Altium's 2H 2022 Market Outlook

Equity and fixed income markets finished the second quarter the way they started it, and closed out one of the worst six-month periods to begin a year in decades. Rampant inflation, uncertainty surrounding the Federal Reserve’s (Fed) interest rate policy, and recessionary concerns are the main catalysts for this heightened volatility. Market volatility will remain until there is more clarity on what path the Fed will take and how great of a contraction the economy will suffer due to the efforts to curb inflation.


What do we know? The annual inflation rate in the U.S. is the highest it has been since 1981 and it has persisted longer than many anticipated. We also know that the Fed is attempting to slow economic activity (primarily by raising interest rates). This means that economic growth will slow (or contract) and corporate earnings should come down as well. Relating to equities, trends in earnings have a strong correlation with stock returns as when earnings expectations come down, equity prices should fall too. Corporate earnings will continue to be a headline risk as we enter second quarter earnings season.


There is a transition that will eventually occur between the number of times the Fed will raise interest rates and when inflation begins to show signs that it is under control. In other words, at some point, inflation is going to improve and the Fed will stop raising rates. We believe the market can find stability once this inflection point is on the horizon and the economic impact of the Fed’s decisions is discernible


It is impossible to know if the current market correction has fully priced in an economic recession and how investors will react to headlines over the next few months. To provide some historical context to market expectations we prepared a study in this note focused on past recessions and associated market corrections. While market corrections can be unsettling to investors, we believe that it is prudent to stay committed to your specific investment plan during times of uncertainty — see our recession analysis within the note.




Q2 and Full Year 2022 Market Highlights


  • Index returns [1]:

Major Asset Class Returns in Q2 2022

Source: 2022 Total Return as of 06/28/22, Bloomberg


  • Most global equity markets have experienced high levels of volatility this year with losses picking up in the second quarter

  • Domestic equity markets were down 13% to 15% for the quarter and are down roughly 18% to 19% for the year [1]

  • Fixed income markets have been equally volatile with broad based fixed income assets and municipal bonds down 11% and 9% for the year respectively

  • The impact from interest rate hikes and the market’s focus on Fed policy led to losses in bond markets that we have not seen in years



Current Fed Policy

The Fed has begun an aggressive tightening policy this year to address the persistent inflation threat we are seeing in the economy.


Fed Chairman Powell stated that the Fed looks at real yields across the yield curve to help judge financial conditions. Real yields, which are nominal yields adjusted for inflation, remain negative in some short-term bonds meaning the Fed still has work to do before they ease their tightening plans. For example, if a 5-year treasury bond is yielding 3.1% and 5-year inflation expectations are 3.1%, the real yield would be zero. This is not good for a saver’s purchasing power.


This is important because going back to 1990, the Fed has never ended a tightening cycle with negative real yields. Therefore, for shorter term real yields to turn positive, we need short-term treasury yields to increase or short-term inflation expectations (heavily influenced by oil, food, and energy prices) to decline.


We will continue to focus on the short end of the interest rate yield curve and real rates to understand when the Fed might be approaching a neutral rate level. Investors will be closely watching for the Fed policy rate to be higher than foreseeable inflation projections before the market believes the Fed has been successful. This transition will be important for markets in search of stability.




Recession Analysis


A recession is declared when the economy experiences a prolonged contraction as measured by factors such as gross domestic product (GDP), unemployment rates, retail sales and income levels to name a few. If looking simply at GDP contraction, it’s conceivable that we are nearing a recession; However, the economy has demonstrated resiliency. While a higher cost of living is undoubtedly pressuring discretionary spending and reducing any excess savings, consumers maintain a healthy balance sheet (consumer debt to income ratios and excess cash are manageable and employment conditions remain robust). Similarly, corporations are well positioned (although earnings expectations are at risk). We believe investors will ultimately focus on the depth, or severity, of a recession, not simply whether or not a recession is declared.



