The equity markets were weak through the end of the second quarter of 2022. The Dow Jones Industrial Average lost 15.3% through June 30th, the Standard and Poor’s 500 Index was down 20.6% and the Nasdaq Composite dived 29.5%. This was the worst first-half performance for the Dow, S&P and the Nasdaq since 1962, 1970 and ever, respectively. Carnage was widespread during the first half of this year, with only select commodities generating positive returns. Gold lost 1.3%, the FTSE 100 declined 2.9%, short-term Treasurys (one- to three-year bills) fell 3.2%, the Shanghai Composite dropped 6.6%, the Nikkei 225 fell 8.3%, mid-duration Treasurys (seven- to ten-year notes) lost 11.0%, junk bonds dropped 15.4%, investment-grade corporate bonds fell 17.0%, Emerging-market bonds tanked 21.8%, the Russell 2000 fell 23.9% and Bitcoin swooned 59.6%. For the most part, if you couldn’t eat it or burn it, you lost money in it during the first half.
Let’s take a look at first half returns in the context of historical stock and bond market performance. 2022’s S&P 500 decline of 20.6% is the worst first-half performance since 1970 (down 20.2%) and the fourth worse since 1928. The other three major declines were 1940 (down 20.9%), 1962 (-26.5%) and 1932 (-44.5%). Of the top 10 worst S&P performances since 1928, five years saw continued negative performance in the second half (worst negative second half performance, 1937: -31.5%; best negative second half performance, 1973: -6.8%). The other five years following a very weak first-half performance saw positive second half returns (best year, 1932: up 53.4%; worst positive second half performance, 1940, up 7.4%). Unfortunately, only one year in our top-ten list managed to recoup its first-half losses by year-end, and that was 1970 which followed up a first-half 20.2% decline with a second-half positive performance of 25.3%. The good news is that every first half decline that exceeded 17% in our list posted positive second half performance, averaging a gain of 24.3%.
An interesting and unusual event was seen in the Treasury market. The U.S. 10-year Treasury bond declined in the first half of 2022 by over 12%. Previous to this loss, since 1928 the 10-year has declined in value only eighteen times, usually in single-digit amounts. 2022’s loss eclipsed the previous record decline of 11.1% suffered in 2009, the only double-digit decline recorded heretofore. While this was unusual, it was not terribly surprising to us. More than a decade of easy-money policies engineered by the Federal Reserve not only drove interest rates to unattractive levels, they also ruined the historical risk-to-reward characteristics of this asset.
U.S Treasury bonds historically performed well when equities performed poorly, offering a partial hedge to equity exposure. By suppressing interest rates, the Fed inadvertently created an asset class with low fixed income return potential matched with equity-like risk characteristics, a bad mix. In the first half of 2022, the traditional 60/40 portfolio (that is, 60% equities matched with 40% long-duration Treasurys) had its worst performance since 1937, a truly horrific year for investors. For the past few years, we have been shortening fixed income durations as we did not like the risk-reward trade-off. As interest rates begin to reflect inflation rates, we will start to lengthen fixed income portfolio durations.
One way to view the 20.6% loss to the S&P 500 during the first half of 2022, is to break it down into its components: the P/E multiple and earnings. So far this year, earnings have grown 6.7% while the P/E multiple has contracted 27.3%. Looking at the equity market’s fundamental valuation, JP Morgan reports that the S&P 500 is now trading at a 15.9x forward P/E ratio and a current dividend yield of 1.8%. While that is not exactly cheap, it is in line with historical levels, and is certainly better than the January 3rd, 2022 readings of 21.4x and 1.3%. At market lows in 2020, 2009 and 2002, the S&P traded at forward P/Es of 13.3x, 10.4x and 14.1x, respectively. At market peaks in 2022, 2020, 2007 and 2000, the S&P traded at 24.1x, 19.2x, 15.1x and 25.2x, respectively. As always there is a caveat: when a recession hits, forward earnings estimates usually decline. The market is trading horribly as we write this. Stocks hitting new lows have outnumbered stocks hitting new highs for the past 34 weeks. This is the longest streak since 1990, with the one exception of 2008-9 during the Great Financial Crisis, when the negative streak hit 43 weeks. Usually, during other periods of weak stock performance, the trend bottomed in the 20- to 27-week range. So, there is hope for a bounce, even if it may be of the “dead cat” variety.
