By Paul Broughton, Portfolio Manager
The S&P 500 is off by over -18% since it’s high reached in early January and we are barely at the half-way point for 2022. It feels absolutely terrible for most investors. Uncertainty seems to be the new normal. Volatility, as measured by the VIX CBOE Volatility Index, is up over 42% this year. This heightened volatility is reflective of the market trying to anticipate whether we’ve priced in enough Federal Funds rate hikes into the short-end of the Treasury curve (the 2-Year Treasury is a decent guide on the level of rate hikes to be implemented). The takeaway from all of this is that we’re likely not there yet as we continue to lurch around where we have weeks with tremendous one or two-day rallies only to see them be eclipsed to the downside by more selling. What should investors be thinking about as we head into the rest of 2022? Although we may not have hit bottom in the stock market—we’re not quite there yet—it is a fool’s errand to wait to catch the absolute low. No one rings a bell to let you know that the market’s hit bottom. Instead, investors need to judge when the market offers really good value. It is our judgement that the downdraft offers good values now, so that those investors who buy today will be quite happy a year or two out, especially when they do so within the context of their investment objectives.
The root cause of this market downdraft and heightened volatility is inflation as every consumer fully experiences its effects. With inflation at its highest level in over 40 years and fears that it will potentially become entrenched, the Fed has firmly committed itself to reducing inflation back to 2%, within the constraints of hopefully achieving a soft landing. The Fed is trying to engineer some demand destruction through a higher level of unemployment and slower spending. That’s blunt talk, but it’s our current reality and the Fed is hoping it can do this gracefully.
The ‘we’re not there yet’ theme was on full display with the May CPI reading on June 10th. Prices rose by 8.6% for the year through May. The market was hoping that the 8.5% reading in March was the high-water mark. Not-so-fast with those hopes was the response. We saw Treasury rates move sharply higher and equities lower as the reality of potentially even higher inflation readings lies ahead this summer.
Fed Chair Powell said on Wednesday, June 22nd, that the economy was strong and able to handle tighter monetary policy. In particular, he pointed out the strong labor market. There are still nearly two job openings for every available worker. Despite this, the blunt force impact of higher interest rates on the economy now has the market focused on the chance of recession as the price to pay for cooling inflation. Indeed, a few weaker data points were sufficient for the bond market to rally sharply in the hopes that weaker growth would tame inflation. Still, Powell’s message was consistent and firm that curbing inflation now is most important.
So, what’s an investor to do as we go into the rest of the summer and year? Keeping an eye on the aforementioned CPI readings, Treasury rates, and simply on the price of gasoline will help in knowing when we’re getting close to some abating in this market volatility and the persistent downdrafts. As well, it’s worth keeping in mind that since Feb 19, 2020 (the high in the S&P 500 right before Covid-19 hit) the S&P 500 is up 19.6% or 7.9% annualized, despite the very difficult and stressful start to 2022. It just doesn’t necessarily feel that way. The point being that over the last two and half years we’re still doing fairly well; all is not lost. And currently the market is trading at a forward P/E of just 16.5x. That’s an attractive level relative to the last several years.
And regarding rates and the price of gasoline: since mid-June we’ve seen Treasury rates move modestly lower. The 2yr-note is now at 3.05% compared to 3.43%, reached on June 14th, and the 10yr is at 3.13%, compared to 3.47%, also on June 14th. As well, gasoline has at least for now stopped going up (that’s a positive) – it’s at $4.93 nationally compared to $5.02 on June 14th. So, perhaps enough consumer awareness of higher prices is starting to slow the rate of spending. This isn’t to imply that we’re close to the end of peak inflation – the market is really good at reminding you that these things are extremely difficult to call. But rather, interest rates and the price of a gallon of gas are worth watching for clues to the potential winddown to this volatility and selling.
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