Investment Strategy

The volatility continues—but when might markets reach the bottom?

May 13, 2022

These 3 signals—inflation peaking, Fed policy shifting, and clarity on Europe and China—can help guide us.

Our Top Market Takeaways for May 13, 2022.

Market update

Another wild one

It’s a fitting week for Friday the 13th. There’s a lot to feel worried about, and the wild market swings of late are emblematic of investors’ apprehension about the path forward. Inflation remains hot (look no further than this week’s U.S. CPI print, more on that later), and the Fed doesn’t seem to be wavering in its speedy path of rate hikes to slow it down. War continues to rage in Ukraine and countries are still actively considering sanctions, disrupting energy supplies. And China’s zero-COVID policy stands to upend not only its own economy but also global supply chains. Adding to the consternation, low liquidity across asset classes and forced unwinds from leveraged investors are exacerbating the moves.

It’s all a lot, and it’s showing up in the price action:

  • Even as the S&P 500 managed to rally hard into yesterday’s close, the index is still down -18% from its highs (a stone’s throw away from a bear market) and around the 4,000 level for the first time in more than a year. If this week ends lower, it would be the S&P's longest streak of weekly losses since 2011.
  • More than 80% of S&P 500 companies are down more than -10% from their 52-week highs, and nearly 60% are down at least -20%.
  • That number is even higher for the tech-laden NASDAQ Composite—over 75% of companies are in bear market territory. The index’s selloff is now the worst since the Global Financial Crisis.
  • COVID darlings seem to have completely lost their luster: the likes of Peloton, Netflix, Shopify, Chewy, and DocuSign are all below or hovering around pre-pandemic levels.
  • Speculative assets have gotten crushed, with Bitcoin cratering below $26,000 at one point (a level not seen since late 2020) and now roughly 60% lower from last November’s highs.
  • Bonds are getting whipsawed. The 2-year Treasury was at one point yielding as much as 2.73% before settling back around 2.60%, while the 10-year has steadily dropped from highs of 3.20% on Monday to roughly 2.90%.
  • All the nerves propped up safe havens. The U.S. dollar is on track to tie with 2021 for the longest streak of weekly gains since 2015. And the yen even strengthened even against the dollar.

How much worse can it get? As bad as it might feel, the chart below shows that markets—across asset classes—still aren’t pricing in a recession. Or, consider a scenario that sees earnings fall -15% next year (roughly in line with the average recession)—from consensus estimates of ~$230 earnings per share in 2022 down to ~$195 in 2023. If you also assume a 18-19x multiple, the S&P 500 would trade at ~3,600 (about another -10% below current levels). That’s not our base case, but we probably haven’t found the bottom yet, either. Headlines could become more negative in the coming weeks, but oftentimes the bottom comes when the news is still dire. Below, we describe what we are watching to help guide our thinking.

This chart shows the year-to-date percentage move of the S&P 500, U.S. IG Credit and U.S. HY Credit relative to the average of the past recessions. S&P 500 is 59% of past recessions, U.S. IG Credit is 54%, U.S. HY Credit is 37%.

Spotlight

When will we know we’ve reached the bottom?

Well, we will never know until we have the gift of hindsight. But we think we will know the bottom is in once:

  1. We see genuine signs of inflation peaking;
  2. The Fed signals a less aggressive shift in its tightening campaign; and
  3. There is further clarity that the worst-case scenarios in Europe and China can be avoided.

On #1: The latest U.S. CPI print showed another hotter-than-expected inflation report.
Both overall inflation (+8.3% over the last year) and the “core” measure (at 6.2% year-over-year, which strips out volatile food and energy prices) came in higher than anticipated in the April report released this week.

Food, energy, supply-chain constrained goods like autos, and reopening categories continued to speed higher relative to the last year. But there were also some signs that some price pressures are (or are close to) cooling:

  • One of the hottest parts of the report came from airlines. Despite making up only 1% of overall consumption, it drove 20% of the month’s jump in core inflation (rising over 18% in April alone). While any price gain that high is cause for pause, it seems like reopening—with the prospect of summer vacations ahead and higher jet fuel prices—drove the gains. We expect this effect to subside as folks’ day-to-day lives get back to normal.
  • While still high and increasing, the seeds of decelerating shelter prices seem to be sown, as price gains noted by leading indicators such as Zillow and apartment listing agencies seem to be rolling over.
  • And, in the jobs report last week, we learned that wage growth—which is one of the stickiest parts of inflation—has started to meaningfully tick lower (and by some measures, is back in line with 2018–19 averages).
This chart shows the contribution to year-over-year CPI for six categories, and headline and core CPI from January 2020 to April 2022. Energy added 0.4% in January 2020 before leading to declines through January 2021, as far as -1.2% in April 2020. It bounced to add a relatively stable 2%–2.5% through April 2022. Food added small increments to start, including 0.3% in March 2020 and 0.5% in February 2021. By April 2022, food added 1.3%. Autos declined at the start, until adding 0.4% in October 2020, and a more robust 1.6% in June 2021 and 1.4% in April 2022. Shelter was relatively stable throughout, adding 1.1% in January 2020, 0.8% in September 2020 and 1.5% in April 2022. Reopening services, which includes lodging away from home, transportation services and food away from home, was trivial until April 2021, when it added 0.6%, then 0.8% in October 2021 and 1.0% in April 2022. All items minus those categories are referred to as other, which contributed a small amount throughout, such as 0.5% in February 2020 and 0.5% in April 2022. Overlaid is the headline and core CPI lines. Headline began at 2.5% in January 2020, dipped to 0.1% in May 2020, then rallied to 5.4% in June 2021 and a relatively softer 8.3% in April 2022. Meanwhile, core began at 2.3% in January 2020, marked 1.3% in February 2021, 4.5% in June 2021 and 6.2% in April 2022.

