The first half of 2022 is not one that investors want to relive any time soon. There was no place to hide within financial markets, except energy. Be it energy stocks within the stock market, or commodities more broadly in futures markets, assets directly tied to rising inflation were the only game in town.
The dichotomy between companies with pricing power and companies without pricing power has never been more starkly apparent. Technology stocks declined more than the market index. These companies tend to have earnings growth expectations out farther into the future than cyclical or slower growth companies. Robust future earnings expectations are hurt more by rising interest rates, and these companies generally had higher valuations going into 2022.
Beyond the Energy sector standing on top and Consumer Discretionary and Technology bringing up the rear, other S&P 500 sector performance was about as expected in an uncertain and declining valuation environment. Utilities, Consumer Staples, and Health Care were all down less than 10% in the first half. These are often referred to as the defensive sectors of the stock market, since consumers continue to buy electricity, toilet paper, soap, and medicine even when the economy is slowing.
Higher interest rates and wider credit spreads meant bonds also had a difficult first half of the year. When interest rates rise, the price of existing bonds in the market fall. They will still mature at par value and continue to pay interest, assuming no adverse credit events for the issuer, but the market price will decline in the interim. The longer the time to maturity, the more extreme the price decline can be. While only declining about half as much as stocks, a -10.4% fall in the Bloomberg Barclay’s Aggregate U.S. Bond Index does rank as one of the more extreme bond market moves over a six-month time period.
The most overused financial jargon term for 2021 may have been the word “transitory” to describe the accelerating U.S. inflation rate. Inflation as measured by the Consumer Price Index (CPI) quickly ramped beginning in the spring of 2021. At the time, the economy was still regaining its footing and the fear was about sustainable economic growth and a COVID-19 resurgence rather than some moderate inflation.1 The Federal Reserve coined “transitory” to describe the phenomenon that it believed would pass once supply chains and the labor market became more normalized, stimulus to consumers and businesses ceased, and demand slowed in response.
But the Fed’s forecast of waning inflation did not come to pass. A slight slowing occurred in the fall of 2021 before the CPI took another leg higher. When the Federal Reserve meeting minutes were released on November 24 for the November 2-3 meeting, people noticed a change in the language surrounding inflation. The Fed was distancing itself from “transitory.”
“Participants generally saw the current elevated level of inflation as largely reflecting factors that were likely to be transitory but judged that inflation pressures could take longer to subside than they had previously assessed.”
Minutes of the Federal Open Market Committee, November 2-3, 2021, page 8
https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20211103.pdf
At its December meeting, the Fed released its Summary of Economic Projections, which still showed the committee did not view inflation as a longer-term threat. The Fed’s median projection for Personal Consumption Expenditure (PCE) inflation stood at 5.3% for 2021, 2.6% for 2022, and 2.3% for 2023.2 If the Fed was beginning to lose faith in “transitory,” it didn’t yet seem truly convinced. The December 2021 and January 2022 meetings would pass with more talk of decreasing monetary support, but no action. Finally, on March 16, 2022, the Fed raised the Fed Funds rate by 0.25%.3 The Summary of Economic Projections for March reflected an expectation for PCE inflation of 4.3% for 2022 and 2.7% for 2023.4 However, by this time, markets were loudly accusing the Fed of being “behind the curve” when it came to fighting inflation. As inflation continued to climb, and the Fed sought to catch up, it would raise Fed Funds interest rates at its May 2022 meeting by 50 basis points (0.50%) and by 75 basis points (0.75%) at the June meeting.5 The Fed’s Summary of Economic Projections released in June now has PCE inflation at 5.2% for 2022 and 2.6% for 2023.6 This may still be too optimistic.
The June CPI showed a higher than expected 9.1% yearly increase in prices.7 Financial markets reacted by raising the probability of a 100 basis points (1.00%) Fed Funds rate increase at the Fed’s July 27 meeting, whereas before the CPI report, markets were pricing in a 75 basis points (0.75%) increase. The chart below shows where market expectations for Fed Funds interest rate levels stand after the CPI release on July 13.
