The S&P 500 posted its worst six-month return in over 50 years to start the year. Inflation is surging, hitting 40-year highs in the United States. At the same time, interest rates are rising, with Federal Reserve Chairman Jerome Powell saying he will do whatever it takes to curb inflation. And, to top it off, a recession may be on the horizon.
For institutional investors, navigating these treacherous cross-currents requires an understanding of just how we arrived at this point.
2022 Market Bubbles: How We Got Here
Arguably, fiscal stimulus exacerbated bubbles already building in the economy. As Friedrich von Hayek, the famous Austrian economist, put it, “The boom plants the seeds of its future destruction.” Leading up to 2020, money supply (as defined by M2, the total of currency, coin, deposits, and money market funds) was rising, but it exploded starting in March 2020 given massive COVID stimulus. M2 increased by $5.8 trillion (41%) between March 2020 and March 2022. Over that same period, the S&P 500 Index rose 47% and bitcoin surged 410%. M2 has only recently flat-lined at a high level as a result of the Fed tapering its bond-buying program. The correlation of the S&P 500 to M2 has been high since the end of the Global Financial Crisis (GFC).
The result: Multiple bubbles are bursting at the same time:
- Global equities: With the outlook for economic growth slowing (due to rising rates and inflation concerns) and with expectations for weaker earnings, equities globally have repriced, reflecting higher discount rates and lower expected profitability.
- Fixed income: Bond prices had been high, reflecting very low interest rates. Rising rates are driving down prices, resulting in negative returns. In addition to falling bond prices, credit spreads are widening from low levels in anticipation of higher default rates (due to the weaker economy). This is a double whammy for investment- and non-investment-grade credit securities.
- Venture capital and buyouts: Private equity managers expect a re-valuation of venture capital and buyouts given higher borrowing costs and a challenging earnings outlook. Investors are keenly focused on positive net cash flow, not growth at any cost―weaker, inefficient startups will struggle in this new paradigm. With private equity reported on a lag, asset owners will likely not see the full extent of re-valuations in their performance for a couple of quarters.
- Home prices: While not quite a bubble bursting, this sector of the real estate market is displaying unsettling signs. The inventory of homes on the market (defined as active on the market or pending sales) has increased from the low of 850,000 in February 2022 to 1.2 million in May, according to the National Association of Realtors, a remarkable 41% increase. In addition, Redfin found that offers over asking prices have slowed as more buyers are priced out of the housing market due to rising mortgage rates and high home prices. A recent study by John Burns Real Estate Consulting showed that with a median home price of $400,000, mortgage rates moving from 3% to nearly 6% over the first six months of the year took 36% of potential buyers out of the market because they could not qualify for a mortgage. Fewer qualified buyers and high prices for single-family homes are pushing people into apartment rentals. Data in the July Apartment List National Rent Report indicates rent growth of 14% year over year as of June.
- Cryptocurrencies: Surging investment, primarily from retail investors flush with cash in 2020, sent the price of cryptocurrencies soaring in 2020. Bitcoin rose from $7,350 at the beginning of the year to $28,980 by the end of the year (a gain of 294%). In 2022, bitcoin reached a peak of $67,550 (a further gain of 133%). Meme stocks and non-fungible tokens (NFTs) also grew in popularity. The bubble in cryptocurrencies burst with the implosion of terraUSD, a so-called stablecoin because its value was said to be tied to a safer asset such as the U.S. dollar. Bitcoin is trading around $22,000 today. While institutional investors have generally not invested in cryptocurrencies, they have caught the eye of the Employee Benefits Security Administration (EBSA) and other regulators.
This market is very challenging for investors as traditional correlations between asset classes―especially bonds and stocks―have broken down when investors need them the most. It is during times like these that our advice to clients, to focus on the long run and adhere to a prudent long-term investment program, matters most. Despite the recent market declines, it bears repeating that investors have benefitted from the strong capital markets in the post-GFC era, growing wealth at an unprecedented rate.