The Worst Year For Stocks Since 1872?

Last year, when it became apparent to everyone that inflation might be on course to rise markedly and sustainably (well, everyone other than the people whose responsibility it is to forecast inflation), analysts rushed to identify the best hedges for a macro environment defined by rising prices.

That entailed a wholesale rethink of multi-asset portfolios which, for decades, leaned heavily on bonds as a hedge against comparatively volatile equities. The assumption of a negative stock-bond return correlation became the bedrock of balanced portfolios and in many cases, leverage was applied to the bond component on the assumption that bonds were a low-vol asset.

Those assumptions ceased to hold in 2022 when, due to high inflation and central banks’ efforts to combat it, rates volatility became the sponsor of a market event. Plainly, bonds aren’t ideal in a high inflation regime, and because US equities were effectively one giant long-duration bet by virtue of big tech’s dominance at the benchmark level, stocks (as defined by the S&P 500 and the Nasdaq 100) proved especially sensitive to rising rates.

On top of that, the idea of equities as an inflation hedge assumes revenue and profits will rise commensurate with prices. If there’s a recession, that might not necessarily be the case given the difficulty of passing along higher input costs to reluctant consumers suffering an acute cost of living shock. And, so, here we are six months into a year defined by generationally high inflation staring at the worst January-June performance for equities in 52 years.

As unfortunate as the S&P’s first half losses most assuredly were, the decline is on track to be singularly bad if you’re inclined to extrapolation.

As BofA’s Michael Hartnett wrote in the latest installment of his popular weekly “Flow Show” series, 2022 could be the worst year for US shares in real terms since 1872.

Two months ago, Morgan Stanley’s Mike Wilson cited deeply negative trailing real returns for equities in chiding bulls who, he said, have “a lot of explaining to do.” Since then, stocks have retreated further and inflation has worsened.

As it turns out, commodities were the best inflation hedge on the board — imagine that, right? Raw materials are annualizing a 59% return, the best in nearly 80 years (figure on the right, below).

Bonds, meanwhile, are headed for their worst year since America’s last civil war. According to one index cited by Deutsche Bank in June, US bonds suffered their worst January-May drawdown since 1788.

Markets are “anticipating a second half recession shock,” BofA’s Hartnett said, adding that the depth of any recession in the context of a credit shock and geopolitical risks will ultimately determine asset prices for the balance of the year.

The bank’s semi-famous Bull & Bear Indicator is stuck at 0.0, a contrarian “buy” signal which portends solid three-month returns “so long as there’s no two-standard deviation event,” Hartnett went on to say.

If you’re wondering what sorts of “events” he means, examples include WorldCom, Lehman, 2011’s US downgrade and China’s overnight yuan devaluation in August of 2015, which I vividly remember. I was at Little Buddha, in Yonkers, when my boss at the time lit up our chats: “Guys, we need to say something about this.”

The title of this week’s Flow Show: “2022 & 1946, 1865, 1872.”