The second quarter of 2022 seems to have eclipsed the first in negative news. We entered into a technical bear market and have chalked up the worst first half for the S&P 500 since 1970. At the end of Q2, the S&P was down -16% YTD and NASDAQ was down -29%. As we predicted last quarter, inflation and the Federal Reserve’s monetary tightening remain in the spotlight. Inflation has yet to make any meaningful declines and the Fed increased the pace of their rate increases to 75 basis points in June. They are clearly focused on the long-term impact of inflation, not the short-term pressure they’re putting on the market. We don’t expect the Fed to stop tightening, even in the wake of negative GDP or further market declines.
Evidence of a cyclical slowdown continues to emerge. Europe is facing the impact of the Russia/Ukraine conflict. China has taken a hit due to their overly strict COVID policies. The Fed is tightening in the US, and inflation remains sticky. While technically personal spending rose 0.2% in May, factoring in PCE inflation of 0.6%, real personal spending actually declined -0.4%. US real GDP was revised down to -1.6% in the first quarter of 2022 and 2Q is predicted to be -2.1%. There’s an increasing chance of two consecutive quarters of negative growth in 2022: the technical definition of a recession.
U.S. consumer sentiment hit a record low in June. People are worried. Markets are down and retirement account balances are declining. Prices are up for necessities, namely food, gas, and housing. Interest rates are rising, making it a challenging time to consider buying or selling a house, or making any major financial decision. The shining light, however, is the extremely strong labor market. Unemployment is at 3.6% and there are more available jobs than unemployed people. Employees continue to hold the upper hand in wage negotiations and have unprecedented freedom to leave their jobs and easily find another. Employers are doing all they can to hold on to employees, knowing how difficult it’s become to replace them. Pent-up demand for services is still strong post-COVID. Consumers seem determined to travel, even with higher prices and constant disruptions. Business spending remains high, and the manufacturing sector is still benefiting from high demand.
This is not the traditional recessionary environment. True, bad news seems to come from all angles, but outliers remain that previous recessionary environments haven’t seen, particularly in the labor market. It’s important to remember there have been 26 bear markets since 1929, but only 15 were followed by a recession. So, can we avoid a recession this time? If not, it’s possible this recession could be quite different. The consequences of the recession: the pain we feel as market participants, employees, and consumers are more relevant. Two quarters of negative GDP is merely an indicator.
To mitigate the risk from a possible recessionary environment, we believe active management and a focus on portfolio construction are essential. We’ve seen higher rates disproportionately impact growth equities, particularly those not yet generating positive cash flows. The same can be said of longer-term Fixed Income: as rates rise, longer-term credits are more highly impacted. At SIMA, we have been systematically reducing riskier assets, such as US Large Cap Growth equities, Small Cap equities, and long-term Fixed Income. We’ve also moved some equity exposure out of Developed and Emerging markets. We’ve continued to add equity proceeds to US LC Value exposure. Large Cap Value names tend to have substantial cash reserves and provide a higher weighting to Energy, Materials, Staples, and Financial names. LC Value provides a higher dividend and historically reduces market volatility in portfolios. In this way, we’ve maintained equity exposure while decreasing overall risk. In Fixed Income, we continue to maintain a shorter duration to reduce volatility as rates rise. While returns have been muted in Fixed Income, rising rates have begun to increase income levels.
At SIMA, our Wealth team continues to believe your personal goals and investment horizons should be reflected in your portfolio, and that your asset allocation should never change due to short-term market risks. Our active management seeks to reduce market volatility without altering equity exposure and market participation. We understand market volatility can be stressful and we’re here to help. Before making any investment decisions, we encourage you to reach out to an advisor who can help navigate a challenging market.
Heather A. Voight, AIF® | Portfolio Manager
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