Risk whiplash: Navigating market volatility

It’s been risk whiplash.

What’s notable, though, isn’t that the market has been questioning the risks, but how quickly it’s moved onto the next one…and the next one…and the next one. Last week started and ended with geopolitical turmoil, with debate about rate cuts and tech earnings in between.

Some might see that as a sign the market is struggling for direction, latching onto worries. Another take is that it appreciates the risks, recalibrates and refocuses. It listens, adapts, and tunes out the noise – staying centered on what it knows.

Today’s Top Market Takeaways focuses on what we do know.

Earnings growth and consumer power trump inflation

The inflation debate is endless, and “the last mile” back to the Fed’s 2% target has been frustrating to say the least. Powell himself noted the recent “lack of progress” at a conference early last week.

But how much does it matter? While there’s still room to go, 2022’s aggressive rate hikes are in the rearview mirror. More importantly, that sticky inflation comes alongside strong growth that’s encouraging spending and investment.

Even with U.S. inflation tracking just above a 3%-handle, consumers are spending at a rate that outstrips it: Real consumer spending (adjusted for inflation) grew at a 2.4% year-over-year pace in February. That’s right in line with its average since the turn of the millennium.

At the same time, earnings are on the rise. The market is expecting S&P 500 profits to grow for a third straight quarter in Q1 and culminate with a very solid 10% for the entirety of 2024. Companies are also using their extra cash to boost dividends, engage in share buybacks, and pursue strategic investments. If firms were acutely worried about the outlook, we probably wouldn’t also be seeing signs of capital markets activity thawing after a two-year freeze – from M&A, to IPOs, to bond issuance.

Higher rates aren’t bad so long as growth is good

If the Fed is on hold because growth is good and it’s just taking longer to trudge back to 2% inflation, the economy seems able to forge ahead just fine. That means it might not matter as much if we get three rate cuts, two, one, or none this year. Of course, the risk is that inflation reaccelerates, but the Fed seems more apt to keep rates on hold as it watches the data before it even thinks about rate hikes.

We’ve seen the economy hold on during periods of high rates before. Back in the 1990s – one of history’s famous instances of a soft landing – the Fed held policy rates above 5% for a considerable time, making little tweaks along the long the way. In the meantime, the economy continued to evade recession for a decade, the unemployment rate steadily declined, and stocks continued to rally for years until the Dot Com bubble burst.

To be sure, that doesn’t mean there won’t be pockets of pain: commercial real estate, some regional banks, and more leveraged areas stand to feel the squeeze of higher rates for longer. But, as we said in our review of last year’s bank failures, those areas of stress don’t appear to represent the broader economy.

Pullbacks in bull markets are normal

Despite all the risk whiplash, the S&P 500 is down just 4% from its highs. Every year sees pullbacks: the average year since 1980 has seen one of 14% and still finished higher 75% of the time.

Bull markets aren’t immune. In the 10 best years over that time period (all of which boasted full-year returns of around 30%), all but one (1995) saw at least one 5% pullback. The average year saw two.

All that’s to say, markets don’t move in a straight line. If this bull market ended today, it would be the shortest one we’ve seen in the last 70 years.

Find focus: Preparing for a range of outcomes

Bad things are bound to happen, and this is not the first time that geopolitical turmoil, monetary policy, or inflation have been the catalyst of market turbulence.

The latest news flow doesn’t change our overall constructive view on markets. We continue to see a U.S. soft landing as more probable than not, and Europe and Japan are in the midst of their own economic recoveries. This isn’t 2022, and even if we see less (or no) cuts, central banks aren’t considering hikes. That means stocks should rally as the dust settles and earnings growth revs up. It also means that investors can use this rate reset to their advantage. Bonds may not work as well as initially hoped this year, but elevated yields mean that fixed income offers an even better ballast and enables investors to lock-in high rates for longer. Other pockets of credit likewise offer opportunity: both preferred equity and private credit can enhance yield, while active stress and distressed managers can nimbly navigate overleveraged pockets of the market. Real assets meanwhile tend to be positively correlated with inflation, offering diversification benefits and access to long-term secular trends.

Above all, having a plan and sticking to it can be the most powerful tool of all. Pullbacks and periods of uncertainty are normal, but in the end, staying invested in a diversified, goals-aligned portfolio has benefited through countless geopolitical crises, wars, pandemics and recessions – and we believe that should remain true.