Strategic Income Outlook: Are We There Yet?

With investors wondering whether we are finally through the worst of the selloff, our latest Strategic Income outlook tries to answer the question, “Are we there yet?”

Are We There Yet?

Anyone who has been on a long road trip has no doubt heard the above refrain, especially those traveling with young children. It seems to be an apt metaphor given the current economic and market uncertainty. The question can be asked about many important topics today, including inflation, the Fed tightening cycle, and the stock market. All three have taken investors on a wild ride so far this year, and understandably, investors are anxiously awaiting better news – some tangible evidence we have “arrived” at the bottom of whatever this is. The stakes are high, as the specter of recession looms over the economy while we try to figure out where we are, but sadly, the answers are not a simple yes or no.

Given market returns so far this year, one certainly hopes the answer is, “Almost.” As concerns over inflation, Fed tightening, and a possible “hard landing” weighed on investors’ minds, the S&P 500 delivered its worst first half performance since 1962 (and nearly its worst since 1932!), losing 19.96% – almost 20% – a level commonly referred to as a bear market. While bear markets do not cause recessions, declines in equity prices (and 401(k) balances) can have negative psychological effects on consumers. On the other hand, given the stretched valuations that many stocks reached after more than a decade of “free” money, it is somewhat reassuring (yet painful) to see valuations come back to earth. It is worth noting that the market recovered nicely in both ’32 and ‘62. The 5-year annualized return following the 1932 first half was 30.0%, and the 10-year annualized return was 10.5%. Likewise, the 5-year annualized return following the 1962 first half was 14.2% and the 10-year annualized return was 10.5%. We hope history rhymes.

Bonds have not been spared either. The Bloomberg U.S. Aggregate Bond Index is down 10.35% for the first half of 2022, and according to Deutsche Bank the performance of the 10-year U.S. Treasury over the same period is the worst since 1788! This may have more to do with the simple math of starting with the lowest coupon rate in 200+ years. However, the good news for bonds is that as prices fall yields rise. As of 6/30, the yield on the 10-year Treasury was 3.0% and the yield on the ICE BofA High Yield Index was 9.0%, so if investors can weather market volatility, base loading a portfolio with higher yields should generate better future returns. As a sign that we may be closer to a bottom, we have seen more non-traditional buyers bottom fishing in the high yield market to take advantage of these more generous yields. Are we there yet? Getting closer?

The Fed has raised its fed funds rate by 150 basis points since the beginning of the current tightening cycle, which started in March. As Chairman Powell has already said, the next raise (in July) will be 50 or 75 basis points, and there are several meetings to follow in the fall. The Fed has been emphatic that containing inflation is their number one goal right now. The concern of strategists, which is amplified by the media, is that everyday citizens believe there is runaway inflation. If one believes that the Fed is stomping on the proverbial brakes too hard and will cause a severe recession, it certainly can change corporate spending plans, which would have a chilling effect on economic growth. After all, CEOs watch the news like everyone else.