by Fidelity Viewpoints
The second quarter was a rough ride.
- Markets: Stocks enter a bear market amid growth fears, rate hikes, and inflation.
- Economy: The US is in the late-cycle expansion phase with moderate recession risk, while Europe faces near-term recession risks, and China may be emerging from its growth recession amid increased policy stimulus.
- Investments: The biggest gainers in Q2 were in more-defensive areas, including consumer staples, utilities, and minimum volatility strategies.
- Valuations: Cyclically adjusted price-to-earnings (CAPE) ratios for US equities remain above non-US valuations, suggesting a relatively favorable long-term backdrop for non-US stocks.
Market summary: Stocks enter a bear market amid growth fears, rate hikes, and inflation
Stock markets across the world led riskier assets lower during Q2, as concerns about the growth outlook weighed on sentiment. Credit-sensitive high-yield and emerging-market bonds suffered double-digit declines. Prices of higher-quality bonds continued to fall amid the rise in interest rates. Commodity prices lost momentum and experienced declines as well, but they remained a rare bright spot, with positive returns for the year to date.
A multitude of crosscurrents challenged the global economy and financial markets. Persistently high inflation, exacerbated by energy-price shocks from the Russia-Ukraine conflict, spurred the Federal Reserve to hike interest rates more aggressively than anticipated. High inflation and tighter financial conditions weighed on consumer and business confidence, and growth fears helped send stock prices into bear-market territory.
After pumping trillions of dollars of liquidity into financial markets the past 2 years, global central banks have pivoted toward monetary tightening. So far, 24 central banks have raised interest rates to combat inflation. The European Central Bank is tapering its quantitative easing program, while the Fed started to reduce the size of its balance sheet in June. Weakening liquidity growth may contribute to elevated market volatility.
Economy: The global business cycle continues to mature
Most major economies experienced maturing trends in their business cycles due to high commodity prices, inflation pressures, and tightening monetary and financial conditions. The US is in the late-cycle expansion phase with moderate recession risk, while Europe faces rising near-term recession risks. China shows incipient signs of emerging from its growth recession amid increased policy stimulus.
Global manufacturing activity exhibited late-cycle patterns, including positive, yet slowing growth rates, inflationary pressures, and rising inventories relative to sales. While global industrial production remained in expansion as of the end of Q2, falling new orders and rising inventories in the US and many other developed economies present a deteriorating outlook for global manufacturing activity.
US inflation reached a 4-decade high of 9.1% in June, although we expect consumer inflation rates to moderate over the next 12 months. The most extreme supply-related pressures are easing, particularly for manufacturing supply chains. Some sectors where price changes tend to be more persistent—such as housing and food—remain elevated but also may be peaking.
The Fed raised its policy rate 125 basis points during Q2 and signaled there is more tightening ahead. Through the lens of our Crisis, Response, Improvement, and Complacency (CRIC) policy framework, the Fed is in the “complacent” stage, in which it is willing to withstand higher market volatility and believes the economy can handle tighter financial conditions.
In the US, profit growth continued to decelerate, but remained positive. Expectations for earnings growth among stocks in the S&P 500 index for 2022 stood at 11%, far above the long-term average earnings-growth rate of 2% in late-cycle periods since 1950. The energy sector led the expected 2022 earnings gains by far (+136%).
Typical late-cycle patterns include a tightening credit market and an inverted yield curve. Fed hikes have raised the cost of borrowing, especially for mortgage rates, but bank-lending standards to consumers and businesses are not restrictive. Our preferred yield curve—the 10-year less 3-month Treasury yield—remains positively sloped. The yield curve likely will continue to flatten, and an inverted curve historically leads recessions by one year.
Labor markets in the US remain extremely tight, with the 3.6% unemployment rate near multi-decade lows. Consumers report jobs are very plentiful, but this and other indicators of employment strength may have already peaked—a typical late-cycle pattern. Nominal wage growth is the highest in decades, although high inflation has rendered real-wage growth negative and is weighing heavily on consumer confidence and real income expectations.
Overseas, China's grudging recovery appears to have gained traction, as industrial activity ticked up amid the lifting of COVID lockdowns. Fiscal and monetary policy easing picked up steam, including measures targeted to support manufacturing, property, and consumer spending. The continuation of zero-COVID policy remains a risk, and the upside for China's policy stimulus and economic recovery appears more muted relative to prior cycles.
Asset markets: Inflation-resistant categories led 2021 gains
All major asset categories sold off during Q2. Commodities and energy stocks fell but remained positive year to date. More-defensive sectors and factors performed relatively well, including consumer staples, utilities, and minimum volatility strategies. Emerging markets outperformed other global categories, but still finished with double-digit declines. Long-duration securities and bonds with lower credit quality suffered the biggest losses among fixed income assets.
Historically, during high-inflation regimes, commodities tend to perform better than bonds when the economy remains in late-cycle expansion. However, fixed income tends to outperform once recession risk becomes dominant. Tilting a portfolio toward more-defensive exposures during recessions may provide diversification benefits regardless of the inflation regime.
Both Treasury yields and credit spreads increased during the first half of the year across all major bond categories. A silver lining to rising rates is that after several years of extremely low bond yields, fixed income assets now offer relatively better income with more attractive valuations. In particular, credit spreads on corporate and emerging-market bonds finished Q2 above their respective historical averages.
For equities, the continued broad sell-off caused valuations for all categories of global stocks to fall further in Q2. Despite lower stock prices, cyclically adjusted price-to-earnings (CAPE) ratios for US equities remain above non-US valuations, suggesting a relatively favorable long-term backdrop for non-US stocks. The US dollar has strengthened versus most major developed-market currencies year to date, particularly against the Japanese yen.
Global earnings growth continued to slow in Q2 from the decade-high rates registered during the profit recovery in 2021. Forward earnings-growth expectations for non-US stocks ticked down, but they remained positive across all major categories of global equities—US, non-US developed markets, and emerging markets.
Copyright © Fidelity Viewpoints