Stock and bond markets have faced a laundry list of concerns in the first half of 2022, including new Covid-19 lockdowns, the continuing Russia-Ukraine war, Central Bank tightening and persistently high inflation, leading to a very tough first half of the year for investors. U.S. equity markets officially entered into bear market territory, dropping more than 20% from recent highs and GDP posted a negative growth rate of -1.5% in Q1 2022. If the GDP number that is reported in late July for the second quarter also shows negative growth, the U.S. will officially enter into recession. Our hope is if we do, it will be mild and doesn’t trigger a larger bear market in stocks. One major concern to this thesis is the emergence of a 40-year high in inflation exacerbated by global central banks being way behind on market tightening policies, now forced to play catch up by raising rates very quickly, the mechanism required to slow the persistence and growth of inflation. A key question is whether or not the presumed increases in the Fed Funds rate will be enough to tamp down the massive inflation now plaguing the American economy. In order to definitively stop stimulating and reverse the trend in inflation, the Fed needs to ultimately raise the rate beyond the neutral rate of interest, defined as the “inferred” rate that can maintain full employment and price stability, while allowing a modest 2% to 3% annual economic growth. History shows this rate to be at least 3.5%, but it may take a larger more painful increase, as many of us remember from 40 years ago. We currently sit at Fed Funds rate of 1.75% after the two increases of 50 and 75 basis points in Q2.

The quarter ended again with major stock and bond indices posting losses for investors and deepening losses year-to-date. For bonds, it was almost as bad as Q1, with the U.S Aggregate Bond index losing -5.1%, bringing the yearly loss to -11%. The S&P 500, DJ Industrial Average and NASDAQ Composite Index posted losses of -16.1%, -10.8% and -22.3% for Q2 and -20.7%, -14.9% and -31.3% for the first half of 2022. Internationally, the EAFE lost -13.7%, and -19.6% for the year respectively. Overall, sector undervaluation at the end of Q2 was 83%, with Communication Services at 61%, Consumer Cyclical at 73% and Technology at 79% representing the most undervalued. Utilities at 107% and Consumer Defensive at 102% were the most over fair value1. Our main valuation concern was from a Price/Earnings (P/E) basis. The S&P 500 ended the quarter overvalued by 21.2%, down from 45% at the end of Q1 and 72% from the start of the year on a P/E basis. Even with prices coming down significantly from three and six months ago, the risk to earnings (in the denominator) remains high and broader overvaluations are still observable on this basis. Considering the headwinds to corporate earnings with current economic conditions and the possibility of a longer recession, we are urging extreme caution when putting new investable money to work.

We look forward to helping our clients understand these challenging economic times, while continually earning your business, your trust and your respect.

Jack A. Kennedy
Chief Investment Officer