In the Loop: Q2 2022 Market Review

Human brains do not like uncertainty. In fact, in 2016, researchers at the University College London showed that their subjects experienced less stress if they knew that they were going to receive an electric shock, versus knowing that there is a small chance of a shock.  Uncertainty caused more stress than the actual painful shock[1].  

The lingering health and economic impact from the Covid pandemic, the invasion of the Ukraine by Russia, inflation, the future path of interest rates, a potential recession – all have created a highly uncertain environment this year. This uncertainty, lack of a clear outcome and possibility of a very bad outcome, namely a recession and further decline in the markets, have caused financial markets to sell off. The S&P 500 finished the second quarter of 2022 in bear market territory, down -21%, and the Nasdaq Composite was off even more, down nearly -30%. The Dow Jones Industrial Average, which includes mature, slower growth companies, fared better on a relative basis and was down -15%. Speculative asset classes, including cryptocurrencies, SPACs, pandemic-theme stocks, and expensive stocks with no earnings were off substantially, as the market justifiably punished companies with limited intrinsic value.  In the fixed income markets, the Bloomberg Barclays U.S. Aggregate Bond Index was down over -10%[2], the worst performance in over 40 years.

At the center of the uncertainty are concerns regarding the Fed’s ability to tighten adequately and rapidly enough to tame inflation and keep economic growth on track, albeit at a slower pace, without tipping the economy into a recession.  Fiscal and monetary policies put in place initially to help with recovery from the Global Financial Crisis of 2008-9, and then again after the Covid crash in 2020, boosted demand for goods, services, and assets and made more credit and funding available, stimulating the economy. This artificial support helped the economy and markets recover after the financial crisis and the Covid crisis.  The low interest rate environment and excess liquidity in the markets, meant as short-term measures, became the market’s “new normal”.  In addition, on the supply side, Covid-19 materially disrupted and temporarily destroyed corporation’s supply chains and their ability to produce products and get them to consumers.  As well, the labor market has fundamentally changed, and many workforce participants retired or quit, reducing available labor supply and driving up wages.  The invasion of the Ukraine by Russia and nearly immediate sanctions created additional shortages, particularly of key commodities and energy. These distortions of “normal” demand and supply, some likely more short-lived than others, have driven prices for assets, goods and services higher and have led to inflation.   

Today there is a lack visibility into the ‘true’ state of the economy and markets, and as a result uncertainty about what happens when the temporary stimulus is removed.  Hopes for an orderly transition back to normal with slow interest rate increases and a methodological pullback of monetary policy support were dashed by accelerating inflation.  The Fed is now forced to implement a faster, harsher monetary policy response to contain inflation.  This is an unusual and difficult situation, made more difficult by the negative news flow around midterm elections and consumer concern about rising prices. Worse, now that the inflation “genie” is out of the bottle, it is hard to put back in, and the Fed has communicated its alarm and implicitly conveyed that it is behind in its response.  This has in turn alarmed the markets.

From this point onward, market participants face a wide range of potential outcomes and a continuing high level of uncertainty.  The Fed’s successful navigation of this environment, or not, is a key factor.  Market participants are watching for inflation reports to bottom, which they may over the next several months as commodity and energy prices have weakened. As well, mid-term elections will weigh on sentiment, but a decisive outcome, one way or the other, will be a positive for the markets.  In addition, the news flow around the invasion of Ukraine by Russia has quieted, however the conflict remains ongoing and with it concerns about geopolitical instability and commodity price pressures.  A resolution to the conflict, particularly if it does not destabilize Europe, would be a positive. In addition, China, while not in the day-to-day news flow, could implement stimulative measures and constructive policy responses to help its housing market this fall after elections.  As well, world supply chains will be helped by a slow return to normal after the country’s extreme Covid lockdown.

On a positive note, because human brains dislike uncertainty so much, often there are real market opportunities during these types of environments. Many high-quality companies are being thrown out with the proverbial bathwater, as extreme pessimism takes over and reactionary investors exit at any price.  Valuations in the market have come down substantially.  This is primarily because of multiple contraction, that is, the price market participants are willing to pay for a company’s future earnings stream.  Some of the froth and speculation has come out of the market, and attention has returned to a company’s fundamentals, or earnings and cash-flow generating power, which is a positive development.  An additional silver lining is that finally, yield is returning to the cash and fixed income markets, and savers now can realize returns on their safer investments, including savings and money market accounts.  While a recession could occur, we could also have a more benign outcome, with lower but still solid growth.  In these types of markets, having a long-term, contrarian view is the key to success, as is ensuring that investment portfolios are adequately diversified and populated with strong, free-cash-flow generating companies.   

---

[1]. https://www.sciencedaily.com/releases/2016/03/160329101037.htm and Archy O. de Berker, Robb B. Rutledge, Christoph Mathys, Louise Marshall, Gemma F. Cross, Raymond J. Dolan, Sven Bestmann. Computations of uncertainty mediate acute stress responses in humans. Nature Communications, 2016; 7: 10996 DOI: 10.1038/ncomms10996

[2] S&P Capital IQ

---