Study of Past Recessions (see table below) [2]


  • There have been 14 recessions since the Great Depression

  • A full economic cycle has lasted 6 to 7 years on average (stages include expansion, peak, contraction, and trough)

  • The average recession has lasted less than one year (recessions are part of the contraction stage)

  • The average S&P 500 Index decline (from peak to trough) during recessionary periods was 30%

  • On average, the S&P 500 Index has increased 22% in the three months following its bottom and 49% after one year

  • While each recession is unique, a parallel can be made between the current economic environment and the 1981-82 recessionary period in this study

  • Fed Chairman Volcker in 1981 was committed to fighting runaway inflation with an aggressive tightening policy and was ultimately successful; Current Fed Chairman Powell believes a similar policy is warranted

  • The U.S. economy today (specifically with strong employment) is in much better shape than it was when it entered the 1981 recession

  • During the 1981 recession, which lasted just over 1 year, the S&P 500 Index corrected 27% to its bottom before recovering 41% in three months and 66% in one year

  • Currently, the S&P has corrected roughly 24% from its peak earlier this year


Recessions Post The Great Depression

Source: Bloomberg & Federal Reserve Economic Data (https://fred.stlouisfed.org)




Summary


As we navigate through uncertainty concerning how long the Fed’s tightening cycle will last and the magnitude of the resulting decline in economic activity, we remain committed to our investment process.


All investors have unique circumstances that must be accounted for when making financial decisions. For some clients we see an opportunity given current market volatility and are putting capital to work systematically. For other clients we may be sourcing retirement cash flow needs from non-market-based assets, allowing time for equity-based investments to recover. These strategies will vary based upon individual client circumstances.


For all clients we are consistently looking for portfolio rebalancing opportunities, while measuring the impact of any tax costs to the benefit of trading towards the allocation target. We are also actively searching for tax-motivated trades to execute by reviewing all positions by individual tax lot daily (such as finding losses to carry forward to help reduce existing or future gains). Additionally, we want to review investment policy statements and target allocations with our clients to ensure that objectives are met.



Gregory Slater, CFA, CFP®, CIPM®

Partner, Chief Investment Officer




Appendix


Chart A: 2022 Total Return of Major Asset Class Indexes

Source: Bloomberg; 2022 Total Return, MSCI EAFE, MSCI Emerging market, S&P 500, Barclays Agg & Barclays Muni indexes


1 - Source: Bloomberg: S&P 500 Total Return Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index. Bloomberg Barclays Aggregate Bond Index

2 - Bloomberg S&P index returns and Recession indicator & Federal Reserve Economic Data (https://fred.stlouisfed.com)

 

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The information contained herein is provided for general informational purposes only, reflects the opinions of Altium which may not come to pass, and should not be construed as personalized investment advice. This newsletter contains certain forward-looking statements that indicate future possibilities.


Due to known and unknown risks, other uncertainties and factors, actual results may differ materially from the expectations portrayed in such forward-looking statements. As such, there is no guarantee that the views and opinions expressed in this newsletter will come to pass. Additionally, this newsletter contains information derived from third party sources. Although we believe these third party sources to be reliable, we make no representations as to the accuracy or completeness of any information prepared by any unaffiliated third party incorporated herein, and take no responsibility therefore. Information presented herein is subject to change without notice.


The performance results presented herein simply reflect the performance of various benchmark indices over a period of time and do not represent any actual performance results of Altium. Past performance is no guarantee of future results and there can be no assurance that any particular strategy or investment will prove profitable. Indices are unmanaged. Any reference to a market index is included for illustrative purposes only as it is not possible to directly invest in an index. The figures for each index reflect the reinvestment of dividends, as applicable, but do not reflect the deduction of any fees or expenses, or the deduction of an investment management fee, the incurrence of which would reduce returns. It should not be assumed that your account performance or the volatility of any securities held in your account will correspond directly to any comparative benchmark index. Bonds and fixed income investing involves interest rate risk. When interest rates rise, bond prices generally fall.