Market Update


Stocks and bonds were hit hard this quarter, with no safe havens outside of cash.  Stocks as measured by the S & P 500 declined 16%, with every sector in the red. The communication services, consumer discretionary, and technology sectors all fell over 20%. International stocks in the MSCI Index were off 14%, while small caps in the Russell 2000 Index were down 17%.

Year to date, most bond funds are down over 10%, with lower credit and longer maturity bonds down even more.  When yields go up, bond prices go down. The yield on 10-year Treasury notes which reached a peak of 3.5% in June, ended the quarter at 3.02%, up from 2.35% at the start of the quarter. Even shorter duration bonds had a big drop in price with yields increasing ½% to ¾% across the maturity spectrum.

With data on inflation surging, the Federal Reserve Board continued to increase its benchmark federal funds rate.  At its May meeting the short-term rate was increased by 50 basis points (1/2 of a percent), and then at the June meeting it was increased another 75 basis points to a range of 1.5% to 1.75%.

Inflation numbers have hit the highest level in 40 years.  The rapid increase in food and energy prices were particularly concerning for the Fed.  This has created an eye-popping increase in inflation expectations, which can become a self-fulfilling prophecy.  If higher than usual inflation is expected to continue, businesses will raise prices. It also drives workers to demand bigger salary increases than they otherwise would.  Accordingly, the Fed is expected to raise rates another 75 basis points this month.

The rate of increase for inflation though, may have reached its peak.  Gasoline prices are high, but now easing, declining 4% in June.  After a year of supply disruptions, several retailers are now looking at excess inventories. The Fed focus on core inflation which excludes the volatile food and energy price components could cool over the summer as retailers put excess inventory on sale. We expect the core personal consumption expenditure inflation index, while still well above the Fed’s target of 2%, will continue increasing at a lower rate of increase as the year goes on.

The uncertainty that exists going forward is weighing on the market. Based in part over the amount of continued Fed tightening / interest rate increases, and how aggressive they may be.  Inflation is at the epicenter of the economic uncertainty, policy uncertainty, and market volatility.  This is fueled by supply chain disruptions, tight labor markets, and geopolitical tensions.

Supply / demand imbalances still exist in food and energy.  The nature of commodity prices moves towards equilibrium over time.  Higher prices will result in greater supply and less demand. By this time next year, we may be looking at deflationary prices in the overall inflation indices, as production increases and a leveling of demand once again bring prices into balance.

The economy is still strong.  Growth as measured by GDP should be between 2.5% and 3.5% over the next few quarters, which historically is considered very robust. Unemployment remains at an ultra-low level of 3.6%. Corporate earnings have come in strong this past quarter and are expected to do well again this month for the second quarter earnings reports. Yet inflation, and rising interest rates are the driving factor behind the market decline.

The markets greatly benefited from declining interest rates the last two years. The higher the valuation and riskier asset, the greater the benefit.  This included many higher valuation technology and emerging growth stocks, and the risk-on mentality extended to crypto-currencies and non-fungible tokens. With rising interest rates all of these have reversed down sharply.  Even companies that had good earnings reports have declined.

Yet every day, financial headlines raise fears over the possibility of a recession, which if one occurs, is at least a year away.  It is just one possible outcome.  It’s also just as likely we have slower steady growth and lower inflation next year. As the economy slows down, earnings likely will be revised lower as well.  This is already factored into the market, with valuations on many stocks trading well below their historical levels.

The Fed is expected to raise rates again this month by 75 basis points. This will bring the Fed funds rate up to 2.25% – 2.5%.  Based on bids coming back into the bond market at the end of June, and longer-term rates going down, we may be close to the peak on the long end of the curve.  Expectations are for the Fed to raise rates up to 4% before they are done tightening.  If that proves true, the Fed may follow the precedent of over tightening. However, we believe the Fed will adjust its monetary policy to keep the economy from slowing too quickly.  We may find opportunities to extend bond durations later this quarter, and we will continue to look for dividend paying stocks that are attractively priced.