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Markets Had a Terrible First Half of 2022. It Can Get Worse.
The first six months were full of surprises, from surging inflation to a crypto implosion. Get ready for more shocks in the second half.
By James Mackintosh
We’re halfway through the year, but markets are beginning to fear we’re not even halfway through the bad news 2022 has in store.
The first six months were full of surprises: Inflation. The biggest selloff in bonds in four decades. A plunge in tech stocks rarely matched in history. And the implosion of crypto.
The looming risk that investors ignored for months is recession. But whether the economy will slump or be just fine remains unknown. Attempts to put a probability on it range from 90% in a Deutsche Bank survey of clients to the spurious precision of 4.11% in the New York Federal Reserve’s recession forecasting model.
While investors are at last focused on recession uncertainty, risks elsewhere in the world could hit U.S. investors, too. Japan might finally be forced to relent and allow bond yields to rise, which would suck back cash the country’s investors had poured overseas. In Europe, the central bank has promised a new plan to support Italy—but we’ve seen this show before. If it follows the pattern of too little, too late, we could see a return of the eurozone debt crisis, something markets are not prepared for.
Almost any economic outcome is likely to prove a fresh surprise. If there’s a soft landing, stocks should do well as the recent recession panic reverses. If there’s a recession, there could easily be a big loss still to come, since only the drop of recent weeks appears to be related to recession risk.
There’s one sliver of good news: Prices are already down a lot, which brings them closer to wherever they will eventually bottom out. The S&P 500 has fallen by the most in the first half of a year since the 21% loss in 1970, when the economy was in recession. Long-dated Treasurys lost 10% even including coupon payments, the biggest six-month loss since Paul Volcker’s Fed forced the economy into recession in 1980.
There’s no sure way to work out what probability the market is putting on the Fed driving the economy into recession this time.
J.P. Morgan strategist Nikolaos Panigirtzoglou says the simplest way to extract probabilities from the price moves is to compare price falls with the average peak-to-trough fall of past recessions. Since the S&P 500 is down a bit over 20% and the average fall in the last 11 recessions was 26%, that suggests an almost 80% chance of recession is priced.
Yet, much of this year’s selloff wasn’t about recession risk. To see this we need to distinguish the direct and indirect effects the Fed has on prices of stocks and bonds.
The direct effect is to push up bond yields and push down valuations of stocks with profits far in the future, which means those with high valuations such as Big Tech. This is what dominated until June, with bond yields soaring and growth stocks crashing, while cheap “value” stocks were basically fine. Exclude the technology sector to strip out the bulk of this effect and economically-sensitive cyclical sectors of the stock market had only slightly underperformed defensives by June 7.
Then it all changed. Investors woke up to the indirect effect of the Fed, which is to weaken the economy. This has almost the opposite effect on asset prices. A weaker economy means less inflation than otherwise, justifying lower bond yields. It also hits earnings, particularly for cyclical companies, which tends to hurt stocks with relatively low valuations more than growth stocks.
Since June 7 cheap stocks have been hammered and cyclical sectors—especially oil stocks and miners—have plummeted. In the past two weeks recession fears showed up in Treasurys too, as investors bet that the Fed will have to cut rates aggressively next year. The drop of almost half a percentage point in the 10-year Treasury is the most over such a period since the first pandemic lockdown. Wall Street analysts have also been racing to cut their earnings forecasts, after ignoring recession risks and actually upgrading earnings predictions in the first five months of the year.
The markets now understand the outlook is clouded, so will be less bothered by a sudden shower. But investors will still get drenched if the storm of a deep recession washes away earnings.
There are clear risks that could be imported from abroad. Hedge funds are betting big that the Bank of Japan will abandon its bond yield controls, which have shielded it from tightening global monetary policy and crushed the yen. If the hedge funds are right—and there’s nothing forcing the BoJ to act, let alone soon—Japanese bond yields would leap and the yen’s extreme weakness go into sudden reverse, roiling markets globally.
Better yields at home, as well as the prospect of losses on the currency, would push Japan’s army of small investors to repatriate their money, pushing the yen up and prices everywhere else down – and adding more upward pressure to Treasury yields.
The risk from Europe is familiar: politics. The European Central Bank acted early to head off a crisis in Italy’s government financing. It now has the difficult job of persuading the frugal north to accept a deal underwriting the country’s bonds, without imposing unacceptable conditions on Italy. If it fails to come up with enough money, Italy and the eurozone could be in serious trouble again by the autumn.
I remain hopeful that recession will be mild, not hit until next year, and perhaps be avoided altogether. But the economic data are going the wrong way, and higher interest rates haven’t even begun to bite on ordinary households yet. The dangers are big, and the markets are still not fully prepared.
