2022 has so far been a tough one for investors, with the major US equity indices down between 20-30% from their recent highs. The S&P 500 has registered its worst-performing first half since 1970. The tech-heavy Nasdaq 100 fell in 5 out of 6 months this year which was the worst first-half performance in 20 years (-30%), coupled with the worst quarterly performance in Q2 since the GFC in 2008.
The risk-off sentiment and low optimism continued to be driven by soaring prices, increasingly hawkish global central banks, the Russia/Ukraine war, China lockdowns, food and energy shortages, and growing recession worries.Inflation in the US came in higher than expected, prompting the Federal Reserve to respond with a broad tightening and preparedness to push the economy into recession if needed. The Reserve Bank of Australia followed suit, and against this backdrop, yields climbed across the curve. Risk appetite fell on worsening recession prospects as equities and credit markets became more volatile. The Bloomberg AusBond Composite Index (0+ Yr), which measures the Australian bond market, was in a bear market during the month, dropping -1.48% and -10.51% over the last 12 months.
The Reserve Bank of Australia raised the cash rate by more than expected 0.5% in early June, putting an end to earlier indications that the typical 0.25% adjustments were on the way. Yields increased ahead of the RBA's meeting, but it was mid-month after US inflation statistics and the Fed's 0.75% increase when yields popped higher. Aussie 3Y and 10Y government bond yields climbed up to 3.70% and 4.21% before closing the month at 3.11% and 3.65%. The AU 30Y yield closed the month at 3.85%.
The higher cash rate adjustment from the RBA was justified because current high monetary accommodation levels were inconsistent with the RBA's observation of economic strength and resilience. Real GDP in Australia increased by +0.8% during the March quarter, compared to an above-trend growth of +3.3% for the year.
June 2022 Summary
- Many US equity benchmarks had their worst first half since 1970
- The RBA raised rates by 50bps surprising many investors
- The US 10Y yield traded up to 3.5% (up 200 bps in H1)
- Inflation data hit 40-year highs while market measures are declining
- Futures markets are pricing a 3% Fed Funds Rate by the end of 2022 and a dovish swing in 2023
- Consumer sentiment has fallen to record lows in the US
Central Banks
Over the previous three Federal Open Market Committee meetings, the Fed has raised the federal funds rate by 25bps (March), 50bps (May), and 75bps (June). Since 1994, June has been the first month when the rate was increased by 75 bps. Markets priced a 50bps hike until 3 sessions prior to the FOMC meeting when the May CPI print and June consumer sentiment data came in much worse than expected.
The Swiss National Bank shocked global markets in the same week when it hiked its benchmark interest rate by 50bps, its first increase in 15 years. Brazil's central bank increased lending rates by 50bps, and the Bank of England raised its benchmark interest rate by 25bps while lowering its growth projection for Q2 to -0.3%. The Federal Reserve, the European Central Bank (ECB), and other central banks seem to be lagging behind the curve, contributing to the most surprising period of inflation in more than 40 years. They are now compelled to catch up with quick tightening, which could hurt global economies and capital markets, lowering the prospect of a soft landing and raising the risk of an outright recession.
Inflation
Inflation figures are still high, with the most recent core CPI (May) excluding food and energy coming in at 6% year over year, down slightly from March's peak of 6.5%. Headline inflation in May recorded a new 40-year high of 8.6% year over year. May PPI (core) was 8.3% (YoY), down from its previous peak of 9.6% in March, while headline PPI reached 10.8%, down from its recent peak of 11.5% in March.
Market measures of inflation tell a different tale, with 5Y breakevens declining by 120bps from their peak of 3.76% in March to a low of 2.56% in June, and 10Y breakevens retreating by 78bps from 3.08% in March to a low of 2.29% in June.
Despite a growing number of market indicators suggesting that peak inflation may be behind us, which is one argument in favour of bonds and decreased rates, the Fed's QT program and the rising supply of Treasuries coming down the pipe are fuelling discussion about future rate hikes.
US Equity Sectors
10 of the total 11 US equity sectors have fallen year to date. Despite a loss of nearly -17% in June, energy is the lone sector that is in the green (+32% YTD). Consumer Discretionary is one notable laggard, falling by a massive -26% in Q2. The Materials sector was the standout in June, falling almost 14% and suggesting that peak inflation has passed.
Commodities
The Bloomberg Commodity Index (BCOM) rose 19% in the first half of this year, following a 27% increase in 2021. However, it fell nearly 17% from its highs in March and June was its third-worst monthly fall since 2008. WTI Crude dropped 8% in June, after six consecutive monthly gains. WTI closed the first half of this year with a gain of 41%, following a 55% increase in 2021. Following the price of WTI crude oil reaching a record high of $130.50 in March, it has remained in a sideways range since then as it consolidates the previous sharp uptrend. The US Strategic Petroleum Reserve (SPR) is now at its lowest level since 1986.
Foreign Exchange
A hawkish Federal Reserve, as well as a decline in risk appetite, helped push the US Dollar Index (DXY) up +10% in the first half. The Euro dropped -8% versus the dollar while the Japanese Yen fell by 18% due to a large divergence in monetary policy compared to the rest of the world. The Bank of Japan is an oddity amongst the central banks at the moment implementing yield curve control (YCC), keeping its 10Y government bond yield 25bps and dramatically weakening the Japanese Yen.
Corporate Earnings
A lot is riding on the Q2 earnings season, which is right around the corner. The stock market will be significantly impacted by reported earnings and management predictions. According to FactSet, 103 S&P 500 firms have given guidance for Q2, with 70% of them being negative. A 10.2% increase in corporate income is anticipated to be the sixth consecutive quarter of growth over 10%. Third and fourth-quarter earnings growth rates are both expected to be over 10%. It will be interesting to see whether firms can continue to enjoy the record operating margins seen in recent quarters.
The Months Ahead
There is a high degree of uncertainty for the second half of 2022 in terms of economic development, earnings growth, inflation, rate increases, quantitative tightening, the Russian conflict, and food and energy supplies. While market indicators have been plummeting at an alarming rate since early June, economic inflation measures have remained steady at 40-year highs. The labour market and unemployment rates are still good, but consumer optimism hit a new low in June. The quick selling began with high-multiple expansion stocks and has now moved into the Value, defensive, and commodity groups. It's impossible to tell how sensitive the economy is to rapidly increasing rates at this time. The overnight Fed Funds Rate sits at 1.50% – 1.75%. The overnight FFR is presently around 1.50% to 1.75%. The futures market is currently pricing an FFR range of 3% to 3.25% by the end of 2022, but it also includes a 50bps cut in 2023, implying a growing risk of recession and a dovish Fed pivot. Commodities and rates are continuing to consolidate in July, with the US 10Y yield trading around 2.79%. The next two weeks will see the start of earnings season for the major banks, and investors will pay close attention to management's feedback and expectations.