Financial Market Review: Second quarter 2022

Global equities (-13.5%) fell sharply in the second quarter, ending June with a 17.5% loss year to date — the worst start to a year in decades. Risk sentiment plunged amid elevated volatility as investors grew increasingly concerned about the economic toll of persistent geopolitical instability, soaring inflation, rising interest rates, and constrained supply chains. Inflation remained elevated globally, with the US Consumer Price Index (CPI) and eurozone CPI both rising 8.6% year over year. Energy prices continued to rise as the ongoing crisis in Ukraine severely pressured oil and natural gas supplies. Europe’s energy crisis in particular intensified; natural gas supplies fell 60% from normal levels amid gas-flow disruptions in the Nord Stream 1 pipeline, forcing European governments to scramble to build natural gas inventories ahead of the winter. Later in the period, the G-7 summit in Berlin concluded with the group reaffirming its support for Ukraine; however, no additional measures were announced as economic pressures dampened the West’s appetite for tougher sanctions against Russia. Despite the risk of slowing economic growth, most global central banks continued to adopt tough policy measures to rein in inflation, with the US Federal Reserve (Fed) and European Central Bank (ECB) reiterating their intentions to increase interest rates more aggressively and scale back pandemic-era stimuli. The Fed increased its target federal funds rate twice during the quarter, raising rates by 50 basis points (bps) and 75 bps in May and June, respectively. In a sharp contrast, the Bank of Japan (BOJ) maintained its stimulus program in hopes that it can achieve a sustainable 2% inflation rate. In China, lockdowns in Shanghai and restrictions in Beijing constrained supply chains as rising COVID-19 case counts disrupted production and kept workers at home. China’s economy began to rebound in June after lockdowns eased, although the recovery has been muted.

Global fixed income sectors cemented their worst-ever start to the year following sharply negative returns during the second quarter. Government bond yields continued to move higher as most global central banks signaled their intentions to tighten monetary policy in response to persistent inflation pressures. Most fixed income spread sectors underperformed government bonds amid increasing concerns that tighter financial conditions could tip the global economy into recession. The US dollar strengthened versus most currencies.

Commodities (+2.0%) increased, driven only by positive results from the energy sector.

Equities

US
US equities (-16.1%) fell sharply during a volatile quarter, ending June with a 20.0% loss year to date. Rampant inflation and tighter financial conditions hurt risk sentiment and increased the probability of recession. Growth stocks significantly underperformed their value counterparts as surging Treasury yields and disappointing earnings results from some of the largest technology companies drove the Nasdaq Composite Index to its biggest quarterly loss since September 2001. Rapidly rising prices for food and energy pushed consumer inflation to its highest level in more than four decades; the headline Consumer Price Index (CPI) increased 8.6% annually in May, from 8.3% in April, undermining hopes that US inflation has peaked. The Fed responded to the larger-than-expected increase in prices by accelerating its pace of interest-rate hikes to 75 bps in June, following a 50-bps increase in May, forecasting that rates could rise to 3.4% by the end of 2022 and 3.8% by the end of 2023. The Fed also began tapering its balance sheet of nearly US$9 trillion in asset holdings that it accumulated in recent years. President Joe Biden assessed options to address surging prices, including reducing tariffs on Chinese goods and a temporary suspension of gas taxes, as rampant inflation has clouded Democrats’ prospects in midterm congressional elections in November. The collapse of TerraUSD and Luna worsened the credit crunch engulfing the cryptocurrency market, with the total value of crypto assets plummeting to less than US$1 trillion from a peak of US$3 trillion in November 2021.

Economic data released during the quarter signaled that the US economy was resilient in the face of inflation and growth headwinds, but activity moderated at the end of the quarter. The labor market showed some signs of softening but remained markedly tight in May, with the unemployment rate holding at a historically low level of 3.6%; jobless claims trending modestly higher; wage growth easing to 5.2% annually; and nonfarm payrolls increasing by 390,000, above consensus forecasts of 318,000, but down from 436,000 in April. Consumer demand cooled against a backdrop of rapidly rising inflation and higher interest rates; US retail sales declined for the first time in five months, slipping 0.3% after a 0.6% gain in April, while nominal consumer spending increased at the slowest monthly pace this year, rising only 0.2% following a gain of 0.7% in April. Increasingly pessimistic views about inflation drove the Conference Board Consumer Confidence Index in June to its lowest level (98.7) in more than a year, although consumers maintained their spending plans for large-ticket items. Soaring mortgage rates and home prices squeezed the housing market, as home construction, existing-home sales, and homebuilder confidence declined during the quarter. The manufacturing and services sectors remained in expansionary territory, but activity moderated amid softer demand, labor constraints, and persistent input cost pressures. Small-business sentiment continued to trend down during the quarter as inflation and labor shortages dented the future expectations of business owners.

