Key Private Bank Investment Brief

Key Takeaways:

1. Some inflation risks are trending lower.

   • Headline inflation numbers, which include food and energy prices, generally continued to trend higher in May. Conversely, core inflation numbers, which strip out food and energy, decelerated slightly in May.
   • Various commodity prices, such as copper, aluminum, and wheat, have dipped sharply in the past several months. Gasoline futures (which tend to be less volatile than spot gasoline prices) have also declined in the past several months.
   • The Biden administration seems poised to reduce tariffs on Chinese goods – this move could also help lower inflation.
   
   

2. Recession risks are trending higher.

   • The Federal Reserve (Fed) seems willing to let a recession happen to quell inflation.
   • The 2-year/10-year Treasury curve has flattened significantly again, which tends to indicate worries about future economic growth.
   • Weekly initial jobless claims were as low as 170,000 in April 2022. The most recent weekly jobless claims number (for the week ending June 25) was 232,000 – indicating that claims have clearly inflected higher. The overall unemployment rate for May was 3.6%; however, it is a lagging indicator. The unemployment rate for June will be released on Friday of this week.
   
   

3. Investors’ willingness to embrace risk may be timeperiod dependent.

   a. The next six months or so could continue to be rocky.

   • For risky assets to find their footing, inflation needs to cool, while the Fed needs to slow down their pace of monetary tightening.
   • Corporate earnings also need to remain strong, although it is very likely that we will see a slowdown in the coming months. In a typical recession, earnings fall about 15%.
   • A workable peace between Ukraine and Russia would obviously be a very positive development.
   
   

   b. Twelve months or so from now, the economic narrative may be entirely different.

   • Inflation may have crested by this point, and the Fed may have paused their rate hiking cycle (or may already be easing rates).
   • Markets tend to anticipate changes in the economic landscape (both positive and negative).
   
   

Equity Takeaways:

After rising about 1% last Friday, stocks fell sharply in early Monday trading. The S&P 500 fell about 1.6%, while small caps dropped over 2%. International shares generally fell 2-3%, led by weakness in the Eurozone.

June equity returns were very poor. US stock markets dropped about 8%, developed international markets dropped about 9%, and emerging markets dropped over 5%. In the second quarter, US large cap equities dropped about 16%.

The S&P 500 dropped about 20% in the first half of 2022, one of the worst ever starts to a calendar year. The previous five worst first halves occurred in 1932, 1939, 1940, 1962, and 1970. In each of those years, the second half calendar year return was positive.

The current bear market is 6 months old (cycle peak was 1/3/22). The average bear market, going back to 1929, lasts 11 months. The median bear market lasts 8 months. The speed of the monthly decline during this year’s decline has been below average – a “run of the mill bear.” Volatility has remained muted during the downturn (trading has generally been orderly).

To get a capitulatory low, volatility would likely need to increase significantly to signal a full washout. Implied volatility (VIX) was 29.5 in early Monday trading – capitulation usually sees significantly higher readings on the VIX (36+).

S&P 500 earnings estimates have begun to inflect lower. Analysts are typically slow to revise estimates. Most of this year’s decline can be attributed to Price/Earnings multiple compression, as earnings have held up well to this point.

Fixed Income Takeaways:

In the last three weeks, 10-year Treasury yields have dropped about 60 basis points, to their Monday morning level of 2.81%. The 2-year Treasury yield was 2.80% in early Monday trading (the yield curve is very flat, reflecting> increased concerns about future economic growth).

High-quality core bonds dropped 4.7% in the second quarter and have declined over 10% year-to-date.

Credit spreads widened significantly over the past month, with high-yield bonds dropping 6.7% in June. Both corporate and municipal bond issuance has remained muted due to the market volatility.

Mutual fund flows remain a headwind to both the corporate and municipal bond markets. Investors continue to pull funds from almost all types of fixed income.