As if the first quarter’s sell-off wasn’t bad enough, it turned out to be just a preview of the even worse second quarter. After a brief period of calm, the S&P 500 (a broad measure of large US stocks) plummeted 16.1%, rounding off the worst first half of the year for US stocks since 1970. International stocks did almost as badly, with the MSCI ACWI ex-US (all major global stock markets except the US) falling 13.7%. Even though oil stocks didn’t do as well as they had in recent months it was still another rough quarter for sustainable investors, whose preferred stocks tend to be growth-oriented.
Bonds didn’t do quite as badly as in the first quarter but the Bloomberg US Aggregate Bond Index was still down 4.7%. Municipal bonds lost a little more ground as well. Once again, the only safe haven was cash. As for cryptocurrency, that’s another story that was very satisfying to some of us.
What’s going on? Inflation, of course. Higher inflation leads to higher interest rates, which make both stocks and bonds less attractive. Eventually, higher interest rates can lead to a recession, which further hurts stocks even as it makes bonds more attractive again. Interest rates are already rising and are expected to keep rising but we don’t yet know how high they will have to go to bring inflation back down and we don’t know if this will cause the economy to tip into recession. After nearly forty years of low inflation and low interest rates, the markets have rediscovered a nearly forgotten type of uncertainty. This made the higher-than-expected May inflation numbers – released in early June – a real shock to the system.
Will Inflation Ever Stop Rising?
After months of steadily rising inflation, many – including me – believed that the peak had been reached in the spring and that we would start seeing lower numbers in May and June. The shockingly high 8.8% annual inflation rate recorded in May took care of these optimistic expectations and then June’s annual inflation came in at 9.1%. This has happened even as supply chain pressures have eased.
Many factors have been driving inflation: lingering supply chain issues, labor shortages, the money injected into the economy in early 2021 by the Biden administration, grain prices, and – of course – energy prices. It’s important to remember that much of the world has been suffering from higher inflation. It’s not just a US problem. Inflation in Germany and the UK is as high as it is here and central banks all over the world have been forced to raise interest rates. So no, it is not all Joe Biden’s fault; the two primary reasons for high inflation globally are the pandemic and Russia’s invasion of Ukraine.
Naturally ever rising inflation is causing real pain to consumers and alarm among economic forecasters, and many fear a return to the stubbornly high inflation of the 1970s. It’s clear that the Federal Reserve was caught by surprise and those at the Fed and in the Biden Administration who called last year’s surging inflation “transitory” are looking a little foolish now. There is genuine concern that the Fed is too late to stop higher inflation from becoming entrenched across the economy as businesses and consumers incorporate higher inflation expectations into their decision-making. This would lead to the situation the US faced in the late 1970s when very high interest rates and a steep recession were needed to break the self-reinforcing high inflation economy.
There is some encouraging data on that front, fortunately. The Fed is now moving aggressively, with two 75 basis point (0.75%) rate hikes behind it and another likely at its next meeting. Consumers and investors remain confident that it will succeed in bringing inflation back down. Both the long-running University of Michigan survey of inflation expectations and the Fed’s own survey have recorded a drop in expectations over the last month and consumers expect inflation to be back to the 2% range over the medium term. The same is true of the bond markets, where the premium investors are willing to pay for inflation-protected bonds has fallen (see recent reporting on Bloomberg and columns by Paul Krugman in the NY Times for details). Falling energy prices and the ongoing normalization of the supply chain should help tighter monetary policy push both inflation and inflation expectations down. Markets will remain obsessively focused on this question for the next several months.
Will the Federal Reserve Drive the Economy into Recession?
When the sell-off was in its early stages the markets were most concerned with the primary effect of higher interest rates: stocks becoming less attractive, especially growth stocks, which are expected to deliver earnings farther into the future. As inflation continued to rise the corresponding need for interest rate hikes grew and a new investor concern arose. Would the Federal Reserve have to raise rates so high that they would choke the economy, just as happened in the early 1980s? The bond market is clearly concerned about this: the shorter term two-year rate on US Treasuries is now higher than the longer term ten-year, a classic market signal of impending recession (though not always an accurate one).
There is no consensus on this issue and in fact, economic growth forecasts are all over the place. Some economists are predicting a recession while others think the Fed will again guide the economy into the fabled “soft landing”. So far, the indicators remain largely positive. Unemployment remains at a mere 3.6% and hiring is strong. While some retailers have been reporting weak sales and a few companies that did especially well during the pandemic lockdown (e.g.: Peloton, Netflix) have seen a sharp drop in sales, overall consumers are continuing to spend. (June retail spending was up slightly). Both consumer and corporate balance sheets are in good shape, with low levels of indebtedness across the economy. Funding from last year’s stimulus and infrastructure bills is still supporting public sector spending and investment across the country.
