Well, the first half of 2022 is in the books and for the broad financial markets and for passive investors it has been an absolute disaster.
The most widely followed US Large Cap Stock index—the S&P 500—put up the second worst start since the Great Depression.
Usually when stock markets are doing so poorly, bond markets are rising but this year investors have faced a double whammy of falling stocks and bonds. The US 10 Year Treasury Bond just had its worst first half of a year going back to just after the American Revolutionary War. The most widely used bond index—the US Aggregate Bond Index—has declined by almost 11% year to date.
So, it goes without saying that for investors without some system of risk management, this year has been very bad.
Now, however, financial assets have become much more attractively priced than at the beginning of the year. Stocks are trading within our range of fair value and bond yields are way too high for continued financial stability.
The next six months in financial markets will be largely determined by the Federal Reserve and the likelihood of a recession.
The Fed is still talking tough on inflation and telling the markets that they will continue to be aggressive with monetary policy. They have said they plan to continue raising rates and reducing their balance sheet assets. We’ve written about what we think they will actually do (stop raising much sooner than their target rate) and recent economic data suggest they may have to pause soon.
The most recent Atlanta Fed Economic Forecast for Q2 is now severely negative. Another negative print on GDP will put us squarely in a recession.
Other real time data is also showing a quickly slowing economy. The bond markets this week rallied on fears of a recession with the 10 Year Yield falling by 0.5%.
The market will most likely react positively to a confirmed recession. That may sound counterintuitive but here is the logic train. The recession hits and is confirmed. The market hates uncertainty and this relieves some of that anxiety. The Fed now has an excuse to pause on monetary tightening and if inflation data slows as well, may have an opportunity to begin to ease policy again. Investors will make assumptions on the length and depth of the recession and begin to look past the earnings decline and begin valuing financial assets on growth once again.
Of the 15 worst starts to a year for the stock market, in 66.66% of those cases the markets rallied through the end of the year. So, expect a period of volatility over the rest of the summer as the markets process the macro-economic data and make their bets on how the Fed will react.
As we’ve written for the last month, we are inclined to add to equity risk at these levels and lower.
