May 2022 Market Commentary
June 6, 2022
Roller coasters, no matter how many ups and downs, or twists and turns, invariably end back where they started. While there are no similar guarantees for financial markets, May was a roller coaster in the truest sense. Over the course of the month, the S&P 500 rose or fell by 1.5% or more on 10 separate days, briefly entered bear market territory, recorded its best weekly gain since November 2020, and ended exactly where it began. Unchanged during the month were the now well-known issues of inflation, the Fed, Ukraine war, and Chinese lockdowns. What changed over the course of the month, however, was investor sentiment.
At the outset of 2022, we expected market volatility to be heightened during the first half of the year as corporate earnings and economic growth slowed, and investors waited to see how aggressive the Fed would be in tackling the highest inflation in 40 years. Unbeknownst to us at the time, was that Europe would soon experience the largest scale fighting since World War II, and China would implement draconian lockdowns to combat the rapid spread of the coronavirus Omicron variant.
Ukraine and Russia notwithstanding, our expectation was that inflation would begin to slow in the second quarter, and that investors would gain a better understanding of how the Fed intends to tackle inflation, which together would help temper volatility in the second half of the year. As expected, April inflation data released during May suggested that inflation may have reached an inflection point, as the three primary measures- consumer inflation (CPI), producer inflation (PPI) and the Fed’s preferred gauge, core personal consumption expenditures (PCE)- all declined, albeit modestly, on a year-over-year basis. In addition, the Fed provided greater visibility into its planned course of action(s), indicating that they expect to raise rates by 0.50% at their next “couple of meetings” but at this time do not feel that a 0.75% increase at an upcoming meeting, is warranted.
The combination of those two factors seemed to assuage some of the concerns that had been building during the first four months of the year. So too did economic data showing that consumers remain relatively healthy and willing to spend, and labor markets remains strong. While April marked the 12th consecutive month of nonfarm payrolls adding 400K+ jobs, May fell just short at 390K. However, despite the generally sound economic data, concerns about a possible recession intensified during the month, spurred by disappointing earnings reports from Walmart and Target in particular, which raised questions about companies’ ability to continue to pass along higher prices to customers, as well as questions about the consumer’s ability to continue to weather inflationary pressures. In addition, by his own admission, Fed Chair Jay Powell acknowledged that orchestrating a “soft landing” (i.e., raising rates enough to combat inflation but not tip the economy into recession) would be “challenging” and that there would likely be some “pain” associated with the Fed’s efforts.
Currently, the biggest wild cards facing markets and the economy are the ongoing ripple effects from the fighting in Ukraine and lockdowns in China. Fighting in Ukraine, and sanctions levied against Russia, have severely curtailed exports of various commodities including grains and fertilizers leading to a surge in global food prices. While developed countries are better able to withstand the rising prices, numerous developing market countries in the Middle East and Africa are facing growing food insecurity. In China, lockdowns of Shanghai and other cities/regions severely impacted global supply chains just as they were beginning to improve. As those lockdown ease and production resumes/accelerates, supply chains will benefit. However, as 2020 and 2021 demonstrated, supply chains cannot easily be turned off and on, thus improvements will likely be gradual as opposed to immediate.
As previously noted, for the month, large caps (S&P 500) were flat. That was a welcome outcome, given that the index briefly entered “bear market” territory on May 20, on an intraday basis. After that brief scare, however, the S&P 500 rallied 5.9% over the following six days to end the month flat, though it remained down 13.9% since the start of the year. While it may be tempting, to suggest that equity markets bottomed on the 20th, such a proclamation could be premature. Despite the S&P 500 itself avoiding bear market territory, 50% of companies within the index ended the month in bear market territory. International market returns were essentially flat for the month, with developed (MSCI EAFE) and emerging (MSCI EM) markets returning 0.2% and 0.1%, respectively.
Fixed income, as measured by the Bloomberg US Aggregate Bond Index, returned 0.6%. Munis were the best performing sector gaining 1.6%, followed by investment grade corporates which returned 0.5%. Similar to equity markets, May looked to be another month of losses for fixed income, especially early in the month as yields continued to climb. However, yields peaked over the first week, after which Treasury bonds rallied over the rest of the month. The 2-year Treasury reached a peak of 2.78% on May 3rd, while the 10-year Treasury peaked on May 6th at 3.13%. From those peaks, yields across the curve dropped 23-28 basis points by month end. The catalyst for the turnaround was a drop in inflation expectations, combined with continued concerns about economic growth. Those factors in turn raised questions about the Federal Reserve’s ability to hike as aggressively as previously envisioned, thereby pulling yields down. In addition, some Fed members suggested that a pause in rate hikes might be appropriate after the next couple of meetings, to assess the impact of recent rate hikes on economic output. Such a pause, however, would only be warranted if a significant decline in inflationary forces was observed.
Municipal bonds saw a more aggressive turnaround, rebounding nearly 3% over the final couple weeks of the month. Both the 2- and 10-year AAA munis fell 45-50 basis points from highs seen on May 18th. The rebound in munis was partly in reaction to the movement in Treasury bonds, but two other factors also had significant influence. First, municipal fund outflows showed signs of slowing after months of consistent redemptions, helping supply and demand normalize. Second, municipal bond valuations had grown very attractive on a relative basis as Treasury yields began to fall early in the month. The valuations became too attractive for institutions to pass up by mid-month, leading to a surge in buying activity, and significant municipal outperformance to close out the month.
Looking forward, we maintain that volatility will likely remain elevated as inflation remains high, corporate earnings and economic activity slows, and talk of a recession increases. However, any meaningful slowing will likely challenge the Fed’s ability to hike rates as aggressively as currently anticipated. If, or more likely when, the Fed is forced to temper the pace of its rate hikes, both equity and fixed income markets should benefit.