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Markets hit by perfect storm in which bad news can be positive

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Hint: Prices for commodities like oil, copper, lumber and wheat have come off their highs set earlier in the year, suggesting inflation may slow down.

Since January, the US economy and stock markets have been hit by the perfect storm.

The S&P 500 registered its worst half year since 1970 and the Dow Jones Industrial Average had its largest first-half decline since 1972. Russia’s invasion of Ukraine began a bloody and disruptive war in Europe, China’s Covid-19 lockdowns added to supply chain woes and hawkish central bank policies conspired to knock down asset values.

Faced with 40-year high inflation, stoked by record money printing since the beginning of 2020, America’s Federal Reserve embarked on a highly aggressive monetary policy tightening programme this year, which has led to plunging securities prices.

The war in Ukraine has magnified the slowdown in the global economy, compounding the damage from the Covid-19 pandemic. Global growth is expected to slump from 5.7 per cent in 2021 to 2.9 per cent in 2022, significantly lower than 4.1 per cent that was anticipated in January, according to a recent World Bank report.

Growth is expected to hover around the three per cent pace over the next two years as the war in Ukraine disrupts activity, investment, and trade in the near term, pent-up demand fades, and fiscal and monetary policy accommodation is withdrawn. As a result of the damage from the pandemic and the war, the level of per capita income in developing economies this year will be nearly five per cent below its pre-pandemic trend.

Inflation fighter: Jerome Powell, chairman of the Federal Reserve (Photograph by Andrew Harrer/Bloomberg)

Ostensibly, Fed chairman Jerome Powell cares a bit more about reversing the perception that he is behind the curve on inflation rather than restoring investor confidence. For the first half of 2022, the S&P 500 index and MSCI World stock indices were down by 19.97 per cent and 20.28 per cent, respectively. While we did see some counter-trend rallies through first six months of the year, the overall direction has been lower.

Historically, bonds have been a safe place to hide during market downturns, but not this time around.

Over the first half of 2022, the Bloomberg US Aggregate Bond Index fell 10.35 per cent as interest rates rose.

The Treasury yield curve had a parallel upward shift during the second quarter in response to an increasingly hawkish central bank. Credit spreads widened further amid concerns of persistently high inflation and higher probability of a recession. The spread between US BBB Corporate and the 10-year Treasury ended last quarter at 2.13 per cent, the highest in the past two years.

In May, the FOMC committee had their third 0.25 per cent rate hike this year. After the May CPI surprisingly reached a 40-year high, policymakers decided to act more aggressively by raising the Fed Fund Target Rate by 0.75 per cent at the June meeting, the largest increase since 1994.

Fed Chair Powell once again reiterated their focus to bring inflation back to the target of two per cent. Markets widely interpreted the Fed’s message as a signal that more 0.5 per cent rate hikes will take place at future meetings.

Looking ahead, financial markets remain highly dependent upon central bank policy. On the good news front, many commodities, including copper, oil, lumber and wheat have been falling and are well off their highs for the year. Any indications of lower inflation may help the Fed to relax its hawkish stance.

Meanwhile, evidence of a slowing economy abounds. In fact, the US may already be in a recession of sorts. First quarter real gross domestic product (GDP) came in a -1.6 per cent and the Atlanta Fed GDP Now is forecasting -2.1 per cent growth for Q2. A recession is commonly defined as two back-to-back negative real GDP numbers.

However, we are now in something of a “bad news is good news” world. Further signs of an economic contraction should also help the Fed pivot back to a less restrictive monetary policy stance.

Fed policy is important for equity prices, but corporate earnings matter too. While estimates for the second quarter have been coming down lately, we may see some upside surprises from those companies which can pass higher costs on to their customers. Importantly, earnings are reported in nominal (rather than inflation-adjusted) terms and thus higher prices could be a positive for some.

Over the next few weeks, many of the largest bell weather companies will be reporting their second quarter earnings. Investors will focus not just on last quarter’s earnings, but also revenue and earnings guidance for the balance of the year.

In this environment, investors should continue to lean into the more defensive areas of the market such as healthcare, utilities, consumer staples and high dividend-paying companies. Later in the year, however, cyclicals could begin to outperform again.

In fixed income, we are finding abundant opportunities to earn historically high current yields, where previously this had not been possible.

Bryan Dooley, CFA is the Chief Investment Officer at LOM Asset Management Limited in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.

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Published July 12, 2022 at 7:37 am (Updated July 12, 2022 at 7:37 am)

Markets hit by perfect storm in which bad news can be positive

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