Markets struggled in June as inflation, the Fed and fears of economic slowdown continued to weigh on investor sentiment. The S&P 500 lost 8.25%, closing the second quarter with a -16.10% decline. Both growth and value stocks suffered by about the same amount in June—the S&P 500 Value lost 8.23% and the S&P 500 Growth lost 8.28%. The energy sector—the only bright spot of the equity markets this year—led other sectors lower with a -16.80% decline as part of a broader sell-off the in the red-hot commodities market. Meanwhile, fixed income markets also saw declines as interest rates rose further; the Bloomberg US Aggregate index lost 1.57% in June, bringing the total losses for the main bond index to 10.35% through the first half of 2022. The yield on the U.S. 10 Year Treasury began the month at 2.84% and rose as high as 3.48% in June before settling at 2.97%.

The main sell-off ran from June 7 to June 16 during which time the S&P 500 saw an 11.87% decline. This selling frenzy was driven by a handful of inflation related factors. The price of oil saw a big run up in early June, hitting a high of $123.68. on June 14. On June 10, the May release of the Consumer Price Index surprised investors by coming in at a whopping 8.6% compared with an expected 8.3%. This drove interest rates much higher—the yield on the 10 year Treasury hit 3.48% by the following Tuesday, June 14, and even the much shorter-dated 2 year Treasury yield hit a high of 3.44% by that same day. Within hours of the CPI data release, rumors began to spread that the Fed would hike its Federal Funds Rate by 75 basis points at its June 15 meeting; this was a swift change in expectations from the 50-basis point hike previously expected and would represent the largest hike in the Fed’s rate since 1994. The Fed stoked this rumor by leaking its consideration to the financial media and then followed suit with the 75-basis point hike on June 15. A subsequent decline on June 16 brought equities to their monthly and year-to-date lows, and then a rally began. The S&P 500 gained nearly 7% over the next week and trailed off into the end of the month with choppy returns.

We don’t advocate obsessing over the daily or weekly swings in the market as described above, but the middle of June illustrated why the outlook is so murky right now. On the one hand we find ourselves in a historically high inflation environment, causing the Fed to tighten policy and pressuring valuations in the stock and bond markets. On the other hand, if that same inflation shocks consumers to the point of changing spending patterns, shocks businesses into hiring freezes and other defensive posturing, it could bring about a recession. Fuel commodities like oil and natural gas, as well as input commodities like nickel, copper, wheat and corn, were skyrocketing into June, only to all see a significant reversal as fears of a recession began to loom larger. Retreating commodity prices may suggest a resolution of the problem we’ve been fixated on—inflation—but may also be indicative of a problem we’re beginning to watch out for—recession. These threats to the market are intertwined and present a complicated puzzle for those who are trying to forecast where things go from here. So many market participants analyze to death the comments of Fed Chair Jerome Powell, trying to ascertain what he’ll do next. Those people would do well to remember that he is faced with the same complicated puzzle that we all are.

News around inflation and the Fed will continue to influence the markets but we believe that corporate news—quarterly earnings results, forward looking guidance issued by executives—from various sectors will begin to carry more weight as we enter the second half of 2022. Heading into Q2 earnings season, FactSet reports that the estimated earnings growth for the second quarter is 4.3%. While that would represent the lowest earnings growth since Q4 of 2020, it is still a positive number and earnings don’t historically grow in recessionary environments. The current forecast for S&P 500 earnings growth through all of 2022 is 10%. What does all of this mean for the stock market? Forward looking price-to-earnings ratio is 15.8; this is below the 5-year average of 18.6 and the 10-year average of 16.9. In other words, if the current earnings expectations pan out then it will mean that stocks are currently cheaper than their historical averages. If you take the bottom-up aggregate of industry analysts covering all of the companies in the S&P 500, their fair value target for the index is 4,987.28 twelve months from now. This would represent a 31.4% increase in price between now and July 2023.

Easy enough, stocks are about to rip higher from here, right? Not necessarily. Analysts don’t have a crystal ball either, and if earnings begin to slip due to recessionary pressures, analyst price targets will need to come down too. The S&P 500 looks historically cheap right now at a 15.8 price to earnings multiple, but if the earnings decline rather than modestly increase then a further leg down in the markets should be expected.

We’ve now seen four different instances in 2022 when the S&P 500 has rallied by at least 5% in a couple of weeks after seeing punishing declines. That should serve as a reminder to investors that attempts to time the market or capitulating after tough losses can backfire big time. If you have a long time horizon with your investments, then this year has presented you with the opportunity to deploy cash at great discounts. If you have a short time horizon, then you should take comfort in the more conservative diversification of your portfolio. We don’t diversify into conservative assets simply to make investors feel better when their portfolio is down by less than the stock market; we do so because it provides sources of liquidity in their portfolio which investors can lean on while riskier assets like stocks recover.

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