Commentary | 2Q 2022
2021 Q2 Market Recap
In the second quarter of 2022, the stock market, as represented by the S&P 500 Index, fell -16.1%. The S&P 500 Value Stock Index fell -11.3% and the S&P 500 Growth Stock Index declined -20.8%. The decline in the most recent quarter brought the total decline over the first two quarters to -20.0% for the broad market. During the same period, the Value Stock Index declined -11.4% and the Growth Stock Index lost -27.6%. The return differential favoring value stocks has been in place for the last two years and represents a reversal of a long-term trend favoring growth stocks.
The disappointing performance experienced by large capitalization stocks extended across the size spectrum. Small stocks and medium size stocks experienced negative returns as well. The S&P MidCap Index produced a -15.4% return for the second quarter, and a -19.5% return for the first half of the year. The S&P SmallCap Index fell -14.1% in the second quarter and -18.9% over the six-month period.
The market’s valuation fell during the second quarter as did the estimate for price volatility. The price to earnings ratio for the S&P 500 was approximately 20 times trailing twelve months earnings at the end of the second quarter. The current level represents a significant decline from that of more than 35 reached near the end of 2021. The VIX, a measure of market volatility, stood at 24 at the end of the first half of the year, a level below the peak of close to 34 reached earlier in the year. Earnings are expected to have risen by 9% to 11% on a year-over-year basis in the quarter just ended. However, real earnings, adjusted for inflation, will have experienced little or no growth over the same time period.
It has been 50 years since the market generated returns as disappointing as those experienced in the first half of 2022. In the early episode of falling market values, the economic environment approximated current conditions. Real economic growth is declining, and inflation is well above the Fed’s 2% target. Real growth was -1.5% in the first quarter and estimates for growth in the second quarter have been reduced as new data is examined. The current consensus forecast calls for little or no growth in the second quarter.
Indications the economy has entered a period of declining real growth include a fall in real disposable income and flattening of industrial production. Job creation has been positive, but not robust. At the center of the analysis of the path forward for the economy is the Fed and its policies.
The Fed has announced it will try and reduce the rate of inflation by raising short-term interest rates. For much of the last 13 years, the Fed Funds rate has been at or near 0%. In pursuit of their objective the Fed Funds rate has been raised to a range of 1.5% to 1.75% from a range of 0.25% to 0.50% at the beginning of the second quarter. The Fed has indicated it will be aggressive in its effort to lower the rate of inflation. However, there is no way of knowing what level of interest rates will be needed to reduce inflation to the Fed’s 2% target.
Recent increases in inflation reflect monetary policies begun in 2008/2009. At that time, to prevent a prolonged period of economic decline, the Fed engaged in open market operations to expand the monetary base, a measure of liquidity. The base rose from $800 billion to roughly $4 trillion over the period from 2009 to 2014.
In 2014, the Fed began to reduce the monetary base which fell to $3.3 trillion in 2019. In response to the economic dislocations arising from COVID driven policies, the Fed again expanded the monetary base to provide liquidity and minimize the damage done to the economy by those COVID related policies. The base grew eventually to $6.3 trillion in October of 2021. At the end of June 2022, the base had been reduced to about $5.6 trillion. Over a period of roughly 13 years, the base has grown by about 600%. If the base had grown at the trend line rate, it would be approximately $1.3 trillion currently. The Fed has chosen to focus on interest rates as a mechanism to reduce inflationary pressures rather than target liquidity. In the past, during the stagflation of the 1970’s, this policy has reduced real growth, but not the rate of inflation.
At this time, there is no reliable way to forecast the consequences of the Fed’s policies. Market participants are looking to the past for guidance. When the Fed tried to reduce inflation during the 1970’s episode of declining real growth and rising inflation, rates were raised to a level higher than that which was anticipated. Eventually, the Fed’s actions brought on a recession. An inverted yield curve, short-term rates higher than long-term rates, is thought to be a leading indicator of a recession. A casual examination of the last six recessions seems to support this hypothesis. Currently, the yield curve is almost flat in the 2 year to 30 year segment of the curve. If the Fed continues with its policy of raising rates, it is expected that the curve will invert, and a recession will follow. This outcome is not a certainty, but the market’s poor performance in the first half of the year is some evidence of growing expectations for a contraction of economic activity and reduced profits in the near term.
While the Fed is trying to reduce inflationary pressures, fiscal policy is pushing in a different direction. The Federal Budget Deficit is projected to be $1 trillion in the current fiscal year. There will be pressure on the Fed to finance that deficit. If the Fed does not accommodate the Treasury’s need for liquidity, Treasury borrowing could crowd out private investment. Fiscal policy will provide a test of the Fed’s commitment to reducing inflation.
There are sources of economic shocks beyond those produced by domestic monetary and fiscal policies. The war in Ukraine is one source of potentials shocks. Tensions in other parts of the world, and the economic policies of US trading partners are also potentials sources of shocks, but for the most part, US economic conditions will be determined by domestic policies.
In the first half of 2022, performance of the market reflected concerns as inflation increased and real growth turned negative. These circumstances prompted some to project economic conditions like those of the extended period of declining real growth and rising inflation experienced in the late 1960’s and the decade of the 1970’s. The unfortunate economic conditions of that earlier period were eliminated through a change in monetary and fiscal policies. The Fed, led by a new Chairman, instituted policies which insured diminished inflation, while fiscal policies included a reduction in tax rates and a lessening of regulations. These policy changes are available now. They have the potential to produce a sound economy and a decades long bull market for stocks.
In the period from 1968 through 1981, when inflation increased, real growth began to decline, and tax rates and regulations were increased, the S&P 500 produced a -2.0% annual return after inflation. In the period from 1982 through 2020 after prices stabilized, tax rates were lowered, and regulations were reduced, the Index generated a 9.0% annual return after inflation. The path to stable prices and economic growth rates is well known. The market will be watching for the first step on that path.