The market movement over the past week has been ruthless. The S&P 500 touched below 4,000 for the first time in more than a year. Megacap tech names contributed the most to the declines. The Nasdaq 100 is trading at its lowest level since November 2020, with losses amounting to more than 10% over just the last three trading days. Europe and Asia also declined. United States 10-year Treasury yields popped as high as 3.2% before falling back below 3% under risk-off pressure.
On a sector level, energy saw the steepest losses (the worst daily performance since June 2020) after crude sank on the back of a pause in the EU’s oil ban and a Saudi price cut in Asia. The speculative parts of the market fared worse. Bitcoin cratered (now down over 50% from last November’s highs), the ARKK Innovation ETF has given up almost all of its COVID-era gains (now at March 2020 levels), and biotech is trading below pandemic lows (which was before any liquidity injections and when the broader S&P was at 2200). Notably, retail traders sold over $1 billion in equities – a three standard deviation move and the most volume since March 2021. The dollar was stronger on a trade-weighted basis, particularly versus commodity-linked currencies. The DXY Index is now hovering around its highest level in the last two decades.
It's too soon to say whether markets are finding a bottom – especially given near-term uncertainty around inflation, China lockdowns, and the ongoing war in Ukraine. That said, it’s important to understand what’s driving the volatility and where our view stands from here.
Why is it so volatile?
- Uncertainty: At the risk of stating the obvious, the current slate of risks – between the Fed’s aggressive hiking path, the ongoing war in Ukraine and its knock-on inflationary effects, plus the China lockdown disruption to global supply chains – are compounding “the unknown” that surrounds the global outlook.
- Leverage: Leveraged investors – like growth-oriented hedge funds and crypto longs – are seeing forced unwinds, which is compounding losses. Leveraged ETFs likely had to sell $10-12bn midweek.
- Liquidity: Liquidity is low across virtually all asset classes – including stocks, bonds and commodities – and this is exacerbating the market moves. The Fed addressed this point in its financial stability report released earlier this week, noting that “while the recent deterioration in liquidity has not been as extreme as in some past episodes, the risk of a sudden significant deterioration appears higher than normal”. When liquidity is low, market swings are naturally more dramatic.
What is our view? Looking forward, we think the path for the equity markets will depend on the outcome of the Fed's battle against inflation and whether it's able to manufacture a soft landing. In the meantime, S&P 500 index swings could remain large until the path of inflation is clarified. In our baseline, we expect that both GDP and earnings will likely continue to grow this year, albeit at a slower pace than in 2021. That said, without more clarity on the path of Fed policy and growth, we think stocks will likely to price in an above-average recession probability and will likely be challenged to sustain prices much above current levels.
Given that the Fed, the war, and China lockdowns are at the center of this uncertainty, we’ll focus our analysis through the lens of these risks.
- Fed policy is already having its intended effect, and is beginning to slow things down, giving the central bank some leeway to undertake less hikes than the market is currently pricing.
Much of the Fed’s rate hiking cycle has already been baked into current pricing (with markets expecting the fed funds rate to be above 2.9% for the next decade). As a result, rates have risen a lot – so much so that financial conditions have repriced meaningfully and some sectors are already feeling the pinch. New 30-year mortgage rates have soared (5.5%) to the widest spread relative to existing mortgage rates (3.4%) on record.
At the same time, we are seeing the seeds of inflation decelerating. The last few reports have shown that demand is indeed rotating towards services and away from goods . Retail sales reports are already showing that consumers are starting to spend selectively. Over the course of the year we expect goods inflation to fall meaningfully. Wage inflation has also started to moderate, with three-month annualized average hourly earnings running around 4% (in line with its 2018-2019 trend).
Monetary policy acts with a lag, and the fact that we are already seeing a slowdown come through gives us confidence that the Fed can get its job done.
- The war in Ukraine continues to whipsaw commodity prices, but fiscal support is preventing the full costs from being passed on to households.
The war in Ukraine and the risk of escalation (such as through active NATO involvement in the conflict, a halt in Russian energy sales, or an outright EU sanctioning of all Russian energy) pose downside risks to growth, especially in Europe. Higher food and energy costs stand to negatively impact consumption, and uncertainty will continue to weigh on investment.
However, government support (such as household transfers, cuts to fuel taxes), solid labor markets, and stable balance sheets, will provide a buffer from the worst outcomes. We expect the war to present continued – yet manageable – risks.
- Despite supply chain shock from lockdowns in China, we’d note that this is occurring as goods demand cools and companies are building back a cushion of inventories. We are in a fundamentally better starting place than during the peak of the pandemic, when many consumers also weren’t able to spend on services.
The impact of lockdowns in China is two-fold – impacting both demand and supply. As mobility restrictions are imposed, consumption and services activities in the country are taking a hard hit (reducing demand). Further, in addition to the build back in global inventories over the last several quarters, it also appears that the worst of the supply chain impact from lockdowns may be behind us. Factories in locked-down areas have begun to reopen (though the recovery will likely be bumpy).
What you may consider doing? While market swings look set to continue, the selloff has brought valuations across asset classes to more reasonable levels. We'd stress three actions you may consider in this environment:
Add to fixed income. As we said before, rates have already risen significantly, and the negative economic feedback loop from higher rates limits their room to move higher from here. Sure, rates could still float upwards – but even if 10-year Treasury yields climb to the realm of 3.5%, our analysis (based on historical moves in credit spreads) suggests that core fixed income would be roughly flat to down 1%.
On the other hand, we think it is more likely that slowing growth and inflation push rates lower. Our outlook for 10-year Treasury yields to finish the year around 2.5% implies core fixed income could return more than 5% from here, and in the event of a recession (which again, is not our base case), returns could be as high as around 15%! That all said, we think that what an investor could lose from any rate movement higher seems worth the protection that duration could provide.
Buy the dip and get defensive in stocks. The S&P 500 now trades at a 16.8x 12-months forward multiple, below both its 5- and 10-year averages. While we expect volatility to keep us in a range of 4200-4600 in the near-term, we expect earnings growth (for which our estimates already account for a slower economy with 10-13% earnings growth in 2022 and 4-6% in 2023) to ultimately drive stock prices to 4600-4700 over a twelve month time horizon. On a sector level, we are focused on healthcare, industrials, and reasonably priced tech. We also like legging into quality energy names on pullbacks, as well as thematic opportunities in sustainability, defense, and reopening. At the same time, we are starting to steer away from Financials and other early-cycle cyclicals.
Monetize volatility across asset classes. Sentiment is incredibly bearish – our model shows two standard deviations into “bearish” territory. Historically, when sentiment is this poor, equity returns are positive three-months forward. That said, in an environment like this, it isn’t just about what you own, but how you own it. From stocks, to rates, to commodities, to FX, consider adding to structures designed to trade ranges and protect principal.
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