In light of the growing stagflationary environment, investors experienced the full brunt of the renewed downside correlation between stocks and bonds during September, historically the worst month of the year. For the first time since 1938, the S&P 500 closed the quarter with a negative return (-5.28%) after earlier rising more than 10% (+14% July through mid-August gain) as breadth turned strongly negative during the last month of the quarter. In fact, to highlight what has become a year-to-date trend, 56.4% of all trading days during 2022 have shown declines for the SPX, including 26.1% of those days featuring declines of at least 1%. Perhaps even more startling, the Nasdaq-100 and long-term US Treasuries are both down by roughly 30% since the start of January and yields on U.S. 10-year bonds hit 4% for the first time since 2010.
Several months ago, investors began to think about stagflation, yet only during the past few weeks have they started to discount the potential for such a nasty outcome into the price of stocks and bonds. Equity indices, including the S&P 500, which had exhibited sharp gains at the start of August, fell hard towards the end of the month. After failing to surpass its 200-day moving average to the upside, the 50-day moving average provided no downside support, as the S&P 500 quickly descended towards 3,900. Once again, the catalyst for this volatility was the latest flip-flop by Fed Chair Powell, as his recent remarks made it quite clear there was no ‘Fed put’ on the horizon.
Sometimes, an investor is simply out of step with markets and that’s the way it has been of late for the team at Forge First. Aside from our ongoing constructive stance on Energy, given our concerns about stagflation, each of our two funds has maintained their exceedingly cautious net exposures. Obviously, given the strong countertrend rally in equity markets, this positioning hurt the funds during July. After reviewing the numbers, this note will discuss why we remain cautious towards stocks, including a fact check on the outlook for inflation.
While we all knew the party was going to end at some point, few expected such a reckoning to begin during the first half of 2022. In our year-ahead commentary, published in early January, we cautioned investors that 2022 could be a down year for markets based on the impact of sticky supply chains and weakening economic growth. However, we saw market weakness in H2, not H1. The principal reason for the earlier-than-expected shellacking of all things financial was clearly the Fed. The central bank of the U.S. waited far too long to admit inflation wasn’t ‘transitory’ and then shocked the market with a 180-degree turn during the 2nd week of January. Yet, talk is cheap (except for the negative wealth effect on investors) because, as you can see from the white line on the 15-year graph below, as of June 30th, the Fed has yet to begin to shrink the size of its balance sheet. But let’s not get ahead of ourselves, and prior to reviewing the second half outlook for markets, let’s recap H1 and discuss why June was so ugly.