Weekly market wrap

Midyear Market Checkup

With just a few days away from the end of June, stocks gained some ground last week but remain down about 10% in Canada and nearly 20% in the U.S., the S&P 500's worst first six months of any year since 1970¹. Aggressive central-bank tightening, concerns around inflation, and the effect of these two factors on growth have led to a rapid adjustment in interest rates, valuations, and sentiment. We think that the economy will continue to slow in the quarters ahead, reflecting the lagged impact of policy tightening. However, the year-to-date sell-off in both stocks and bonds has improved future returns for long-term investors. We'd offer the following perspective on how the economy, stocks and bonds are shaping up at the midyear point and what could be in store for the second half.

^{Source: Morningstar, Edward Jones as of 6/23/22. Stocks represented by the S&P 500, bonds by the Bloomberg Barclays U.S. aggregate bond index, and commodities by the Bloomberg Commodities index. Past performance does not guarantee future results. Market indexes are unmanaged and cannot be invested into directly.}

The graph shows returns for stocks, bonds and commodities through the first half of this year, and how they compare with the returns of an average year. 

The economy

First-half assessment:

• After having grown north of 4.5% in 2021, the U.S. and Canadian economies entered the year from a position of strength¹. A positive outlook was supported by pent-up consumer demand because the pandemic headwinds had started to fade, the labour market was robust, and corporate and household finances were solid. Yet, lingering inflation pressures, which worsened following the invasion of Ukraine and lockdowns in China, started taking a bite out of personal disposable income and savings, and forced the Fed and BoC to signal an aggressive rate-hike path.
• First-quarter GDP unexpectedly contracted in the U.S., driven by a drag from exports and a decline in inventory spending. But consumer spending, which accounts for nearly 70% of U.S. GDP, continued to grow at a solid pace. A real-time estimate of second-quarter GDP from the Atlanta Fed is currently showing 0% growth¹. While there is a risk of another quarter of negative growth that would meet the definition of a "technical" recession (two consecutive quarters of negative GDP growth), an "official" recession as designated by the NBER Business Cycle Dating Committee is not in the cards in the first half. There are no signs of a widespread downturn in activity or in the labour market. Relative to the U.S., the Canadian economy has experienced a stronger rebound in the first half, supported by a lagged economic reopening, and growth in output in the resource and construction industries.

Second-half prognosis:

• As we move into the second half of the year, demand will likely decelerate as consumers and businesses react to the sharp rise in borrowing costs. Typically, changes in central bank policy impact the broader economy with a lag, but the interest-rate-sensitive sectors, such as housing and autos, are already slowing. Mortgage applications are in a downtrend, mortgage spreads have widened and existing home sales in Canada and the U.S. have been declining in the last three months¹.
• The labour market remains tight, which, along with household savings, will continue to support growth. However, applications for U.S. unemployment benefits (initial jobless claims) have been slowly rising over the past two months, as companies are taking a more cautious approach to hiring amid elevated costs and slowing demand. Even as conditions shift, it will probably take a while to clear the imbalance between labor supply and demand and for unemployment to rise meaningfully. Job openings are still twice the number of unemployed workers¹. We don’t think that the economy is facing an imminent threat of a recession, but the downside risks are increasing.
• Inflation has broadened and proven stickier, which means that the BoC's foot will remain firmly on the brakes for the economy this year. While a lot of the factors that are driving inflation are outside of the BoC and Fed control, the sharp rise in rates will have an impact on demand, economic activity and eventually inflation. Last week's drop in commodities and pullback in bond yields was a reminder that prices respond to the changing conditions, and that there is still a path for the Fed to move more gradually in the back half of the year.

^{Source: Bloomberg, June FOMC projections}

The graph shows U.S. real GDP growth and the Fed's recent projections.

Equity markets

First-half assessment:

• The first half of the year contained an all-time high for stocks early on, then the longest losing streak since 2001 followed, and now we are seeing an ensuing bear market in the U.S., the second 20%+ drawdown in three years1. With oil prices up 40% this year, energy was the clear outperformer and the only sector to post gains along with consumer staples¹. Utilities also outperformed, as investors sought the safety of companies that are less sensitive to the business cycle. On the other hand, growth-style investments lagged the most as bond yields rose, with the TSX technology sector down 50%¹.
• A breakdown of the market return into two components -- 1) change in valuations, and 2) change in corporate earnings -- reveals that this year's decline in stocks has so far been exclusively driven by a decline in valuations, with corporate earnings growth acting as a partial offset. Specifically, the S&P 500 price-to-earnings ratio has fallen 26% (from 21.3 to 15.7), while forward earnings have risen by 6%². For perspective, in the past five Fed-tightening cycles since 1985, valuations declined 20%². Similarly for the TSX, valuations have fallen 23% while earnings are 12% higher as shown in the graph below.