At this point, the housing market is the biggest concern. Mortgage rates have risen sharply in recent months. Only a little over a year ago it was possible to get a 30-year fixed rate mortgage for under 3%. Now borrowers are being charged 6.5%. This is already having an effect on housing prices. While mortgage rates are no longer rising as quickly, the housing market is likely to continue to slow, especially since prices in many parts of the country are sky-high. Housing is such a big driver of the US economy that a sharp slowdown in this sector would likely hurt overall growth hard. Fortunately, lenders have been much more conservative than they were in the run up to the 2008-09 financial crisis.
We’ll Always Have Schadenfreude
A consolation for those of us who invest based on economic and financial fundamentals has been the collapse of the Cryptocurrency and “Meme Stock” bubbles. The highest-flying investments usually fall the hardest when the good times come to an end and the more speculative the investment the harder it usually falls.
Despite years of hype and soaring prices, cryptocurrency backers have failed to displace government-backed currencies outside of illegal niches such as drug smuggling and paying ransoms. About all one can buy with crypto is other crypto. It has so far failed to establish itself as a means of exchange, even in El Salvador, which has declared Bitcoin to be legal tender. With crypto failing as a means of exchange its backers touted the digital coins as a store of value, safe from inflation and government interference. But cryptocurrencies have no intrinsic value; they are only worth what someone else is willing to pay for them. At least a tulip bulb can be planted in the ground to grow and flower. As interest rates started rising and investors became more cautious, gravity caught up with cryptocurrencies, including the so-called “stable coins” that were supposedly anchored to the value of the US Dollar. The two biggest cryptocurrencies – Bitcoin and Ethereum – are down over 70% from their peaks in 2021. While this is a disaster for those who were caught up in the hype and invested in crypto it is very satisfying for the rest of us who remained skeptical, particularly since the Cryptocurrency bubble burst without infecting the real financial system.
The Meme Stock bubble didn’t last as long as most of the excitement was in the first quarter of 2021. Many of the true believers in such stocks as GameStop, AMC Entertainment and Bed, Bath and Beyond remained invested nonetheless, convinced that more conventional investors were overlooking these troubled companies’ true value. Some even believed that they were fighting for justice by causing Wall Street hedge funds to lose money on their short positions. In the end, the economic fundamentals won out, as they generally do, eventually. According to Bloomberg an index of meme stocks (Solactive Roundhill Meme Stock Index) lost over 50% in the first half of the year.
A Challenging Time for Sustainable Investing
Just as sustainable investing was becoming mainstream it has found itself challenged on several fronts. By their nature, the kinds of stocks that sustainable investors buy tend to be growth stocks in newer – and therefore cleaner – industries. Sustainable investors don’t own a lot of slower growing, older industries because they are dirtier, and – of course – they avoid commodities producers in the energy and mining sectors. While the stocks that sustainable investors buy are of higher quality companies that should do better over the long term because of their reduced exposure to ESG risks, they also happen to be the kind of stock that does worst when rising interest rates are the markets’ biggest worry or when oil prices are high. This year has been no different and many sustainable investment strategies have performed even worse than the stock market as a whole.
Even as regulators in the US, Europe and elsewhere have worked to legitimize sustainable investing by cracking down on greenwashing, the field is facing a political backlash in much of the US. A number of states have passed legislation forbidding state and local governments from doing business with banks that have cut back on financing for oil and guns or blocking public pension funds from using ESG criteria in selecting investments. ESG was never meant to be political but like everything else in the US, it’s been drafted into the culture wars.
Neither the markets’ move into value stocks, high oil prices nor political backlash are forever, though. The long-term case for sustainable investing remains the same. Companies that manage their ESG risks and pay attention to the environmental and social contexts in which they operate should do better than their peers over the long run, just as they did in the years between the 2009-09 financial crisis and the beginning of 2022.
Is the Market Going to Go Up or Down? Yes.
It is rare indeed to see such diverging forecasts for the US stock market as we have now. Some Wall Street prognosticators are predicting a further sell off, others say the worst is behind us and some are even predicting a rally. Some believe that the market is cheap, based on expectations of future company earnings. Others point out that Wall Street earnings estimates often lag economic reality and that therefore expectations of future earnings are going to fall and the market is actually expensive.
The stock market’s recent volatility reflects this lack of consensus. One day investors are panicked that inflation could keep spiraling upward, the next they are worried about the potential for aggressive monetary tightening causing a recession, another day they believe that the Fed has things well under control and the economy will continue to grow.
For what it’s worth, the widely followed Case Shiller Price Earnings Ratio, which is based on inflation adjusted company earnings over the last ten years currently stands at 29x. While this is the lowest level in three years, according to multiple market observers, it is still well above the long-run average.
In this uncertain environment, stock market investors are not advised to take large risks yet it is also too late to panic. The same careful selection of investments and focus on high-quality companies with strong balance sheets and a good long-term growth outlook that has long underpinned most sustainable investment strategies continues to seem to be the best way to approach these uncertain markets. With markets looking for direction instead of consistently going up or down this may also be a better environment for active investors than for index funds.
Urban Larson
Principal
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