The headwinds for markets continued blowing hard in June. The S&P 500 declined by 8.4% in the month, bringing the year to date selloff to about 20%. The tech heavy NASDAQ was no different with its 8.7% fall and its year to date correction is now 30%. The small cap Russell 2000 had a similar drop for the month and its first half of 2022 decline is 24%. If the first stage of the bear market in stocks was a readjustment of valuations, the 2nd stage we’re now in can be attributed to concern over slowing economic growth. After seeing a 1.6% drop in Q1 GDP, there is now a growing number of economists that are anticipating another economic contraction in Q2. Notably, at the end of June, the Atlanta Fed lowered its own Q2 GDP estimate to -2.1%.
The month of June brought an increase to the magnitude of interest rate hikes by the Federal Reserve. With a tip off by the Wall Street Journal, the Fed raised the fed funds rate by 75 basis points, an acceleration from the 50 basis point increase seen at the May meeting and the fed funds futures market is pricing in a high possibility of another 75 basis point increase in late July. This helped to lift rates higher across the yield curve in June but we’ve seen a reversal lower in the early days of July as recession fears grow and the market reduces its expectations for Fed tightening.
The economic growth worries are a global phenomenon, particularly in Europe as that region struggles with very high energy prices, especially natural gas. Also, China’s still very strict covid approach is inhibiting the growth of the 2nd largest global economy. The European STOXX 600 index was down by 8.2% in June with the German DAX itself down by 11.2% in June. Chinese stocks were the big outperformer in contrast, as it responds to hopes that China might shift away from its zero tolerance covid stance and fiscal and monetary policy will help growth. The Shanghai comp was higher by 6.7% in June.
Corporate credit was also under pressure in June as the strength, or lack thereof, of one’s balance sheet has become front and center in a slowing economic backdrop at the same time the cost of capital is going higher. The Bloomberg high yield spread index to US Treasuries widened by a rather large 166 basis points in the month to the highest level in two years. The higher quality investment grade index saw widening of a much smaller 26 basis points to 155 basis points, but also the highest in two years.
With respect to the high inflation that is driving the monetary tightening by central banks and in turn the recession concerns, there is hope that we’ve seen peak goods inflation. I specify ‘goods’ in order to differentiate it from the ‘services’ side of the inflation equation. As a reminder, there was a massive shift in spending towards goods over the past two years spurred on by work and learn from home and financed by government checks. We are now seeing excess inventory of many items that consumers already have. Consumers are in turn shifting their spending this summer towards leisure, travel and hospitality, and still paying very high prices for home rentals. One bright spot in the inflation story was the 6.7% drop in the CRB raw industrials index after a 3.4% fall in May.
First the Valuation Reset and Now Growth Worries
The combination of the most aggressive monetary tightening in 40 years, a fiscal spending hangover brough on by $5 Trillion of US government spending in 2020 & 2021 and the recent slowdown of consumer spending in response to higher inflation, has shifted investor concerns towards the deteriorating earnings picture. It is why the upcoming earnings season is going to be so crucial as companies themselves tell us how business is and what their guidance is for the 2nd half of the year.
As stated above, there is a growing likelihood that the US economy will contract again in Q2. While conventional wisdom defines a recession as two quarters in a row of contraction, the National Bureau of Economic Research, which ends up making the call, says “that it is a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” So whether an economic recession is official or not at some point this year, from an investor standpoint it is essentially semantics if the end result is still an economic slowdown.
What this means for corporate earnings could be notable as analyst expectations for 2022 are still very high as we enter earnings season.
What Europe is facing is an energy inflation storm. The price of natural gas in Europe, as measured by the Dutch TTF (Title Transfer Facility), was up 65% in June and to put it on an equivalent US natural gas price basis, it would be around $50 per million BTU vs the US price of around $5.50 as of this writing. That is not only a painful price for consumers that need to heat and cool their homes but for businesses that use natural gas as a feedstock for their factories.
The Eurozone as a whole saw an 8.6% y/o/y increase in headline CPI for June that was reported on July 1st. This as the European Central Bank just ended its QE program and still has rates below zero. They meet in the 3rd week of July and are expected to hike their deposit rate by 25 basis points which would bring rates to a still negative -.25%. We believe this rate should get back above zero for the first time since early 2014 after the following meeting.
Other Central Banks
The Reserve Bank of Australia just hiked interest rates by 50 basis points for the 2nd straight time but with a rate of only 1.35%, there is still more to do. In mid-June, the Bank of England increased its bank rate by 25 bps to 1.25%, taking a slower approach than others. On June 1st, the Bank of Canada raised rates by 50 bps to 1.50%. The Swedish Riksbank on the last day of June also hiked rates by 50 basis points to .75%. These central banks, among others, all misread the inflation story over the past few years and are now doing their best to catch up.
Due to expectations of a global economic growth slowdown, the prices of energy and industrial metals have seen a pretty sharp pullback over the last few weeks of June and into early July. Supply constraints are still very apparent and deep, but a softening of demand is now the focus. Some commodities though are more elastic than others but they are all getting grouped together with respect to the selling. The very high-profile price of gasoline peaked at just over $5 per gallon according to AAA and as of this writing has pulled back to $4.80.
Agriculture product prices also pulled back in June and that continued into the beginning of July. The CRB food stuff index fell 3% in June and further in the first few days of July. With worries about rising energy and food prices, this is welcome for many.
There are really big cross currents impacting both the financial markets and economic activity. While there are some early signs that inflation is peaking, central banks are still trying to normalize policy and the end result creates major headwinds for both an interest rate sensitive economy and markets that have been addicted to a low interest rate environment. These headwinds are exacerbated by the Federal Reserve simultaneously reducing the size of its balance sheet in a monthly exercise known as quantitative tightening which drains reserves from the banking system.
We don’t anticipate that the investing landscape will get easier anytime soon. It is important to remember that recessions and market pullbacks are a natural part of business and economic cycles. As we continue to navigate this cycle, it remains vital that investors have a plan that suits their short term liquidity needs over the next 2-3 years. Knowing that period of time is covered can help separate the balance of one’s portfolio from what I believe will continue to be a choppy time for the economy and markets. Time horizon is really crucial right now and the best friend of any investor. Please do not hesitate to reach out at any time with questions or for any discussion on the economy and these markets.
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