On June 16th, the S&P 500 entered bear market territory for the first time since March 2020. Inflation—and more importantly, the Federal Reserve Open Market Committee’s (FOMC) response to it—have increased the likelihood that the economy will slow and may even contract, leading to a recession. Economic indicators and company outlooks are currently mixed as to what the future holds, but stock markets seem to indicate that cooling is at hand. Since the start of the quarter, the S&P 500 declined 16.11%. For the first half of the year, the S&P 500 has fallen 19.97%. International markets have behaved similarly. The MSCI EAFE is down 14.32% for the quarter and 19.23% for the year.

The Consumer Price Index (CPI) has increased at levels not seen in four decades. Unprecedented levels of government stimulus in response to the pandemic, supply chain disruptions still working their way through the system, and shocks to food and energy prices resulting from the continued war in Ukraine are all contributing factors. Interest rates moved higher across maturities in reaction to aggressive rate hikes from the FOMC as they deal with these high inflation levels. The 10-year US Treasury ended the quarter yielding 2.97%, up from 2.33% on March 31st. Most recently the Committee increased the short-term rate target by 75 basis points (0.75%). The FOMC has indicated that inflation will be the main focus at upcoming meetings and another 75 basis point increase is expected in July.

Labor and housing markets, both of which have been extremely tight, are beginning to show signs of slowing down, but wages and home prices are still increasing in most markets. Mortgage rates have increased dramatically along with interest rates. Housing affordability is decreasing despite wage increases for many workers. Low inventory levels continue to support current housing prices, but there are fewer buyers: current homeowners are reconsidering moving to a larger home and many renters are forgoing homeownership at this time.

Looking Forward

There are far more questions than answers presently, and this increased uncertainty is contributing to the heightened market volatility for both stocks and bonds. Over the next several quarters we will learn how effective the FOMC rate hikes have been at slowing demand and thus staunching inflation. However, if they tighten too far, their actions may lead to a recession. Of course, by the time a recession is at hand, markets will already be focusing on the recovery. Prices will likely have improved and the increased volatility we are currently experiencing may have eased – making timing the bottom extremely challenging. It is a bit paradoxical but the certainty of a recession means calmer markets compared to the uncertainty of whether or not one will occur. At this time, risk of recession is increasing but is certainly not imminent and the strong labor market and recent gains in wages (thus spending power) may mean any contraction experienced could be shallow.

Not all of the inflation we are currently experiencing can be influenced by the FOMC. Some is driven by supply constraints still resulting from rolling lockdowns in China, which impacts component part manufacturing for finished goods. Also, continued conflict in Ukraine and disruptions to the agriculture and energy infrastructure in that region—among other factors such as international sanctions—are largely out of the Fed’s control. Price increases should moderate as higher borrowing rates impact demand, but it may remain above the FOMC’s comfort zone for some time. However, should these outside factors subside, price growth may slow significantly.

Corporate earnings have held up relatively well despite higher input costs and are expected to continue growing, albeit less robustly than last year. Markets will be keeping a close eye on upcoming quarterly reports, especially on the outlooks provided by companies to see if the resilience can continue or if cracks are beginning to appear more broadly. Stock valuations have declined and now trade on par with long-term averages. Historically, investors can expect decent returns looking out five years given current levels. But in the short-term, prices may continue to trend lower.

Bear markets and economic recessions are certainly not pleasant to discuss or experience, but long-term investors know they are short-term in nature. Over time, the key to success is sticking to an asset allocation strategy that matches their long-term financial plan. Tactical positioning changes made in our customer portfolios earlier in the year, such as shortening bond portfolio durations and increasing natural resource investments exposure, mitigated some of the declines but there were very few places to hide. Going forward, we expect markets to recover and are using the current weakness to improve portfolio quality and implement tax-management strategies that we believe will lead to better investment outcomes and overall client experiences.

Thank you for allowing us to serve you, it is an honor that we do not take for granted. As always, we are here to answer your questions and make sure your current asset allocation is still appropriate for your circumstances. If it has been a while since you have visited with us, please do not hesitate to call or email and set up a meeting with your Hills Bank Trust and Wealth Management Officer.

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