The second quarter of 2022 provided negative returns for most major financial markets. There was little room for escape as a combination of economic factors pushed asset prices lower. An environment of higher gas prices, supply change disruption, conflict in the Ukraine, increasing inflation rates, and the U.S. Federal Reserve raising short-term interest rates was too much for many investors. As a result, the value of stocks and bonds both moved lower from March 31st 2022 to June 30th 2022. The hardest hit was the previously “high-flying” large cap technology stocks. The NASDAQ Index was down 22.44% in the second quarter and down 29.22% for the first six months of 2022. The S&P 500, which also held an over-exposure to large cap technology stocks lost 16.45% in the second quarter and 19.97% year-to-date. Small cap stocks and international stocks performed similarly as these asset classes experienced second quarter drops of 17.49% and 15.37% respectively. Bond investors suffered as well. The Bloomberg Aggregate Bond Index shed 10.16% in the first six months of the year. The decline in both bonds and stocks during the same time period is unusual. However, a simultaneous threat of inflation (bad for bonds) and a future economic slowdown (bad for stocks) left little opportunity for positive returns.
Although there was no shortage of theories to explain the overall retrenchment of stocks from January’s all-time high, the real battle was likely just between elevated growth (inflation) and potential economic slow down (Federal Open Market Committee raising interest rates). Most investors, consumers, and all living creatures could agree that the cost of everything was increasing. By the end of the second quarter, inflation was flexing 9.1% higher than just twelve months previously. The disagreement was with what will happen next. One side became fearful that the FOMC would raise interest so high, or so rapidly, that it would choke off economic expansion and force the U.S. economy into a protracted slowdown. The opposite position prophesized the strength of the U.S. was so strong that increasing short-term interest rates would have little impact on overall financial conditions. This battle came to a peak during the first week of June as stock sellers became far more motivated than stock buyers in advance of the FOMC rate decision on June 15th. From June 1st to June 15th the S&P 500 lost 8.20%. The FOMC decision on June to increase the target Fed Funds rate by .75% to 1.50% was well-received by both sides.
It appears the U.S. economy will side-step a deep economic slow down (for now). It is unlikely that a sustained recession could exist with a current unemployment rate of only 3.5%. Recessions frequently begin with major job losses. This leads to consumers spending less on goods and service that culminates with an economic contraction. Job losses are not a part of the current economic discussion. With a Help Wanted sign in the window of nearly every business, the employment market remains very strong.
D’Arcy Capital believes that inflation will remain elevated. With low unemployment and a supply chain that remains imperfect, more money will be chasing fewer goods. This leads to higher prices. However, investors must remember that owning assets (especially stocks) is often the anecdote for inflation. As companies are forced to increase prices, more money (nominal) is collected by the owners (stockholders). To maintain a constant standard of living (in real terms) consumers should own assets that will increase with inflation. Stocks generally can adjust with inflation and have the added benefit of being relatively easy to buy and sell.
D’Arcy Capital had overweighted the energy sector since the end of 2020. This sector was one of the few bright spots in 2022. The S&P 500 Energy Index Sector was up 31.6% for the first six months of 2022. D’Arcy Capital now believes there are probably better sector opportunities available to investors. D’Arcy Capital continues to favor value stocks, the biotechnology sector, municipal bonds, and short-term fixed income securities. D’Arcy Capital is less optimistic in the near-term potential for index investing, large technology growth stocks, and long maturing bonds. From the early 2010s until the pandemic in 2020 it became increasingly easy to identify the leading category of investments. Investing in the S&P 500 was a clear winning tactic for nearly a decade. And, more specifically, the large cap technology sector was a “can’t miss” strategy until almost one-year ago. Now the leadership is unclear and has not been fully determined. However, the leading investment approach for the last 10 years is unlikely to be in first place for the next 10 years. It is probably more important than ever that investors are fully diversified across numerous asset classes.