The latest government reports on inflation have been monstrously bad. The June Consumer Price Index (CPI) increased 1.3% over May levels (which were up 1.0% over the previous month’s level). Over the last twelve months, the CPI is up 9.1%, the largest increase since November 1981. Core CPI, which excludes food and energy, increased 5.9% over the last twelve months. The June Producer Price Index (PPI), which measures wholesale prices, increased 11.3% in the last twelve months. The inflation levels of the PPI usually take 6-12 months to work through to the CPI, suggesting that inflation levels will remain elevated (and volatile). While companies are pressing hard to pass cost pressures through to their customers, workers are seeing real wages decline. Wage growth is not keeping up with inflation. Currently, real average hourly earnings are declining at a 4% rate, the highest seen since the 1980s. Surveys suggest that consumers are pessimistic. The Conference Board’s Expectations Index is at its lowest level in nearly a decade. The University of Michigan’s Index of Consumer Sentiment is at its lowest level on record. Lower than any previous readings during recessions. The U. of M. survey has been conducted since 1952. One would expect to see a meaningful contraction in consumer demand given this situation. Oddly, this has not happened. Yet. During a meeting with analysts following his second quarter earnings report, Jamie Dimon, CEO of JP Morgan, said that the job market and consumer spending looked healthy. He then added, “But geopolitical tension, high inflation, waning consumer confidence, the uncertainty about how high rates have to go and the never-before-seen quantitative tightening and their effects on global liquidity, combined with the war in Ukraine and its harmful effect on global energy and food prices are very likely to have negative consequences on the global economy sometime down the road.” Charlie Scharf, CEO of Wells Fargo said, “Overall, our consumer deposit customers' health indicators, including cash flow, payroll, and overdraft trends are not showing elevated risk concerns. However, we're closely monitoring activity by segment for signs of potential stress and for certain cohorts of customers, we have seen average balances steadily decline to pre-pandemic levels following the final federal stimulus payments early last year and their debit card spend has also been declining.” So, the consumer is still consuming, despite elevated price levels. Why is that?
Obviously, a large part is low unemployment levels. Consumers must feel secure in their jobs, and they are getting raises even if the raises are lagging inflation. The 11.0 million unfilled jobs currently available is almost twice the 5.9 million people who are unemployed. A major contributing factor, we believe, is very unusual. Stimulus checks and deferred spending during the lockdown has bolstered consumer balance sheets to almost unprecedented levels. Households’ savings deposits grew to almost $8.0 trillion during the pandemic, up from balances of $5.0 trillion before the pandemic. At the end of the first quarter this balance had declined to $5.4 trillion. Some of the balances were consumed, some invested, and much was used to pay down debt. The Brookings Institute estimated that households accumulated $2.5 trillion of excess savings between March 2020 and January 2022. JP Morgan independently estimated that households generated $2.26 trillion in excess savings and have now drawn down $250 billion. We do see that Household financial obligations as a percent of disposable income stands at 14% currently, down from the 17-18% levels seen before recessions in 1991, 2001 and 2007. For now, the consumer’s balance sheet looks very healthy. It is difficult to assess how much of this excess went to SPACS or Meme stocks (bad) versus how much went to pay down credit card or mortgage debt; or how much has been consumed versus how much remains as a rainy-day fund.
The relative health of the consumer’s balance sheet gives the Federal Reserve a golden opportunity to crush inflation quickly. GDP shrank 1.6% in the first quarter of 2022, and likely contracted modestly in the recently-ended second quarter. By some definitions, this would suggest that we are already in a recession. In previous periods of high inflation, former Federal Reserve Boards were too timid when implementing tight-money policies. In the late 1960s and 1970s, this resulted in never getting ahead of inflationary pressures. In the early 1980s, this resulted in a “double recession” in a short, two-year period. If the Fed can get ahead of inflation quickly this year, given the solid consumer financial position, the recession likely will be less damaging than if it slow-walks its response. A recession in 2023, given an extra year of high inflation and the likely drawdown of excess savings, would be far more destructive. We are hopeful, but not yet optimistic.
Wall Street and the Fed are worried about a relapse of Covid, weak Chinese growth, corporate margin pressure, high financing costs, negative revisions to earnings estimates, galloping inflation rates, elevated retail inventory levels, real wage deflation and decelerating consumer demand. Good. These are all things of concern, as they should have been last January. However, they are not secrets and consumers, companies and even entire economies will adapt to make the best of the current conditions, no matter how challenging. Stay disciplined.
Your Team at Baxter Investment Management