Both the stock and bond markets continued their struggles in the second quarter this year following a rough first quarter. The S&P 500 closed down 20.6% in the first half of the year with the worst start since 1970. The NASDAQ lost 29.5% for its worst start ever, and the bond market fell 10.35% for its worst start since 1980.
Inflation continues to dominate the list of market worries as the Federal Reserve takes steps to increase the Fed funds rate and tighten monetary conditions in order to try to keep inflation from becoming entrenched. Supply chain shortages and the Russian invasion of Ukraine continue to push up the cost of energy and goods, which is working against the Fed’s efforts to combat inflation.
With inflation remaining at elevated levels, the Fed has indicated that they intend to front-load their rate hikes, meaning there will be larger rate increases early on in the process. The Fed indicated early in the year that they would hike rates in a more slow and steady manner, but they have had to make adjustments based on how difficult the economic conditions have become to try to reduce inflation.
The Fed chose to raise the Fed funds rate by 0.75% in their June meeting and indicated they may hike between 0.50%-0.75% again in their July meeting. By front-loading their rate hikes, the Fed is aiming to restrict financial conditions faster in hopes of having a larger tightening effect on financial conditions to bring down inflation.
Faster rate hikes have also caused the stock and bond markets to react negatively due to the fear that a more aggressive Federal Reserve rate hike cycle has a higher probability of becoming overly restrictive causing an economic slowdown, which also increases the probability of a recession.
GDP growth turned negative in the first quarter of 2022, in large part due to an increase in imports and a decrease in exports, causing a record U.S. trade deficit, however many of the other GDP indicators remained strong. GDP growth has been trending lower in the second quarter of 2022 as well, indicating that the Fed rate hikes are beginning to have a slowing effect on GDP growth.
The Fed has a difficult job ahead in trying to slow consumer demand by tightening financial conditions enough to reduce inflation while trying not to tighten too much that demand contracts too far causing a recession.
The Fed stated that they remain committed to tackling inflation so it does not become entrenched. The second half of the year should provide a lot more clarity on Fed policy to see if front-loading rate hikes works to slow inflation without becoming overly restrictive to economic growth.
The stock market is looking for clues that inflation has peaked and will come down to less elevated levels before putting in a bottom. The stock market usually bottoms well before the economy, so while economic conditions may continue to slow for the remainder of the year, we will look for clues that inflation has peaked and begins to subside for the possibility of a turnaround in the stock market.
We continue to be mindful of the risks that the market faces this year from a more aggressive Federal Reserve, elevated inflation, continued supply chain issues, and continued geo-political risks. We recommend staying the course with your investment objectives with the understanding that markets go through cycles and both the stock and bond market will eventually find their footing.
It is important to focus on the longer-term goals and objectives with an understanding that severe pullbacks will come and go as part of a normal market investment cycle. We also recommend communicating with us if any short-term cash needs arise so we can look for opportunities to be proactive when raising cash for any necessary distributions, helping to protect against possible short-term negative moves in the market.