Thus far, 2022 has proven to be the exact opposite of 2021. Whereas last year was characterized by easy money, peak economic growth, and peak corporate profits, 2022 has seen a tightening of financial conditions, lower economic growth, and slower corporate profits. This combination has led to very difficult returns from various asset classes thus far in 2022.
According to Morgan Stanley research, this is the worst first half return for the S&P 500 Index since 1962, the Japanese Yen since 1989, and US 10-year Treasury since the 1970s. We wrote in our last quarterly commentary that we thought Q1 weakness in the equity and bond market was attributed to a growth scare and not a full-blown pending recession. At the time of our Q1 outlook, our base case was that this extreme weakness would not spread more broadly to all US equity sectors. However, inflation-sensitive assets could not avoid the acute weakness in all other asset classes and underperformed in Q2.
Our view is that markets are experiencing a vicious negative feedback loop. Higher inflation stemming from supply chain shocks lingering post-Covid, excessive stimulus, and tight labor markets have forced the Fed into draconian rate hikes. Higher rate hikes have pressured longer-duration assets. Significant downturns in growth, speculative technology, and cryptocurrency have caused investors to de-gross their books. Investors are selling their biggest year-to-date winners to bring risk levels down; this has led to a significant downturn in commodity and inflation-sensitive assets in recent weeks. There were no places to hide in Q2. We believe the Fed has been too late and aggressive with rate hikes, creating this negative feedback loop.
We wrote the following in our Q1 outlook: “Admittedly, inflation-sensitive assets have seen strong returns over the past 12-18 months. That does not imply that the upside is limited, but we acknowledge that the rate of change could slow in the future.” This has proven to be the case in Q2. Inflation will need to come down for the Fed to take its foot off the gas pedal.
In summary, we believe there are three notable risks that the economy faces:
the Fed continues to be behind the curve and is stepping hard on the gas pedal
the Fed is looking to unwind its balance sheet at the same time it’s hiking interest rates
inflation has not peaked.
Can the broader economy withstand these risks without entering a recession? The stock market has already discounted the recession, in our view. Many high-quality growth stocks are down 30-35% year to date. Crypto assets and unprofitable technology stocks are down as much as 75% from their all-time highs.
Historically, buying US stocks in a recession has proven to be a good risk/reward, as your margin of safety usually widens and markets mean revert. Investing is about assigning probabilities, and we think now is an attractive opportunity to start nibbling on stocks and credit if you are a long-term strategic investor. These opportunities more than likely won’t linger long.
You can never be sure we have reached the market lows, which is why investors must assign probabilities. We simply think the risk/reward for long-term strategic investors is attractive.
We wrote in our last commentary that broadly owning a portfolio of diversified sets of asset classes and owning multiple factors, inflation hedges, and alternatives will be paramount in 2022. We continue to advocate these disciplines. After all, they are Astoria’s True North.