It was one of the worst first halves of a year in financial market history: the S&P 500 Index lost 19.96%, the NASDAQ Index was down 29.23%, and our global benchmark, the MSCI ACWI IMI, was down 20.44%¹. Bonds offered little refuge as the Bloomberg Aggregate Bond Index was down 10.35%¹. Here we detail what we believe are the key factors behind the selloff and our perspective on the remaining six months of 2022.

Factors Driving the Selloff:

• Inflation, running at the highest rates since the early 1980s¹, forced the Federal Reserve (Fed) and many global central banks to start tightening financial conditions quickly and on a larger scale than had been seen in decades. Many of these central banks chose to wait too long to start tightening and then, in essence, were forced to slam on the brakes in an effort to catch up to inflation.
• Our view is that this stubbornly high inflation was caused by a combination of extraordinarily accommodative monetary policy and fiscal stimulus during the pandemic, severe supply chain constraints caused by the pandemic, and commodity price shocks resulting from the pandemic and geopolitical issues. 

Outlook for H2/22:

We believe the outlook for financial assets through the rest of this year is supported by a changing inflation environment. We think the Fed will not need to be as aggressive in fighting inflation in H2/22 because many of the factors that the caused the rapid surge of inflation appear to be subsiding:

• China has re-opened its economy after strict lockdowns in H1/22 due to the pandemic. This will likely boost production and transportation of needed goods throughout global supply chains.

• Commodity prices have plunged across the board. After peaking in late spring and early summer, prices of items as diverse as copper and agricultural products have dropped sharply, which would help to reduce costs throughout the economy if the trend were to be sustained.
• Inventories at retailers have steadily increased in a sign that supply chains are healing.
• The Core Personal Consumption Expenditures Price Index (PCE), a preferred Fed inflation gauge, has fallen from a high of 5.3% in February to 4.7% year over year at the end of May¹. This occurred before some of the aforementioned price declines in commodities and the reopening of China’s economy.
• The Fed has increased the Fed Funds interest rate from, in essence, 0% to over 1.50%, which has slowed aggregate demand to better match supply. As one example, 30-year fixed rate mortgage rates nearly doubled from 3% to just shy of 6% in the first half, which has in turn slowed housing demand.

Odds in favor of recession and a continued bear market have increased but, as of now, this is not our assumption for the following reasons:

• The slope of the Treasury yield curve has not been persistently negative – the 10-year/2-year spread is +0.08% and the 10-year/3-month spread is +1.26%¹. Historically, when these spreads have turned negative and stayed negative for several months, recessions have typically followed 12-18 months later. While the curve is indeed very flat, it has yet to turn persistently negative. 
• The yields on the riskiest (high-yield) bonds compared to Treasury bonds have widened but not blown out as we have seen in prior recessions. The Bloomberg US Corporate High-Yield Average Option-Adjusted Spread Index is currently at 5.69%, up from 2.83% at the start of the year¹. The long-term average since 1993 is +5.02%,¹ so although the spread has widened this year it is to only slightly above average. To put this in perspective, it rose to almost 9% during 2020 recession, almost 17% during the 2008/9 recession, and nearly 10% in 2002 during the bursting of the dot com bubble¹. Therefore, we believe credit markets are not signaling an imminent recession as of now. 
• Labor markets are tight as jobs are being created and unemployment is low. There are around 5.5 million more open jobs than there are unemployed individuals¹. The unemployment rate at 3.8% is one of the lowest in the last 50 years¹. It is hard to imagine an imminent recession with labor markets so tight.
• Manufacturing data, typically a leading indicator, has clearly softened from levels above 60 last year, but is still at expansionary levels at 53 on the ISM Purchasing Managers’ Index¹. Historically, this number has typically fallen below 50 prior to recessions¹.
• The US mid-term elections will soon be over, which will remove one element of uncertainty. Perhaps post-election, elected officials could craft and implement a targeted infrastructure spending plan focused on improving economic productivity, which would help battle inflation longer term and support the economy in the shorter run. 
• Corporate earnings are likely still growing. Earnings season will start ramping up in the weeks ahead and Wall Street analysts’ estimates are for 4.1% earnings growth for Q2². Though this is a marked slowdown, earnings typically start falling during recessions¹.
• Valuations are now reasonable if inflation calms down. The forward P/E ratio for the S&P 500 is 15.94x versus a 25-year average of 16.86x.

We again reiterate that this environment requires patience, balance and discipline from investors. We do not know exactly when inflation and related volatility with subside, so we want to focus on what we can control. We are longer-term investors, not day traders. We think investors should be prepared for continued volatility and consider these actions now:

• Look for opportunities to tax-loss harvest while simultaneously increasing the quality of holdings.
• Rebalance
• Diversify any concentrated positions 
• Expect continued volatility in 2022
• Stay near “neutral points” with risk tolerance (i.e., if your risk tolerance indicates a 60% stock/40% bond allocation, then stay near that target) and do not try to time market moves.
• Seek companies that have strong competitive advantages, excellent management, solid balance sheets and generate free cash flow, which should allow them (and you as an investor) to hedge inflation.
• Seek opportunities for investment-grade yield: since interest rates have moved substantially higher this year, one can now find high-quality bonds that offer attractive yields.
• Review your financial plan. Unless something has changed with your liquidity needs, time horizon or general financial situation, we do not think you should make any large changes to your asset allocation. Also, consider other planning techniques like Roth IRA conversions, which may help your tax situation in the future.
• Don’t panic and make rash decisions. Inflation will come down over time and our economy and markets will be much healthier if we can maintain higher levels of interest rates compared to the last decade or so. 

Thank you for your confidence in our team during this time of volatility,

Asset Management Department

Sequoia Financial Group

Sources:  1.  Bloomberg/Bloomberg News, 2. FactSet, 3. Ned Davis Research, 4. Morningstar Direct