The second quarter of 2022 was a difficult period for both stocks and bonds as the Federal Reserve, faced with unacceptable high inflation reports, lifted interest rates in June by 75 basis points. This was the highest rate increase implemented since 1994. The credit markets anticipate another 75 basis point increase later this month.
The Fed is raising rates this year in the hope of generating enough economic slack to bring inflation down meaningfully in the coming quarters. The risk is that they tighten too much, causing the U.S. to slide into recession. We believe a recession is quite likely, as stock market declines of the magnitude seen thus far in 2022 have almost always resulted in an economic slowdown. Already nearly $12 trillion dollars in financial wealth has been lost by U.S. investors during this bear market. This will adversely impact consumer spending in the times ahead.
Signs of slowing economic growth can be seen in recently reported data. The housing market has turned down as mortgage rates doubled from 3% at the start of the year to 6% currently. Commodity prices are falling after spiking earlier in the year. We will be watching second quarter earnings reports carefully, as rising labor and energy costs are reducing corporate profit margins. A combination of very strong dollar and supply chain difficulties will also weigh heavily on large U.S. multinational operating earnings.
With the S&P 500 index and Nasdaq composite down 20.0% and 29.2% respectively, the stock market has garnered most of the media’s attention in recent weeks, but fixed income performance has been equally soft. The Bloomberg U.S. Aggregate Index, widely viewed as a proxy for the U.S. bond market, is down 10.4% for the first half of 2022 and off to its worst start in half a century.
By many measures, the double-digit losses in stock and bond indexes make 2022’s first half the worst financial markets start to a year since 1970. Rising interest rates have been particularly problematic for the more speculative equity securities, particularly companies that haven’t yet demonstrated that their business models can generate consistent profits.
We continue to emphasize stable operating businesses and high-quality balance sheets in our security selection process. Declining security prices invariably set up excellent long-term investment opportunities, but patience and strict purchasing disciplines are necessary to balance future rewards with current capital risks.
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