Fundamentals are strong and central banks should tame inflation—without tipping us into recession. That said, risks abound.
Market turbulence: What does it really mean for investors?
- There is a low chance the U.S. economy falls into recession this year. With the Fed raising rates, the key question is whether central banks are choosing to prioritize inflation above growth.
- Are Europe and the U.S. moving a little closer to recession? Yes. But a recession is always possible. The key is whether it’s probable.
- We’re stuck in a game of ‘how high can we go’ with interest rates. Where bond prices lead, equities follow. Short-term, that’s effectively meant stocks and bonds are behaving like risk assets.
- As markets begin to feel monetary policy is in fact stymying the pace of rising inflation, investors will pivot to refocus on the fundamental outlook and valuations. It’s going to take time for that to happen.
Macro costs and market backdrafts. We came into this year with expectations that while slowing, growth would continue at an above trend pace. That remains the case, but inflation is leaning heavily on the outlook. The inflation roar we’re seeing is exacerbated by war in Ukraine and by China’s zero-Covid policy involving lockdowns, which is weighing on Chinese growth and the global supply chain.
The war in Ukraine isn’t something investors should look past quickly. It’s a humanitarian crisis. It’s also a national security priority. No one knows how Russia’s war will play out. The same can be said for the macro costs and market backdrafts. It’s important to recognize what we can’t know.
We’re constructive but cautious on the outlook for growth, labor markets, spending, earnings, buy-backs and corporate default risk. Runaway inflation will gradually be tamed by central banks. It’s not if, but when … and how. More on the ‘how’ a bit later. Factory output is rising, inventories are lean and being rebuilt. We continue to see a gradual and healthy rotation from goods to service sector spending.
M&A activity is robust, as are corporate investment and capex. In the U.S., we are back to pre-pandemic savings rates (Figure 1). There is well in excess of $2 trillion in savings on personal balance sheets because of pandemic driven government stimulus. That’s a positive as it relates to both economic normalization and consumption in the face of higher prices.
U.S. savings rate back to pre-pandemic levels
Investors are pricing in rising uncertainty. Tail risks are pronounced and binary. You can clearly see that in daily market volatility. Fear sells better than greed in the current market environment. Lower-lows and lower-highs across markets have put the burden of proof on bulls, both in equity and bond markets. So far, the market behavior we’ve seen rhymes more with the late 2018 growth scare, not a full-blown recession. That doesn’t mean we can’t get there.
Inflation above growth? I think there is a low chance the U.S. economy falls into recession this year, even with a more hawkish tone from developed market central banks. With the Federal Reserve (Fed) at the front of the pack with regard to tightening, the key question for investors is whether central banks are choosing to prioritize inflation above growth. Today, the answer is no. They need to tame inflation and not ‘break’ growth.
We know the global economy is slowing from an above-trend pace. Also, that inflation is a problem. The interplay between monetary policy and markets is incredibly challenging. Inflation will continue to be watched carefully. While we believe the pace of inflation is topping out, we’re not going to know for certain for another few quarters. That will continue to frustrate investors, adding to uncertainty.
Are Europe and the U.S. economies moving a little closer to recession? Yes. But a recession is always possible. That’s how a cycle ends. The important question to ask: is a U.S. recession imminent and probable? No, but the risks are higher than they were in March. Neither the U.S. nor Europe is poised to fall into deep recession in 2022. That said, the outlook for Europe is more challenging because of the ongoing war in Ukraine.
Markets are pricing in an aggressive tightening cycle from both the Fed and the European Central Bank (ECB) this year. The ECB hasn’t raised policy rates in over a decade. The Fed just raised policy rates by 50bps. That’s the first time we’ve seen a hike that large in over two decades.
Investors are taking a ‘rip the Band-Aid off’ approach to monetary policy. They’re doing the heavy market lifting for policymakers. Ultimately, that should be seen as good news for markets as well as sentiment. Between now and then, we have more air pockets to get through.
The bond vigilantes have returned to challenge the Fed and the ECB. They’re effectively putting fixed income markets in ‘price discovery’ mode. That means rates will stay volatile, prone to overshooting to the upside. We’re stuck in a game of ‘how high can we go’ with interest rates. Where bond prices lead, equities follow. Short-term, that’s effectively made stocks and bonds behave like risk assets.
We’re seeing signs that inflation is beginning to plateau. That’s supportive of our view and portfolio positioning. We have a long way to go before inflation moves markedly lower (Figure 2). But slower inflation will help calm jitters. Investors need to see policymakers, starting with the Fed, quickly regain control. That’s the message the Fed continues to deliver. Do more now, to be able to do less ahead. Getting there is going to be an artful balancing act.