The path and speed of higher interest rates, coupled with the decidedly not transitory state of inflation, explain much of financial market performance in the first half. Everything else equal, higher interest rates mean lower valuations for stocks and bonds since higher rates increase the discount rate on future cash flows. Future cash flows for stocks would be earnings and dividends, and future cash flows for bonds would be coupon interest payments. Inflation’s strength and persistence have been the surprise versus market expectations six months ago. Valuations for stocks as measured by the S&P 500 have fallen from a Price/Earnings (PE) ratio on next-twelve-months expected earnings of 21.3 at the beginning of 2022 to 15.9 as of this writing on July 15, 2022.8 That represents a 25% reduction in valuations, which by historical standards is roughly equal to the valuation contraction during the 2008/09 recession, but not yet close to the 41% fall in valuations from 1999 through 2002 as the tech bubble burst.8 What is different is the speed of the valuation contraction. It took 21 months for the 1999 and 2008 market declines to reach a 25% contraction in valuations. We have accomplished that in the first six months of 2022.8 The chart above illustrates how fast Fed Funds interest rates have risen and are expected to continue rising. We began tracking these probabilities on February 23 when markets were expecting Fed Funds to reach 1.50% by December. Today, those December expectations have reached 3.50% or higher. With one 0.50% and one 0.75% rate increase behind us, and potentially more large moves ahead of us, an aggressive Fed is having a faster than normal impact on asset valuations.
The chart below shows just how fast valuations have contracted as compared to the tech bubble decline in 1999 and the financial crisis in 2008. Solid lines represent falling valuations through PE ratios. Dotted lines are falling Earnings Per Share (EPS) estimates. Each is plotted at the beginning of the first month of PE, multiple declines and stops when PE ratios bottom. PE ratios begin declining first, then earnings estimates follow. In 1999, valuations (PE ratios) declined far more than earnings. In 2008-2009, earnings declined much more than valuations. So far in 2022, we have a rapid valuation decline, but no decline in earnings expectations… yet. However, it’s about time for that side of the equation to appear.
It’s worth pointing out that the chart above does not include the rising Fed Funds rate cycle that ended in 2018. This is because that cycle produced very little in the way of market impact as fiscal stimulus in the form of personal and corporate income tax rate cuts offset the rise in interest rates.
In economics, there are leading, coincident, and lagging indicators. The blue line in the chart above is financial conditions as measured by the Chicago Federal Reserve. It is a leading indicator. It began tightening late in 2021. Roughly six months later in April of 2022, the Citi Economic Surprise Index began to fall. This measure is a mix of economic data and can be considered coincident, or reflective of current conditions. Lagging indicators are things such as corporate earnings, inflation, and employment. This chart explains why corporate earnings in the first quarter of 2022 held up just fine. The impact of tightening conditions hadn’t really taken hold yet. That is likely to change now that we’ve had a quarter of disappointing economic data.
Markets will wrestle with many questions during the second half of the year. Chief among them will be inflation. How long does it persist at these levels? How fast does it fall once it begins to decline? Will the Fed have to put the economy into a recession to whip inflation? When will a recession occur and how deep will it be? If a recession occurs, will the Fed let it persist long enough to create enough slack in the economy to prevent inflation from immediately returning once economic growth improves again? These are difficult questions no one can answer in advance. They are complicated by persistent challenges to global supply chains, China’s zero-COVID policy, U.S. labor market dislocations, transportation bottlenecks, geopolitics, etc. Second quarter earnings season will be revealing as companies give us insight into what are sure to be rapidly changing business conditions during the quarter.
Tracy Bell, CFA®
Director of Equity Strategies
S&P 500 Index is regarded as a gauge of large cap U.S. equities. The index includes 500 leading companies and captures approximately 80% of the available market capitalization.
Presentation is prepared by First Horizon Advisors – June 13, 2022.
Sources:
1 U.S. Federal Reserve - https://www.federalreserve.gov/monetarypolicy/files/monetary20211103a1.pdf
2 https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20211215.htm
3 https://www.federalreserve.gov/monetarypolicy/fomcpresconf20220316.htm
4 https://www.federalreserve.gov/monetarypolicy/fomcprojtable20220316.htm
5 https://www.federalreserve.gov/monetarypolicy/fomccalendars.htm
6 https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20220615.htm
7 https://www.bls.gov/cpi/
8 FactSet
