Stocks and most other assets had a very difficult first half of 2022. The S&P 500 Index fell by 24% from its January 3rd peak before its recent bounce, with the index finishing the first half down 20%.

No S&P 500 sector beyond Energy at +32% generated a positive return in the first half. The next-best performing sectors posted negative returns, Utilities at -1% and Consumer Staples at -6%. Consumer Discretionary (-33%) and Communications Services (-30%) were the worst performers.

Other asset classes also posted negative returns. Ten-year Treasury bonds (-11%), investment-grade corporate bonds (-14%), and high-yield bonds (-14%) had negative absolute returns. With both stocks and bonds posting negative returns, the benchmark 60% stock/40% bond portfolio posted its worst first half return since 1932 (-17%).

The first half selloff was sparked by higher-than-expected inflation readings, which caused a faster-than expected pace of Federal Reserve interest rate hikes. With the 10-year Treasury yield rising from 1.4% to 3.0%, stock valuations compressed with the S&P 500 P/E multiple falling by 24% (from 21x to 16x). This highlights that the market selloff has been driven by valuation rather than earnings. S&P 500 consensus 2022 and 2023 earnings estimates have both been revised up so far this year.

Inflationary pressures were expected to recede in the first half. Instead, they remain stubbornly high, aggravated by the war in Ukraine and lingering supply-chain issues. With the economy slowing after last year’s rapid growth, the major concern is that higher interest rates will push the economy into recession before inflation cools. Consequently, market participants will remain focused on upcoming inflation readings. Cooling inflation (which the consensus still expects) would allow the Fed to slow the pace of interest rate hikes, reducing the probability of recession, and would most likely be well received by stocks.

Last week brought more news of a slowing economy, but some hints of cooler inflation. The ISM Manufacturing PMI (a timely business survey) dropped 3.1 points in June, down in six of the past eight months, to 53.0, missing the consensus of 54.3 (readings above 50 signal expansion, below 50 contraction). It was the lowest level since June 2020, as factory activity growth has moderated considerably since its peak 15 months ago. The current level of the PMI is still consistent with continued expansion in manufacturing output and the broad economy, but at a much slower pace. The ISM estimates that the PMI corresponds to 1.5% annualized economic growth. But the expansion is still widespread across industries, suggesting that while momentum is slowing, recession is not imminent. Of the 18 ISM industries, 15 reported expansion last month, including moderate-to-strong growth in the six biggest industries.

The supplier deliveries index of the ISM survey dropped 8.4 points to 57.3, its lowest level since July 2020, and no longer consistent with further upward pressure on inflation. Indeed, the ISM Prices Index fell 3.7 points to 78.5, down for the third consecutive month, and well below its cycle peak of 92.1 which was reached a year ago. The ISM noted that the decline supports a continued slow but steady move towards price softening.

While the BEA Personal Income and Outlays report showed inflation pressures remained elevated in May, there were some early signs of moderation. The personal consumption expenditures (PCE) price index climbed 0.6%, the second most in seven months, driven by higher energy costs. However, the core PCE price index, which excludes energy and food, rose a smaller 0.3%, and less than the consensus of 0.4%.

Given the uncertainty around the path of inflation and interest rate hikes, we favor owning high-quality blue-chip stocks and have a defensive sector positioning. With our July sector strategy update, we raised the defensive Utilities sector to an overweight and dropped the deep cyclical Materials sector to a neutral. Energy and the defensive Health Care sector remain high conviction overweights. The Health Care sector has grown its earnings during each of the last six recessions while its valuation is favorable relative to its history. Energy continues to benefit from very low spare productive capacity while valuation is favorable.

 


 

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