Inflation remains elevated
A bumpy ride to a soft landing? A lot of bad news is priced into markets. Today, when stocks rally investors feel under risked. And when they fall, investors feel recession is close at hand. That emotional asymmetry is weighing on sentiment.
Investor sentiment has weakened markedly across multiple indicators. That’s a sign markets are nearing emotional exhaustion. It will ultimately be constructive for risk assets. We’re not there yet. Capitulation happens in waves; it’s a process not an event.
Valuations across risk assets have repriced lower, reflecting higher rates and greater uncertainty. But cheaper isn’t cheap. That’s an observation about lower returns ahead, not an outright bearish comment. It’s also a remark to anticipate current levels of market volatility to be with us for longer than most investors want or expect.
The success of the balancing act around central bank tightening is dependent on policymakers not over-shooting on policy rates. Central banks will continue to be challenged by investors along the way, starting with Fed in pole position. That said, market balance is also dependent on the strength of earnings.
Investors have significantly discounted equity valuations from where we started the year. Some of that is coming from rising inflation and policy rates. Some relates to concerns about operating leverage ahead and, by extension, earnings growth. Pre-Covid, net income margins ran around 11-12% for the S&P 500. They rose to around 13.5% in 2021 (Figure 3). I expect we’ll see margins work their way back to pre-Covid levels over the next year.
Margins are well supported
Revenue and earnings growth for the first-quarter came in strong, both in the U.S. and Europe. While company guidance is cautious, we continue to expect mid-to-high single digit revenue growth this year and next. While those levels of top-line growth may seem aspirational, they’re not.
We expect economic growth this year to be above trend and move back to more normal levels next year. The risk to that view skews down, not up. I’m anchoring on an inflation rate of around 3-plus percent in the U.S. and Europe over the next 12 months. Nominal growth will likely run in mid-single digits. All of a sudden, revenue growth of mid-to-high single digits doesn’t seem a stretch. Earnings will depend on margins. So far, they’re holding in and healthy.
Analysts are forecasting $1-trillion of buybacks this year in the U.S. M&A activity globally is robust. There is a great deal of fundamental and technical support for the equity market as we look into next year. Those observations inform and support our equity positioning.
Both corporate and individual balance sheets are strong. Individuals and companies continue to sit on a tremendous amount of cash. Companies, in general, have refinanced and extended debt maturities at incredibly low interest rates. The affordability of existing debt stock today isn’t a concern. It may become an issue next year.
Both stocks and bonds have seen substantial drawdowns this year. High correlation between stocks and bonds can happen when central banks aggressively tighten policy rates. That’s the moment we’re in. Investors haven’t seen a cycle like this in a very long time. Some have never seen it.
An overweight to stocks versus bonds may seem counterintuitive in the current market environment. We are underweight core bonds and duration because we expect interest rates to press higher. We are overweight stocks because we see greater upside versus bonds over the next year. As interest rates move higher, we’ll continue to revisit our fixed income positioning. The higher rates go, the more attractive bonds become. That includes credit markets.
As markets begin to feel comfortable that monetary policy is in fact stymying the pace of rising inflation, investors will pivot to refocus again on the fundamental outlook and valuations. It’s going to take time for that to happen. In the interim, I expect markets to remain volatile. Investors have a recency bias, expecting markets to quickly bounce back. They will, but not quickly. High volatility will continue to weigh on investor emotion.
Markets today feel like a virtual game of ping-pong. It’s important to remember that markets do this on occasion. We are repricing the risk free rate, policy rates. That has thrown broad markets into a period of high volatility. As long-term investors, we are keeping a close eye on both tactical investment opportunities and the horizon.
For money being managed with a long-term horizon, the best strategy is to stick with it. Individuals tend to blink at the worst moments, selling low and buying high. Staying invested is the key to successful long-term investing. I know it’s a cliché. But it’s something worth repeating as it can quickly be forgotten in more extreme market moments. Think back to the first-quarter of 2020. We’ll get through this.
There is a lot of noise and uncertainty embedded in the macro data and swirling investor sentiment. Neither will be resolved soon. Risk assets are stuck in a very broad trading range. We have a few months ahead of us that are going to look and feel the same. There isn’t an obvious catalyst short-term to change this. We’re on a very bumpy ride to what we believe will be a ‘softish’ landing. Steady hands prevail.
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