The U.S stock market ended the quarter officially in bear market territory, down more than 20% for the year. While there have been multiple factors causing the market to experience its worst first half of the year, since 1970, the cause can be really be synthesized into one word: inflation.

In order to curb runaway inflation, the Fed has been aggressively raising interest rates, playing catchup with 1.5% worth of rate increases, with more to come. The supply chain constraints the Fed thought would be “transitory” and ease, proved to be longer-lasting, exacerbated by the Russia-Ukraine war and rising energy prices.

So what does all this mean for client portfolios? And will the Fed’s actions, cure inflation, but plunge the economy into recession? Indeed, there is evidence that we may be in a recession already if you use the “two-quarters of negative GDP” definition. While only the OECD can make that official pronouncement, if I were to call it, I would say we are already in a recession. That may actually be good news for investors, as it means the Fed will have to be less hawkish going forward. If you look at the yield curve, the bond market is already looking ahead to the first Fed rate cuts.

Whereas we were advocating for interest rate hedged bond exposure, now that the impact of Fed cuts is being felt, we are favoring unconstrained fixed income exposure, with a quality tilt.  We are optimistic about market prospects in the second half and expect the market to recover much of its first-half bear market losses.

If we are in a recession, it is a unique animal characterized by a strong job market.  The consumer is quite healthy, resulting in not “demand destruction” but “demand discretion.”  There continues to be pent-up demand for travel, entertainment, and apparel, and savings levels are still healthy.

The Fed may not be able to execute a precise soft landing, but it should be able to bring inflation down to manageable levels without creating too much economic pain.

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