“When a man’s neck is in danger, he doesn’t stop to think too much about the feeling.” -Agatha Christie
The first half of 2022 ended mercilessly last week. The S&P 500 fell about 20%, the worst of the top six months for this index since 1970. The NASDAQ fell about 30% while the small cap Russell 2000 index fell about 25%.
Stocks slumped through the first half of the year on the back of the highest levels of inflation since the early 1980s, record high gasoline and diesel prices, awful consumer sentiment and to rising interest rates. The war in Ukraine has only added to these woes and this conflict is likely to drag on at least until the end of the year and no serious peace talks are currently underway.
So what will the second half of 2022 bring for battered investors? 3 predictions are highlighted below.
Recession fears are well-founded:
The US administration and other government officials keep saying that a recession is not ‘inevitable‘. Unfortunately, many of those same officials were saying that inflation was going to be ‘temporary‘ and ‘transient‘ as 2022 also began. They seem to be just as prescient this time around.
The fact is that for most consumers, the recession has already begun. With wages growing at five to six percent a year and inflation north of eight percent, the average consumer has lost purchasing power for 15 straight months. This has depleted savings as the average savings rate is now back below 5%, the lowest since 2008.
The lower and middle income brackets have been particularly hard hit by rising prices, as a large portion of this population commutes and/or rents. With rents rising in the mid-teens on average last year, gas up more than 50% and grocery prices up more than 10%; these consumers have been put in a vice.
They will likely be joined by the upper income strata shortly. The stock market evaporated $11 trillion in value in the first half of the year. This will lead to a negative’wealth effect‘. Layoffs will also increase in the coming months as the economy enters a recession. Consumer sentiment, which is already at historic lows, will fall further.
With the consumer representing almost 70% of the economy, it is easy to understand why economic projections keep being revised downwards. The Atlanta Fed’s GDPNow just slashed its projection for second-quarter GDP growth to a negative 2.1%. If this forecast is even close to correction, the country is already in technical recession after the negative performance of 1.6% in the first quarter of this year, which the ‘experts‘ assigned to ‘temporary adjustments‘. Sound familiar? Acknowledging that the country is in a recession will be a recurring theme this summer.
The energy sector ends its outperformance:
Energy was one of the few bright spots in the market during the first half. The Energy Select Sector SPDR (XLE) ETF rose almost 25% even as most of the rest of the equity universe creaked. The sector benefited from soaring crude oil and natural gas prices. This is partly due to the war in Ukraine and Western sanctions on Russian energy exports.
These policies, unfortunately but predictably, did not work as expected. Russia is raking in record revenues from soaring energy prices and the ruble is at multi-year highs and is currently the best performing currency in the world. Meanwhile, the Western consumer has had to contend with record gasoline prices. Europe is particularly vulnerable to any kind of stoppage in the flow of natural gas as winter approaches.
There was an article on Seeking Alpha over the weekend explaining how JP Morgan believed oil could rise as high as $380 a barrel in the worst case scenario where Russia cut production by five million barrels a day. However, historically, the cure for high oil prices is high oil prices. Oil soared to over $145 a barrel in 2008, before entering a massive free fall as Western economies entered a deep recession due to the financial crisis. With recession looming here and in Europe, energy prices look set to decline by the end of 2022. This is already starting to be reflected in the strong sell-off in the energy sector over the past two weeks. I expect the energy sector to underperform the broader market in the second half of 2022.
The health sector will be a winner:
Investors are already gravitating towards the ‘defensive‘ sectors of the market as economic activity continues to decline. One of them is the healthcare sector whose revenues will hold up much better than most industries in a recessionary scenario.
Recession or no recession, people still have to get their prescriptions filled, undergo chemotherapy treatments and undergo necessary surgeries. I recently established long covered positions in big drug names like Merck (MRK), Gilead Sciences (GILD) and Pfizer (PFE) as I build exposure to this part of the market. The three names have a reasonable valuation, pay handsome dividends and have liquid options against their shares.
Biotech also appears to have bottomed out recently after falling around 60% since the start of 2021. With hundreds of small biotech names selling at or near net cash on their balance sheets, it was difficult for the sector to d go even lower. There was also long-term technical support in development. Given Big Pharma’s valuations and large cash reserves, I expect M&A activity to also pick up in the second half of this year.
I don’t think the second half of 2022 will be as bad as the first half for investors. Barring a deep recession and/or a major escalation in the Ukraine war, of course. That said, I don’t think the markets have bottomed yet either. Declining economic activity and soaring input prices will have a significant negative impact on profit margins. I expect the second-quarter earnings season to be when forecasts will be lowered across most market sectors and reflected in downgraded earnings projections by analyst firms.
As a result, my cash allocation is close to 25% and I continue to use simple covered call strategies for the majority of my portfolio holdings to further mitigate downside risk.
And those are some thoughts as trading begins in the second half of what has been a brutal year for investors so far.
“Any order is an extremely precarious balancing act. -Walter Benjamin