Within the S&P 500 Index (-16.1%), all 11 sectors posted negative results for the quarter. Consumer discretionary (-26.2%) was the worst-performing sector, weighed down by the automobiles (-36.6%) and internet & direct marketing retail (-34.7%) industries. Communication services (-20.7%) underperformed, led lower by the entertainment (-33.8%) and interactive media & services (-23.0%) groups. Information technology (-20.2%) was another top detractor; the semiconductors & semiconductor equipment (-28.4%), technology hardware storage & peripherals (-21.3%), and software (-17.0%) industries detracted most. Consumer staples (-4.6%) was the topperforming sector, buoyed by the beverages (+2.1%) industry, but offset by food & staples retailing (-15.5%).

Europe
European equities (-8.3%) fell over the quarter as increasingly hawkish central bank policies, slowing economic activity, surging energy prices, and mounting recession risks weakened Europe’s economic outlook. A sharp reduction in natural gas supplies from Russia heightened fears of critical energy shortages and rationing across the continent. European gas prices continued to skyrocket as supplies fell 60% from normal levels amid gas-flow disruptions in the Nord Stream 1 pipeline, forcing European governments to scramble to build natural gas inventories ahead of the winter. European leaders also agreed to a compromised embargo on seaborne Russian crude oil, with temporary exemptions for supplies delivered via pipeline. Surging energy prices drove annual headline inflation in the eurozone to a record high of 8.6% in June, up from 7.4% in April, adding significant pressure on consumers, businesses, and the ECB. The ECB planned to end its remaining asset purchases on July 1 and indicated that it will raise rates by 25 bps in July and potentially by a larger amount in September unless there is a rapid improvement in the inflation outlook. ECB President Christine Lagarde struck a hawkish tone, stating that “inflation pressures are broadening and intensifying” and that the bank is prepared to curb monetary policy more aggressively. The bank will also apply special flexibility in its emergency bond-purchasing program and accelerate plans to create a tool to address financial fragmentation in the eurozone.

Eurozone manufacturing growth slid to a 22-month low as the eurozone manufacturing Purchasing Managers’ Index (PMI) dropped to 52.1 in June, from 54.6 in May. Output contracted for the first time in two years due to weaker demand, while new orders fell at the steepest pace since May 2020. Earlier in the quarter, the services sector expanded at a robust clip as pentup pandemic demand drove greater spending on tourism and recreational activities. However, preliminary data for June showed that services growth slowed markedly. Eurozone consumer confidence in June fell just short of the all-time low set in April 2020, with soaring inflation weighing on consumer purchasing power. Industry confidence declined to a level rarely seen since the European debt crisis of 2012.

Germany’s (-12.2%) large manufacturing sector and export-oriented economy was particularly hard hit by high energy prices. The government triggered the second phase of its national gas emergency plan, bringing it one step closer to rationing gas to industry. In the UK (-2.9%), the Bank of England (BOE) implemented its fifth consecutive rate hike, preferring gradual, steady rate increases to balance inflation against recession risks, even as a string of disappointing economic data releases cast a pall over the country’s economic outlook. An intensifying cost-of-living crisis prompted UK Chancellor Rishi Sunak to unveil a multi-billion-pound fiscal-aid package designed to lessen the impact of soaring energy prices. In France (-8.8%), President Emmanuel Macron defeated far-right leader Marine Le Pen to win a second five-year term in office. However, he subsequently lost his majority in the National Assembly, creating significant obstacles to his domestic reform agenda.

Emerging markets
Emerging markets (EM) equities (-8.0%) sold off as global economic conditions decelerated amid elevated geopolitical tensions, ongoing supply-chain disruptions, and surging food and energy prices. Tighter global monetary policy also weighed on investor sentiment. Asia was the top performer, followed by Europe, the Middle East, and Africa (EMEA) and Latin America.

Asian equities (-6.2%) fell, with broad risk-off sentiment and expectations for higher inflation pressuring Thailand (-4.9%), the Philippines (-14.4%), and South Korea (-15.2%). In Thailand, an uptick in tourism helped offset the negative impacts of higher prices. The central bank held interest rates steady, while the government announced an extension of price caps on many essential goods and services. The Philippine central bank increased rates in line with expectations, although the country’s relatively gradual approach to lifting rates pressured the peso, which fell to its lowest level versus the dollar since 2005. South Korea’s government passed a record-sized extra budget to offset the impact of COVID restrictions. Inflation rose at the fastest pace in 14 years and the central bank opened the door to larger rate hikes. Taiwan (-16.6%) dropped amid increased geopolitical tensions with China and a selloff in technology stocks. India’s (-9.9%) central bank surprised the market by raising interest rates twice, with inflation eclipsing the bank’s targeted range. China’s (+4.6%) economic activity strengthened as the composite PMI rose above 50, indicating an expansionary environment for the manufacturing and services sectors. President Xi Jinping reiterated that China would maintain its zero-COVID strategy, raising concerns about the durability and duration of the recent economic upturn. Additionally, China and India were aided by steep discounts on imports of Russian oil.

