Dieting is Hard

Dieting is Hard

After a poor start to 2022, US stocks declined again in the second quarter. The S&P 500 fell more than 16% over the period, and has dropped nearly 20% year-to-date. While the issues of inflation, quantitative tightening, and Ukraine are all well documented, the decline accelerated in the quarter. So, what happened for US stocks to turn more negative and what is our outlook?

The main driver of equity market weakness in 2022 centers around whether the Federal Reserve’s interest rate tightening cycle will simply cool the US economy or cause a full-blown recession as it seeks to suppress inflation. Certainly, inflationary pressures have proven more persistent than “transitory”. The Federal Reserve has finally conceded this. After a 25-basis point hike in March and a 50-point increase in May, the Fed raised short-term interest rates by another 75-basis points in June. It had been 28 years since the market had seen a rate increase that large.

Rising prices are not just a United States problem but rampant globally. The Russian invasion of Ukraine added a monkey wrench into the equation, by affecting grain and global energy prices. The war’s effect on European energy costs is likely to push many of the continent’s economies into recession, adding pressure to a global slowdown. The Fed may now seem serious about curtailing inflation, but its ability to influence global commodity prices is limited. Attempts to cool the economy without successfully restraining prices risks producing stagflation (a recession with inflation). This risk weighed on equities in the quarter.

Additionally, investors are grappling with the reality of a new monetary backdrop. Not only are rising rates a more restrictive element affecting valuations, but the demise of Quantitative Easing (QE) is underway. The monetary experiment of QE, where the Fed regularly purchased bonds to inject liquidity into the market and to artificially suppress interest rates, buoyed markets through the dot-com/Y2K bubble, sub-prime crash, and most recently the Covid pandemic. Now that QEs long-feared most dangerous consequence, inflation, has actually occurred (even if coincidentally), the QE experiment may be indeterminately abandoned and unwound through Quantitative Tightening (QT).