After brutal first half, investors are wondering what’s next

After a historically bad first half of the year for equities and bonds, investors are licking their wounds and searching for good news amid the geopolitical conflict, decades-high inflation and recession warnings that have plagued markets.

“2022 has started off as a bear, and the risks remain, including inflation and recession,” an outlook report from Purpose Investments said. “And while we are not uber bullish, given the declines and valuations, the second half certainly looks like it should be better than the first half.”

The S&P 500 entered a bear market last month and recorded its worst first half since 1970. The Nasdaq fell almost 30% to start the year, while the S&P/TSX Composite ended the first six months down 11%.

There was no safety in bonds, either, with yields rising dramatically as central bankers turned hawkish to combat inflation. Yields on global bonds rose from an average of 1.3% on Jan. 1 to 3% by the end of June, the Purpose report said, leading to a 14% drop in global bonds.

So, is there any good news for investors?

A Q3 outlook report from Russell Investments pointed to more attractive valuations for equities and bonds. The one-year forward price-to-earnings multiple for the S&P 500 dropped from 21 times at the start of the year to around 16 times last month. (Since 1990, the median multiple is 15.4 times.)

This doesn’t mean equities are cheap, the report said, but value has improved.

Part of the challenge for investors will be determining if and when inflation has peaked, and how slowing growth will affect earnings.

A report last week from BMO Economics said earnings expectations have held firm so far this year, with 2022 profit growth for S&P 500 companies expected at just under 10% compared to 9% at the start of the year.

“Looking ahead, we see economic growth slowing to a standstill around the turn of the year, which should be a headwind to profit growth,” the BMO report said.

However, if firms can pass on price increases, inflation should support nominal earnings numbers. “As we start to see earnings reports and guidance roll out of the next few weeks, the level of resilience on that front will be key in dictating where stocks go from here, along with the evolution of inflation trends,” the report said.

Investor anxiety in the second quarter was centered around central bankers’ ability to engineer a so-called “soft landing,” or raising interest rates enough to slow inflation without triggering a recession.

In a Q3 outlook report last month, BlackRock didn’t place odds on the likelihood of a soft landing but said it’s positioning portfolios more defensively. The asset manager recommended a “barbell” strategy to position for both potential outcomes.

“The optimal portfolio to combat inflation is very different from the optimal portfolio for a recession,” it said. Energy and financials can serve as inflation fighters, while health care provides “a dose of resilience.”

Traditionally defensive sectors such as utilities and staples are expensive, BlackRock said.

Purpose is less keen on energy and financials — and on Canadian equities more broadly. The firm started the year with an overweight tilt to Canadian stocks but it’s reduced that weighting to neutral for the second half.

The report pointed to “excessive leverage” in the financial system from Canada’s frothy housing market and high household debt, which could impact Canadian banks.

“The best time to buy commodities was when inflation was not on anyone’s radar, not when it’s making multi-decade highs,” the report said. “If we extend this logic to Canada as a whole, this is not the ideal time to be overweighting an index with heavy commodity and housing exposure.”

Purpose is also moving to a neutral weighting on alternatives after being overweight in the first half proved effective.

“Leaning on diversifiers and real assets were the places to be,” the report said. “For the 2nd half, given bonds are bonds again and we believe equities will enjoy a rebound on fading inflation, we find less need to be overweight alternatives.”

Bond yields are attractive again following the selloff in the first half, and the firm is moving to market weight.

The Russell Investments outlook also said bonds should benefit as recession risks start to outweigh inflation.

“From an asset allocation perspective, we believe bonds will ultimately reassume their role of being the portfolio ballast as recession risks get more baked into the market psyche,” the report said. The Canadian 10-year bond yielding around 3.5% is not only an attractive yield, it said, “but the total return potential is enhanced in a recessionary risk-off environment.”

Russell also warned about Canadian debt and the risk for a more painful recession north of the border. Still, the firm was neutral on Canadian equities, preferring them to U.S. stocks.