Inflation, Higher Rates, and Recession Risks Push Stocks and Bonds Lower in the Second Quarter.
The S&P 500 continued to decline in the second quarter, hitting the lowest level since December 2020 as still-high inflation, sharp increases in interest rates, rising recession risks, and ongoing geopolitical unrest pressured stocks and other assets.
After a rebound in March, the S&P 500 dropped sharply in April While some reasons for the
declines were similar to first quarter, April’s sell-off was due to a massive COVID-related
lock-down in China, which continues to enforce a “Zero-COVID” policy. Small outbreaks are met with intense city- and province-wide lock-downs, impacting an estimated 300 million people. Nearly 80% of China’s economic output were shut in and shut down, essentially halting the world’s second-largest economy. This hit stocks hard in April, and the S&P 500 fell 8.7%.
Selling continued in early May, as the Fed raised interest rates by 50 basis points, the single-
biggest hike in 22 years. At the May 4 press conference, Fed Chair Jerome Powell signaled plans to use aggressive rate hikes to tame inflation and that weighed on stocks, pressuring the S&P 500 to fall to new 2022 lows in mid-May. Towards the end of the month, markets staged a modest rebound. First, as COVID cases declined, China started to reopen, and by the end of May, the port of Shanghai was operating at 80% capacity. Then, Atlanta Fed President Raphael Bostic stated the Fed might “pause” rate hikes in late summer or early fall, which gave investors hope the end of the Fed rate hike cycle may be closer than previously thought. Finally, some inflation metrics implied price pressures may be peaking.
That, combined with deep, short-term oversold conditions in equity markets, prompted a solid rally in late May and the S&P 500 finished the month with a fractional gain.
All four major stock indices posted negative returns for the second straight quarter. From an investment style standpoint, both value and growth registered losses for the second quarter.
And all 11 S&P 500 sectors finished second quarter with negative returns. Relative out-performers included defensive sectors such as utilities, consumer staples, and healthcare;
quarterly losses for these sectors were modest.
Third Quarter Market Outlook
The S&P 500 just realized its worst first-half performance since 1970. This is understandable considering inflation reached a 40-year high, the Federal Reserve raised interest rates at the fastest pace in decades, the world’s second-largest economy effectively shut down and the Russia-Ukraine war raged on.
But while volatility and market declines have been unsettling and painful, the S&P 500 now sits at more historically attractive valuation levels. At current prices, a lot of negativities have been priced into the market, opening the possibility of positive surprises as we move forward.
For instance, a peak in inflationary pressures in the coming months could prompt the Federal Reserve to hike rates less than currently feared, and that could be a materially positive catalyst for markets.
Bottom line, markets have experienced numerous macro- and micro-economic headwinds so far this year. Sentiment is very negative at the moment, and a lot of potential “bad news” has been at least partially priced into stocks and bonds at these levels, again creating the opportunity for potential positive surprises.
To that point, the S&P 500 has declined more than 15% through the first six months of the year five previous times since 1932. And in all those instances, the S&P 500 registered a solidly positive return for the final six months of those years.
Past performance is not indicative of future results, and we continue to be vigilant to additional risks to portfolios, but market history shows that positive surprises can and have occurred even in difficult markets such as this. More importantly, markets eventually recouped the losses and moved to considerable new highs.