Q2 2022 Market Update

The second quarter was even more challenging for investors. It was the worst first half of the year for developed market equities in over 50 years. Here is an economic and market update from Sagace Wealth.

After a difficult start to the year, the second quarter was even more challenging for investors.  It was the worst first half of the year for developed market equities in over 50 years.  Bonds, typically the stable asset class during economic turmoil, have also been hit so far this year failing to provide the protection that portfolio managers seek from fixed income.

Bond prices moved significantly lower as a result of expected aggressive increases in interest rates by the Federal Reserve (the Fed) to combat inflation. Bond prices move lower as interest rates rise, and markets now expect interest rates to rise to 3.4%, 3% and 1.6% in the US, UK and Europe, respectively by next year.  The increased trajectory of interest rates has also contributed to a decline in equity valuations, along with concerns about the growth outlook.  Recession fears have risen, due to the squeeze on consumers from higher prices and higher borrowing costs as the central banks seek to fight inflation.

One bright spot is that valuations are now below their average since 1990 in every major region other than the US.  In the US, the cheaper parts of the market now trade at relatively low valuations compared with history.  For example, the Russell 1000 Value Index is trading on a price-to-earnings (P/E) multiple of 13, compared to the Russell 1000 Growth Index that still trades on a P/E of 21.  That’s despite growth stocks having already significantly underperformed value stocks so far this year.  The Russell 1000 Growth Index is down 28% year to date, whereas the Russell 1000 value index is only 14% lower.

Despite increased recession fears, consensus analyst forecasts still project growth in company profits for both this year and next.  One significant risk with P/E ratios already looking cheap for most markets would be if company earnings disappoint relative to expectations, or if the still relatively expensive US growth stocks continue to see further declines in their valuations.

While unemployment remains low and wage growth strong, consumer sentiment has fallen sharply. The University of Michigan Consumer Sentiment Index has plunged this year. The Conference Board’s consumer confidence survey has held up better, given the higher importance it attaches to questions about the labor market, but has also weakened.

Another concern for the US economy has been the Fed’s determination to get inflation under control, with the median Fed member now expecting to have to raise interest rates to 3.8% by next year to control inflation.  The Fed forecasts that unemployment will need to rise to just above 4% to get inflation down.  However, the market is clearly worried that getting inflation under control could require unemployment to rise much higher, as has historically been the case.

There are already some signs that expectations for higher interest rates are starting to weigh on economic activity. With house prices almost 40% higher than at the start of 2020, and 30-year fixed mortgage rates having risen from below 3% to nearly 6%, housing has become much less affordable. That development is starting to be seen in the economic data, with the number of home sales declining.

On the plus side, while the number of housing transactions, and the associated economic activity, could continue to slow, it appears unlikely that we will see a repeat of the 2008 housing-led financial crisis.  That’s because 95% of Americans today are on long-term fixed rate mortgages, compared with only 80% in 2007.  So, there should be far fewer forced sellers.  There has also been much less sub-prime lending, and the banks are now better capitalized, which means they are more able to withstand any loan losses that might be seen in a recession.  On top of this, there has been much less home building than in the run up to 2008, so there are far fewer homes available for sale today than was the case in 2007.

While risks remain, investors should remember that markets have already fallen a long way.  So, even if we do end up in a recession, selling stocks now and buying them back cheaper would require an ability to time the bottom of the market in a way that very few professional investors have historically been able to do.  Therefore, we are maintaining a neutral allocation to risk assets while bringing government bond positioning closer to the benchmark as interest rates stabilize at higher levels.

While it has been a challenging start to the year, this is a normal part of the economic cycle.  Bear markets happen roughly every three years and typically represent good buying opportunities for long term investors.

As always, we appreciate your trust and are available at any time to discuss your specific portfolio and financial circumstances.  Please reach out to our Wealth Advisor, Banner Clark, at bclark@sagacewealth.com if you have any questions.

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