Nan Wang
US equity markets had a rough first six months this year, amid concerns of persistently high inflation and rising risk of a recession. After the worst start to a year in half a century, the S&P 500 index has lost 20.5% while the Dow Jones Industrial Average Index dropped by 15.3%.
The technology-heavy Nasdaq index declined by 29.5%, the sharpest first half selloff ever.
As more investors enter a “sell the rally,” rather than “buy the dip” mood; the second half of the year may provide more volatility and therefore more opportunity.
Macroeconomics
Some analysts define a recession as two consecutive quarters of negative gross domestic product (GDP).
In the US, a recession is determined by the National Bureau of Economic Research (NBER), using a set of data including “real personal income less transfers, non-farm payroll employment, employment as measured by the household survey, real personal consumption expenditures, wholesale retail sales adjusted for price changes, and industrial production”, with an emphasis on the first two items.
In late June, US first quarter GDP was adjusted lower, from -1.4% to -1.6%. Markets largely dismissed the negative GDP number, presuming that lower government spending and the higher trade deficit will revert in the following quarters.
On the other hand, softer consumer spending data has caught the market’s attention. As the largest component of the US GDP, consumer spending accounts for approximately two thirds of the nation’s output.
In May, real personal spending fell for the first time this year, by 0.4%; the previous four months data were all revised lower. During the same period, inflation-adjusted income declined by 0.1%. Weekly jobless claims have ticked up in recent month, but still remain near pre-pandemic lows.
As various macroeconomic measures show signs of weakening, there is increasing concern of a recession within the next 18 months. Looking at the 12 recessions since 1948, the median increase in the jobless rate was 3.5%, jobless rate was above 6.1% during all these periods.
Given the strong employment numbers, the U.S. could still avoid a recession despite the slowdown.
Inflation
The US central bank has a dual mandate to promote maximum employment and maintain stable prices. As the unemployment rate continues to decline this year and approaches the pre-pandemic low of below 4%, Fed Chair Jerome Powell has repeatedly emphasised the Federal Open Market Committee (FOMC)’s focus to bring inflation back to their 2% objective. After the Consumer Purchase Index (CPI) unexpectedly accelerated to a 40-year high in May, policymakers raised rates by 75 basis points (0.75%) in their June meeting, the largest increase since 1994.
On the other hand, the Fed’s preferred gauge of inflation, the Personal Consumption Expenditure Index (PCE) showed sign of peaking in March.
Although the June CPI once again surprised on the upside, at 9.1%, the increase was largely the result of higher gas prices. This month, gas prices have, in fact, been on a steady decline which should place downward pressure on next month’s headline CPI number.
There are also signs of prices dropping across other sectors. Many commodities including copper, oil, lumber and wheat have fallen dramatically from their recent peaks.
Shipping rates, although still way above their pre-pandemic levels, have come down significantly. According to the World Container Index, the cost to ship a 40-foot container from Shanghai to Los Angeles, one of the busiest shipping routes, has decreased from its peak of $12,000 to $8,000. Semiconductors, an important component in phones, computers and electric cars, have also seen prices moderate as the supply shortage recedes.
Sign of easing inflation will put less pressure on the Fed to employ hawkish policies. Analysts are expecting more 50 bps increases this year; however, a rate cut is possible as early as next year if inflation gets under control. A less hawkish Fed should help boost market sentiment and could lift stock prices.
Historical returns
According to our study of past bear markets, the US has had 26 bear markets since 1928. The average length of a bear market was 289 days, and the S&P index lost 33% on average during those downturns.
The average recovery one year after the end of a bear market was 24%, and the average bull market has lasted 2.7 years, gaining 112%. Since US equities have been in a decline for more than six months, we may be closer to a rebound as the market sell off deepens, if history repeats itself.
Investor sentiment
An increasing number of indicators are beginning to signal that the market may be close to a bottom. Individual investors’ sentiment toward the stock market are quite bearish, as measured by the AAII US investor sentiment readings.
In late June, bearish readings were almost three times higher than the bullish reading. During the same period, the percentage of S&P 500 companies trading above their 50-day moving average dipped below 5%, the lowest in two years.
The VIX Index, which is widely used as the market’s fear gauge, has been trading between 20 and 35 this year. Although higher than previous year’s levels, it is below typical market bottoms level of above 45.
Conclusion
In periods of elevated volatility, it is even more important to stick to your investment discipline. For long term investors, higher volatility represents opportunities to buy and add to high quality companies at a discount.
As the investment guru Warren Buffett famously said, “Be fearful when others are greedy, be greedy when others are fearful.”
More pain may be seen in the global economy, but investors should be prepared to not miss the next ride up.
Nan Wang, CFA, is a portfolio manager at LOM Asset Management Ltd in Bermuda. Contact the Cayman office of LOM at (345) 233-0100 for further information.
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