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  1. Home
  2. / Investing
  3. / Stocks

After the Worst Half Since the '70s, What's in Store for the Second Half?

The short answer is a rough patch, especially if the housing market takes a serious tumble.
By MALEEHA BENGALI
Jul 05, 2022 | 09:30 AM EDT
Stocks quotes in this article: WMT, TGT

As we end the first half of 2022 with the worst performance for equities and bonds since the 1970s, the question on everyone's mind is, "Is it time to buy the market now?"

Ordinarily when equity markets have dropped precipitously, this new generation of traders has been rewarded over the last decade for just buying the dip. It has been a handsome payoff for anyone so inclined to mechanically buy the dip without asking too many questions.

It is this same complacent nature that had given rise to such lofty valuations across the board. Thanks to the Fed's Modern Monetary Theory experiment when no harm could be done from endless money printing, these traders are now coming to terms with the consequences of their actions, namely inflation. Just because it never existed in the past decade, it did not and does not mean it could not happen this time around. And it did, in full steam.

Financial advisors have made their careers over the past decade recommending a 60-40 equity/bond portfolio, which had worked extremely well as bonds and equities were a perfect hedge, until now. Of course, these correlations and analysis were run over a period where there was no inflation, so it worked. But with inflation rising to as high as nearly 10% year over year this year, bonds collapsed. In addition, the Fed is now embarking on quantitative tightening (QT), not quantitative easing (QE), which means less bond buying by the Fed. Inflation is bad for both equities and bonds. The same 60/40 mix that was designed to be a hedge is now a double-edged sword as investors get hit from both sides.

The markets in the first half of 2022 seemed a déjà vu of 2008, when global supply tightness along with a huge demand surge caused a massive surge in commodity prices, especially oil. Just like then, the equities and other asset markets were flashing red, but oil refused to acquiesce to it until only months later.

Demand and supply tightness can take commodity markets only so far until demand falls in line with supply. The economy that we are in today is one that is showing contraction across the board, as shown by the Atlanta Fed's second-quarter estimate of a 2% decline in GDP. Fed members can only stare at their computer screens as the only tool they have had to support the markets has been to cut rates and QE.

Today with inflation where it is, they cannot do that. If they did, then we would be earmarked for stagflation for life. All they can do is hope that supply chains ease and pullback in demand is hard enough to take asset prices, especially raw material prices, lower across the board. Demand is key here and the Fed's only choice is to stay strong and keep tightening as fast as it can so that it will have room to cut rates at some point next year if it needs to, or unless something in the system snaps.

Most look at markets down 20% and scream pain, yet the S&P 500 is still up 12% from its pre-Covid levels. The $20 trillion to $30 trillion in stimulus printed at the time of Covid lows caused markets to reach new highs, and the sudden demand surge caused supply shock as the system did not have time to prepare for that surge.

It remains to be seen what we have in store for the second half of 2022, but one thing is for sure -- the Fed's work is not done for now. Oil prices may have fallen 15% and basic resources are down 20%-plus, but soon we need to start seeing rent, gasoline and the cost of consumer goods come down as well.

For now, the US consumer is trapped. Consumers are unable to spend as they did as they have used up all the government stimulus money. We can see that in retailers such as Walmart (WMT) and Target (TGT) that have announced massive stocking of inventory and price discounts to come.

The US 10-year bond yield has dropped down to sub 3% from highs of 3.5%, suggesting that we are now entering a deflationary phase. Deflationary phase does not mean the end of inflation; it just depends if it can get back down to the 2% to 3% target with which the Fed is comfortable.

The inflation scare has now moved into a growth scare as recession is already in the cards in various economies. The financial system is like a Jenga tower. How deep and long the recession will be depends on how well the Fed is able to engineer this delicate balance of tightening without the pieces of the tower tumbling too soon. The black swan could be the housing market, as there is a real threat of real estate prices falling given the surge higher in mortgage rates and monthly mortgage payments doubling for the same house. Who knows, maybe this is not 2008 after all, but a 2008 version 2.0.

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At the time of publication, Bengali had no positions in the stocks mentioned.

TAGS: Economy | Federal Reserve | Interest Rates | Investing | Stocks | Housing Market | Real Money

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