking its long rate at 25bps. While the Yen has already depreciated a significant amount, it made a significant technical breakout back in April when it crossed above a 15-year resistance level. From a technical perspective, breakouts from long-term bases signal the start of a new trend that can often be more powerful and longer-lasting than what many would normally expect.   

Corporate Earnings 

Q2 earnings season is on the horizon. Reported earnings and management guidance are likely to have a significant impact on the stock market. According to Factset, 103 S&P 500 companies have provided guidance for Q2, of which 70% have been negative. This compares to the five- and 10-year averages of 60% and 67%, respectively. The earnings growth rate is expected to be 4.3% which would mark the lowest since Q4 2020 (3.8%). Revenue growth is expected to be 10.2% which would mark the sixth consecutive quarter above 10%. However, Q3 and Q4 earnings growth rates are both expected to be above 10%. A key question is whether companies can continue to enjoy the record operating margins seen over the past few quarters. As of June 24th, the forward 12-month PE ratio for the S&P 500 is 15.8, which is below the five- and ten-year averages of 18.6 and 16.9. 

Looking Ahead

There is a great deal of uncertainty for the 2H of 2022 regarding economic growth, earnings growth, inflation, rate hikes, quantitative tightening, the Russian war, and food and energy supplies. While economic measures of inflation are hovering at 40-year highs, market measures have been rapidly falling since early June. The labor market and unemployment are still positive; however, consumer sentiment reached a record low in June. The steep selling initially led by high multiple growth stocks has rotated into the Value, defensive, and commodity groups. It is unclear how sensitive the economy is to rapidly rising rates. The overnight FFR is currently at the 1.50% – 1.75% range. While the bond market is currently pricing an FFR range of 3% - 3.25% by the end of 2022, it is also pricing in a 50bps rate cut in 2023, which implies an increasing risk of recession and a dovish pivot by the Fed. Both commodities and rates are continuing lower starting July, and the 10yr UST Yield hit a low of 2.79%. The big banks kick off earnings season in the next two weeks, and markets will be keenly focused on management’s commentary and guidance.   

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