Several EMEA (-13.3%) countries in Central and Eastern Europe were hampered by the spillover effects of the Russia/Ukraine war, with Poland (-21.3%), Czech Republic (-2.9%), and Hungary (-15.2%) declining amid inflationary pressures and concerns about energy security. Turkey (+1.5%) benefited from improved ties with Saudi Arabia. South Africa (-13.5%) combatted higher prices, while a decline in several key commodity spot prices reduced the exporting nation’s trade differential.

Latin American equities (-15.6%) declined sharply amid political and economic headwinds. Chile (+1.5%) advanced, but soaring inflation and a polarized political climate surrounding the process of drafting of a new constitution drove the peso lower. Chile’s lower house rejected two proposals for a new round of pension fund withdrawals, weakening the popularity of the country’s new president, Gabriel Boric. In Mexico (-14.1%), a deteriorating economic and fiscal outlook amid rising inflation and higher fuel costs posed downside risks to the country’s economy and its sovereign debt rating. In Brazil (-16.7%), aggressive monetary policy tightening threatened economic growth. President Jair Bolsonaro, who trailed in the polls ahead of October’s presidential election, announced that all federal gas and ethanol taxes will be removed through the end of the year, shifting the tax-receipt burden to the Treasury. Colombia (-19.8%) declined following a significant political shift as Gustavo Petro was named president-elect. Petro will become Colombia’s first leftist leader and intends to bring new regulations to big business, raise taxes, curtail the country’s oil and mining industries, and reestablish lost ties with neighboring nations. In Peru (-30.2%), President Pedro Castillo was asked to resign from the Peru Libre Party after being accused of breaking up the party in Congress.

Fixed Income

Global GDP growth exhibited some divergence during the first quarter as GDP in most countries continued to expand, in sharp contrast to notable contraction in the US and Japan. Inflation pressures remained acute, though commodity prices declined sharply late in the quarter to provide some relief. US labor market strength persisted, while housing market resilience was tested by surging mortgage rates, lack of inventory, and home-price appreciation. The eurozone’s Manufacturing PMI expanded at its weakest pace in 22 months amid lower demand. Consumer confidence in Germany fell to an all-time low amid concerns about surging food and energy prices as supply-chain disruptions persist. Japanese industrial production declined by the most in two years due to weaker vehicle production and continued supply-chain disruptions. China’s retail sales slipped as lockdowns associated with its zero-COVID policy drastically reduced consumer spending. UK inflation accelerated to new highs, driven by mounting energy and food prices. Sanctions imposed on Russia by the West led to retaliatory measures from Moscow, including restrictions in gas supplies to parts of Europe, raising concerns about Europe’s energy security. By the end of the quarter, global growth had slowed moderately due to tightening financial conditions, but inflation continued to surprise on the upside, and most major central banks became more hawkish.

Global sovereign yields moved sharply higher as most major central banks supercharged their hiking cycles to deal with high inflation. Within the G10, select central banks including the Fed, Reserve Bank of Australia, and Sweden’s Riksbank raised rates with surprisingly large moves (50 – 75 bps). Even the Swiss National Bank surprised at the June meeting with a 50-bps rate increase in a hawkish pivot. This occurred against a backdrop of softening global growth indicators in major economies, driven by concerns about energy shortages and the cumulative effect of rate hikes. Specifically, US two- and five-year breakeven inflation rates declined sharply, reflecting concerns that the Fed’s rate hikes could pull the US economy into recession. The ECB announced its plan to end its quantitative easing and begin hiking rates in July, with President Lagarde suggesting a larger hike would likely be appropriate in September if inflation pressures persist. The ECB’s announcement at an ad hoc emergency meeting to accelerate the design of a new anti-fragmentation instrument and apply flexibility to its Pandemic Emergency Purchase Programme reinvestments eased some fears which had contributed to the blowout in peripheral yields. The BOJ and the People’s Bank of China (PBOC) were the notable exceptions, with both retaining accommodative policy. The BOJ doubled down on its yield-curve control policy, buying a record amount of Japanese government bonds late in the quarter to cap the 10-year yield at 0.25%. EM central banks, particularly across Latin America and Central and Eastern Europe, the Middle East, and Africa also continued lifting their policy rates in larger increments, while Asian central banks raised rates more modestly than other EM regions. The PBOC maintained its accommodative policy as disruptions emanating from COVID-related mobility restrictions sharply weakened Chinese activity data.

Currencies

The US dollar rallied strongly versus most currencies as it became increasingly clear that the Fed will likely tighten policy more aggressively to counter persistently high inflation. The Japanese yen declined to its weakest level since 1998, as the BOJ remained the outlier among major G10 central banks by not tightening policy. Higher-beta, commodity-linked currencies across developed markets and EM (South African rand, Norwegian krone, New Zealand dollar, and Brazilian real) were the other major underperformers as recession concerns came to the forefront by the end of the quarter. Latin American currencies, which had held up well in the first quarter, ended lower on a combination of rising political risk (Colombian peso), global recession concerns (Chilean peso), and fiscal slippage risks driven by inflation-related subsidies (Brazilian real).