Markets tumbled hard the first half of 2022. Year to date, the S&P 500 is down 20.6%, the NASDAQ 29.5%, and bonds 11%. The S&P 500 hasn’t seen a worse half of a year for more than 50 years. Cryptocurrencies fell even further, with Bitcoin losing more than 50% so far this year. Two bright spots are commodities: oil and the US Dollar, the former up due to constrained supply stemming from the war in Ukraine and the latter gaining strength against other currencies as investors seek safety in the world’s reserve currency.

Are interest rates to blame?

Yes and no. On June 15, the Federal Reserve raised interest rates by 0.75% and is poised to implement another increase as soon as this month. The aggressive rate hikes are negatively impacting stock and bond markets, but as I wrote recently, the key to turning around the markets, and the economy in general, is taming inflation. The latest inflation gauge, the personal consumption expenditures price index (PCE), remains stubbornly high at 6.3%, more than three times the 2% rate the Fed is aiming for. While external factors are out of the Fed’s control — factors like the Russia-Ukraine conflict and China’s Covid shutdown exacerbating already-constrained supply chains — the one tool the Fed does have is its ability to raise rates.

All eyes are on the Fed as it walks a tightrope between raising rates aggressively enough to slow inflation — but not so much as to throw the economy into a recession. By raising rates, the Fed is trying to cool down an overheated economy characterized by high consumer spending and limited production capacity that, together, have created demand that outstrips supply. Raising rates makes borrowing more expensive — for everything from car and business loans to mortgages — thereby discouraging both people and businesses from spending. With inflation and higher rates slowing down economic growth, the challenge will be to slow it down fast enough to keep inflation from getting entrenched (in other words, to encourage prices to go back down, rather than stay at current heights), but not so fast as to halt demand and drag the economy into a recession. But the Fed’s priorities are clear: to get inflation under control, even at the risk of recession.

Will the second half of 2022 bring better news?

Historically, when the first half of the year has been poor, markets tend to stage a comeback in the second half. There have been two previous instances since 1960 where the S&P 500 has dropped more than 21% in the first half of the year; in both of those cases, stocks rebounded 15% and 27% during the second half of the year.

While past performance, as we all know, is not a guarantee of future performance, there are still some reasons to be (very) cautiously optimistic. Last week saw a slowdown in consumer spending and a decrease in home sales and prices, and while the PCE index is still high at 6.3%, it didn’t increase further from the month before. Higher prices and higher rates seem to be forcing consumers to spend less, which, as mentioned, does help cool down the economy. At the same time, unemployment remains low, which leads some to conclude we are not headed into a recession.

The bulls present plenty of optimistic scenarios for the second half, balanced by those who believe there is more pain to come before it gets better. Only time will tell who got it right.

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