Second-half prognosis:

• We expect more volatility because uncertainty remains as to how restrictive central bank policy needs to be to break the back of inflation. As GDP growth slows and likely falls below, earnings expectations will probably move lower (analysts expect S&P 500 and TSX earnings to grow 10% this year and 23% respectively)¹. While valuations have already corrected, the likely necessary process of revising earnings expectations could weigh on sentiment in the months ahead. The kickoff of the second-quarter earnings season in three weeks will provide some clarity on how resilient the outlook for corporate profits is. Our sense is that current estimates will be clipped, but this year's earnings will still be able to rise from last year.
• Without the benefit of central bank support, the bottoming process will likely be bumpy and prolonged. And for stocks to stage a durable rebound it will likely require several months of moderating inflation. Given the unpredictable nature of geopolitical events that affect commodity prices, the range of outcomes is wide. However, the markets are already pricing in some type of a recessionary outcome, and the pullback is creating compelling opportunities for those with a broader time horizon.
• Over the past 80 years the average bear market (11 instances including those that were triggered by deep recessions like in '07-'08) saw equities decline 35% from their peak over the course of a little over a year². Considering that stocks are currently down about 20% and that the average bull market has lasted almost five years with stocks rising 177% on average, the benefits for staying invested appear to offset the risks ². For long-term investors, it is ultimately more important to be well-positioned for expansions than to try to time recessions. We think diversification across asset classes and a focus on higher-quality investments can help navigate the heightened volatility, while also positioning investors to benefit from the next upcycle.

^{Source: FactSet, Edward Jones, 6/23/22. Past performance does not guarantee future results. Market indexes are unmanaged and cannot be invested into directly.}

The graph shows that this year's decline in stocks has been exclusively driven by an adjustment in valuations rather than a drop in earnings estimates.

Fixed-income markets

First-half assessment:

• A key reason why performance for balanced portfolios has suffered more this year than past equity-market pullbacks of this magnitude is that bonds have not provided their typical diversification benefit (bond prices tend to rise when stocks decline, and vice versa). Instead, bonds sold off along with stocks in the first half, as the central banks' signaling of an aggressive tightening policy triggered a major reset in yields. The 10-year GoC yield more than doubled in six months and hit a new cycle high at about 3.6% before falling sharply last week, as recession worries weighed on commodity prices¹.
• The bond market priced in the fastest hiking cycle since the 1990s, with the fed funds rate expected to settle in the 3.50% - 3.75%% range by the end of the year from 1.75% in the U.S. and 1.5% in Canada currently, indicating a mildly restrictive policy. For perspective, the Fed and BoC estimate that the neutral rate (where policy is neither accommodative nor restrictive) is about 2.5%¹.

Second-half prognosis:

• Bonds are down, but they’re not out. With interest rates having reset higher, we expect better returns in the second half of the year, and we see an opportunity emerging to put some cash to work. Investors can now find attractive yields in higher-credit-quality bonds. The additional income earned from intermediate- and long-term bonds can help compensate for the increased interest-rate risk relative to cash or other cash instruments, in our view.
• Without attempting to predict the exact peak in yields, the 10-year at around 3.5% or slightly higher is consistent with the market pricing and the Fed's projection of what the peak policy rate will be. As shown in the graph below, long-term government bond yields in the past have tended to converge near the peak of the fed funds rate for the cycle. Historically, the 10-year has peaked about two months before the last Fed hike, on average². While we are still possibly a year away from that point, markets have front-run the Fed and BoC faster than in the past and are already pricing in an aggressive rate-hiking cycle.
• Amid growth worries and recession anxiety, we think that bonds can once again show their value by helping buffer against ongoing equity-market volatility. Inflation pressures will likely start to ease in the second half, and investors are now getting paid an adequate return, in our view, suggesting that bonds will be better able to help provide portfolio protection. But as the economy slows and borrowing costs rise, the credit environment will become more difficult, which is why we recommend a focus on quality. As the economic expansion moves toward the late stage of the cycle, lower-quality fixed-income asset classes (high-yield bonds) become less likely to outperform their higher-quality counterparts. We think U.S. investment-grade bonds strike the right balance.

^{Source: FactSet Edward Jones. Past performance does not guarantee future results.}

The graph shows the cycle peaks in the 10-year Treasury yield and the Fed funds rate

Angelo Kourkafas, CFA
Investment Strategist

^{Sources: 1. Bloomberg, 2. FactSet, Edward Jones calculations}

Weekly market stats

^{Source: Factset 06/24/2022. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. * Source: Morningstar, 6/27/2022.}

The Week Ahead

Economic data being released this week include GDP by industry on Thursday.