We’re almost halfway into the year now, and we have seen the US financial markets dip with the S&P 500 index down 13.5% year-to-date, the Dow Jones Industrial Average down 9%, and the tech-heavy NASDAQ down a whopping 23% as of market close Thursday, June 2nd. Not even the biggest names are safe from the downturn. Well-established blue-chip companies have also been extremely volatile, as if trading like meme stocks or crypto. Big names like Walmart, Target, Amazon, Facebook, and Netflix have all taken a hit. After Netflix announced that it lost 200,000 subscribers in the first quarter, the first time in 10 years the streaming giant has lost subscribers, its stock tanked 22% and 35% each in one day on two separate trading days after the announcement. Tech giants Facebook and Amazon both experienced huge declines in valuation after disappointing earnings reports. Facebook lost almost $200 billion in its valuation in one afternoon after missing its quarterly earnings per share expectations and experiencing a drop in users for the first time in its history. Amazon stock decreased 14% the trading day after posting a loss in earnings per share for the first time in four years. Shares of retailers Walmart and Target both posted declines of roughly 20% over a few days and 25% in one day, respectively, after disappointing earnings.
With any portfolio, stocks are considered to be the more risky or volatile asset class with bonds being the more conservative and less volatile. When stocks go down, investors flee to bonds for safety. However, bonds haven’t been a safe haven for stocks in this market either. The Bloomberg Barclays US Aggregate Bond Index (measure of the total US bond market as a whole) has been down roughly 9% year-to-date. With the stock and bond markets both down the one must ask; how did we get here?
The US economy and financial markets were growing until March of 2020 when the Covid-19 pandemic brought them to a screeching halt. In order to stop the spread, the US economy was shut down. Many US workers lost their jobs, and businesses closed their doors. The unemployment rate skyrocketed to 4.4% with the number of unemployed persons rising from 1.4 million to 7.1 million. With the economy effectively shut down, the stock market fell. After only a month, the S&P 500 reached its nadir, down 34%.
In order to stimulate the markets, the Federal Reserve under the direction of Chairman Jerome Powell slashed interest rates to zero and injected liquidity in the market via the Fed’s $120 billion dollar a month bond buying program. This liquidity injection acted as a short-term solution to stimulate economic growth in a low interest rate environment. After the S&P bottomed on March 23rd, 2020, it doubled in only 354 trading days, making it the fastest bull market rally since World War II. For comparison it takes bull markets over 1000 trading days on average to reach that doubling.
Since the beginning of the year, the markets have reversed course. Due to a confluence of factors including Russia’s war in Ukraine, supply chain bottlenecks, the covid lockdown in China, 40-year-high inflation, and Fed interest rate hikes, the market has done an about face.
Russia’s invasion of Ukraine has increased the cost of oil and gas as the US and much of Europe relies heavily on Russian energy imports. Russia is the third largest crude oil-producing country behind Saudi Arabia and the Unites States, producing 12.1% of the total 2020 output. Since Russia’s invasion, many Western countries have slapped Russia with economic sanctions. On March 8th, the US went as far as to place an embargo on Russian crude oil imports. These sanctions and embargoes have hit Russia the hardest, but they have still had an effect on gas and energy prices throughout the Western world. Since Russia invaded Ukraine on February 24th, the average daily cost of regular gas in the US has increased from $3.54 per gallon to $4.76 per gallon. That’s a roughly 34.5% increase in gas prices.
Another factor contributing to this down market is the persistent bottlenecks in global supply chains. After Covid-19 lockdowns and restrictions eased, global demand for trade and products have surged, leading to a spike in demand and a limited supply unable to meet that demand. There’s not enough global trade infrastructure like seaports, roads, and bridges. Other examples include not enough shipping containers, dearth of truck drivers, and limited warehouse space. All this has led to increased prices for consumer goods and a shortage of those goods. And this is a problem that isn’t going away any time soon, according to Tim Huxley, CEO of Hong Kong-based shipping company Mandarin Shipping. “All of these issues, they are here to stay for quite a while to come,” Huxley said. In addition to this global supply chain bottleneck, China’s zero-Covid policy has led to increased restrictions and lockdowns once again that have only exacerbated these ongoing global trade issues.
40-year high inflation and rising interest rates are also a player in this game. To prevent the US economy from going into a recession and stimulate economic growth, the Federal Reserve took a dovish monetary/fiscal approach involving quantitative easing. The Fed buys government bonds and other securities, which effectively increases the money supply and lowers interest rates, making it easier for banks to lend money and people to borrow money. Of course, an increased money supply in a low interest rate environment increases inflation. Consumer Price Index (CPI), which is a common measure of inflation, increased 8.5% from March 2021 to March 2022. We haven’t seen an inflation surge this high since the early 1980s, making inflation at a 40-year-high. To combat out-of-control inflation, the Fed has instituted several interest-rate hikes, 25 basis points (.25%) in March and 50 basis points (.50%) in May. The Fed has also begun tapering its monthly bond buying program. All of this is meant to slowly bring down inflation without stifling economic growth and driving the US into a prolonged recession. It is expected that the Fed will make several more interest rate hikes before reaching a terminal rate of around 3% in the year 2023.
Here’s two possible courses the markets could take. In the first scenario, we have a recession bear market, and in the second scenario, we could have a non-recession bear market. In a non-recession bear market, stock valuations decrease without a decrease in company earnings. Non-recession bear markets last much shorter than recession bear markets with a smaller hit to the S&P 500. On average they last 4 months with an S&P drawback of 22%. Recession bear markets last much longer, 19 months on average, with a 30% S&P drawback. Many economists consider a 20% S&P decline from a previous high to be bear market territory. The S&P 500 did enter that territory a few weeks ago for some time before recovering. With so many factors at play, it’s impossible to predict the market’s trajectory. Will the market continue to bounce back from here, and the US avoid a recession, or will the market continue to fall, and the US enter a recession? Time will tell.