Mid-Year Market Outlook

July 26, 2022

Markets rarely give us clear skies, and there are always threats to watch for on the horizon. But the right preparation, context, and support can help us navigate what lies ahead. How businesses, households, and central banks steer through the rough air will set the tone for markets over the second half of 2022. The sources of turbulence are clear. A global economy that was already vulnerable to inflation from supply chain disruptions, tight labor markets, excess stimulus, and loose monetary policy came under more pressure when Russian aggression in Ukraine added sharply rising commodity prices and Europe on the brink of recession to the mix. The effects have included renewed pressure on interest rates, which hurt bond investors and contributed to tightening financial conditions, and a much more aggressive stance by the Federal Reserve (Fed) and other global central banks. Add in the typical market challenges of a midterm election year and the third year of a bull market, and it’s made for a bumpy ride.

Understandably, rising prices, slowing economic growth, and a challenging first half for both stocks and bonds have many investors on edge, and fatigue from more than two years of COVID-19 measures doesn’t make it any easier. For several months, both bonds and stocks had been going down in unison, a relatively rare occurrence. The dual weakness in stocks and bonds has been decidedly uncomfortable for many. This relationship has been normalizing in recent weeks, indicating some reappearance of the historical pattern which should help bring down volatility in a diversified portfolio.

With all that has occurred this year, negative headlines have dominated the news cycle, driving investor and consumer sentiment to record lows. However, given that markets are always forward looking, it is important for investors to remain focused on what lies ahead. There will most certainly be challenges, but there are also some tailwinds from a strong job market, resilient businesses, and the likelihood that inflation will soon start to slow. Markets historically can even get a little lift from lower uncertainty around elections as midterms approach.

Many portions of the U.S. economy remain relatively strong. An argument for continued near-term momentum in the economy is the cushion provided by household and corporate balance sheets. Respectively, they were $5.8 trillion and $1.1 trillion higher in 1Q 2022 vs. the same period in 2019. The personal savings rate has fallen in recent months, implying that households are drawing down savings as they grapple with higher inflation and lower real wages. However, the data show that there is still a strong cash buffer. This combined with a robust job market (3.6% U.S. unemployment rate) offset some of the growth slowdown caused by inflation. With consumer spending making up 70% of the U.S economy, we believe the U.S. consumer and thus economy have some tools to weather the inflation storm.

Despite the positives in the economy, the chance for recession continues to rise, particularly as the Federal Reserve remains on an aggressive rate hiking campaign. While their focus has been on quelling inflation, the question remains if their interest rate increases will overly contract the economy at the same time. Many investors expect the Fed to hike rates by an additional 2.00% prior to the end of the year.

There is a growing consensus among forecasters and the general public that a recession seems inevitable, but there is strong disagreement about the timing and severity. To provide a more objective framework for understanding “when” it might happen, the following preconditions typically fall into place prior to an economic downturn: leading economic indicators contract, corporate profit growth turns negative, and the unemployment rate rises as companies pull back. While some of these indicators have weakened, none have fallen durably into place yet. There are many factors to consider when assessing the depth of a recession, but housing and labor play a critical role. The current strength of the job market and the firm underpinnings of the housing market due to limited supply and high lending standards are arguments against being overly fearful about a severe downturn.

The deluge of negative sentiment surrounding the economy drove U.S. stocks into a bear market (down more than 20% from its highs) during the first two quarters of the year. However, history suggests there is reason for optimism as we look ahead. When analyzing other time periods when stocks experienced a 2-quarter decline of this magnitude, the average gain over the next 2 quarters has been 21.5%. The average performance over the following year has been 31.4%, consistent with the average gain off a midterm election year low (32%).

While there is no way to know when the market will stage such a recovery, history tells us it usually occurs near the scariest down days. Here’s a key stat to remember: over the last 20 years, 70% of the stock market’s best days have occurred within two weeks of its worst days. This speaks to the perils of trying to time exit and entry points during heightened volatility like the current environment. Doing so means potentially – if not probably – missing out on the market’s best rallies that every equity investor needs to drive investing success.

The coming months will be key to understand the path forward for the US economy and markets. Volatility may not be at its end, but clarity on several data points on the horizon (inflation, corporate earnings, midterm elections) may provide the stability the market is seeking.

As always, please feel free to reach out should you have any questions regarding our outlook or your portfolio.

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