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Second Half of the Year

Stocks ended the quarter under pressure as the selling resumes across all major U.S. stock market indexes. S&P 500 Index (SPX) has fallen more than 3% for the week, 8% for the month, and 16% for the quarter. The large-cap index has officially entered a bear market with a year-to-date decline of 21%.


Market internals, macroeconomic, and geopolitical conditions show no signs of improving. S&P sectors sustained strong selling as a rolling bear market has begun to spread into leadership areas such as energy and commodities. Market breadth readings have contracted as fewer buyers emerge during market dips.


The lack of sustainable rotations in the eleven (11) major S&P sectors is troublesome. All eleven sectors lost ground from the previous quarter. The defensive areas such as consumer staples, healthcare, utilities, and real estate held up better than the higher beta and economically sensitive sectors (i.e., consumer discretionary, communication services, and technology).


The sector rotations continue to favor a defensive tilt among investors as market volatility increases and recession fears spread. Selling in the energy and material sectors warns of commodity prices peaking. Sharp declines in the consumer discretionary, technology, and communication services sectors signal a slowing economy, tighter monetary policies, and less liquidity.

WTI crude, copper, gold, silver, and other commodities also witnessed sharp corrections giving up their impressive gains from earlier in the year.


Fixed income markets also succumbed to a reversal as bond yields declined. The 10-year minus 2-year yield spread nears another inversion. The yield curve inversion during early-Apr 2022 is a shot across the bow warning of an impending recession. A second yield inversion, if confirmed, increases the risk of a recession starting as early as the end of the year to early 2023.


As the first half ends, it is one of the worst starts for SPX since 1970. First-half losses are also one of the poorer performing periods dating back to the late-1920s.


The second-half market outlook will depend heavily on the Fed and its ability to manage interest rate hikes and reduce its balance sheet in a manner that contains inflation without slowing down economic growth and triggering a recession.


If the Fed tightens too aggressively, a recession occurs. In this scenario, investors should be situated in bonds as yields fall.


On the other hand, if the Fed tightens not enough, inflation will spiral out of control. Inflation-related assets perform best under this scenario. The ideal situation is for the Fed to strike a balance, creating the economic backdrop for a soft landing. Stocks will perform best under this scenario.


Although the odds have increased for a recession, investors should maintain a defensive tilt until a firmer stock market bottom occurs.


The ideal stock portfolio for an inflationary environment is different for an economic recession. Investors should maintain a barbell investment approach until the two opposing economic outcomes play out during the second half.


One side of the barbell consists of inflation-related stocks such as energy, materials, financials, and healthcare. The other side of the barbell consists of recession-proof defensive sectors such as consumer staples, utilities, income stocks, and low-beta value names.


While today’s economic and credit cycles are different than in the past, history tends to repeat or rhyme. A barbell strategy comprising inflationary and recessionary stocks strikes the right balance for most investors for the second half.


Source: Chart courtesy of StockCharts.com

Source: Chart courtesy of StockCharts.com

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