The verdict: It looks like we still have several elevated inflation prints ahead (especially relative to the Fed’s 2% target), and this latest report encourages the Fed to keep going. But there are some initial signs that the hottest of the hot prints could be behind us—with a meaningful deceleration in price increases possibly taking shape throughout the second half of the year.

On #2: This week, Chair Powell reaffirmed the Fed will likely hike by 50 basis points (bps) at its next two meetings, continuing its speedy, hawkish path.
The longer inflation is high, the longer the Fed will be intent in keeping up its swift pace of hiking. Powell echoed this in his own comments this week, but he also noted the Fed is “prepared to do less” if “things come in better than we expect.” He also reiterated the central bank is not “actively considering” a mega 75 bps move (but we’d never say never).

Investors seem to be getting slowly on board with the idea that Fed policy will be effective. This week, markets priced out some rate hikes, now expecting the policy rate to reach 2.7% by the end of this year and a high of 3% by the end of its hiking cycle (versus 3.3% just last week).

This chart shows the fed funds rate and market expectations from December 2021 until December 2022: • At 0.25%, the Fed hiked +25 bps on March 17, 2022 • At 0.5%, the Fed hiked +50 bps on May 4, 2022 Then, market expectations are: • +50 bps on June 15, 2022 • +50 bps on July 27, 2022 • +25 bps on September 21, 2022 • +25 bps on November 2, 2022 • +25 bps on December 14, 2022 In total: +25 bps through seven hikes in 2022

To that point, as we discussed last week, there are already signs that, given bond yields have risen dramatically in anticipation of future rate hikes, Fed policy is slowing things down. For instance, the housing market—the most interest-rate sensitive part of the economy—is the first indicator to show this playing out. If you walked into a bank today to get a new 30-year fixed mortgage, the spread between your rate (~5.5%) versus someone with an existing mortgage (~3.4%) is the widest on record. Also to that end, existing homes on the market are increasingly seeing price cuts.

The verdict: Fed policy is at work, and we think what’s in the price is enough to slow growth and inflation—the risk, of course, is that it’s too much. But improvement in the data in the coming months could very well convince central bankers that a shift to “do less” is warranted, setting the Fed up to engineer a “soft landing.”

On #3. Lockdowns in China are ongoing, and Europe continues to grapple with further disruptions to energy supply.
In China, factories in locked-down areas have begun to reopen (though the recovery will likely be bumpy), and it’s reassuring that globally, companies had been building back a cushion of inventories over the last several quarters. However, management commentary during this latest earnings season has highlighted that companies are cautious about supply uncertainty, especially as it relates to semiconductors that power much of the digital economy. A continued switch in consumer spending habits from goods to services stands to limit the pain, but we are also carefully monitoring how companies are handling these challenges.

At the same time, reports came in this week that Russia halted gas transports to Europe through a Polish pipeline, perhaps a sign of retaliation for Western sanctions. Government support (such as household transfers and cuts to fuel taxes), solid labor markets and stable balance sheets are providing a buffer from already high prices, but an escalation that results in a halt of all Russian energy sales, or an outright EU sanctioning on Russian energy, is still a big risk.

The verdict: Much unknown, and more clarity needed here.

Overall: Investors are clearly unnerved about the path forward. But should these dynamics come to fruition—especially should the Fed engineer a soft landing—investors need not price the worst case scenario of a recession.

Investment takeaways

So what can you do?

Sitting in cash or hitting “sell” can have dramatic consequences during times such as these. Not only is inflation high, eating away at how much the cash in your wallet is worth, but consider if, for instance, you’d sold when markets were also down 18% during the COVID crisis. Even if you’d reentered markets six months later when the outlook felt clearer (and missed out on experiencing the actual market bottom), you still would have been meaningfully worse off than staying invested.

This chart shows the value of a $100,000 investment in the S&P 500 in January 2020 to May 2022 based on three decisions: staying invested, exiting the market at the -18% drawdown and reinvesting after six months, and exiting the market at the -18% drawdown and reinvesting in cash. All three lines lined up, valuing $103,801 on February 19, 2020, and $84,453 on March 11, 2020. At this point, if you stayed invested, it would have fallen to a low of $68,986 on March 23 before rising steadily to $111,336 on September 2, $151,979 on January 4, 2022, and finally $125,366 by May 12. If instead you decided to exit the market on March 11 for six months, the value of the investment would be $89,460 on October 12, 2020, $123,513 on January 4, 2022, and finally $101,884 on May 12. Lastly, if you decided on March 11, 2020, to exit the market and reinvest in cash, the value would have flatlined and marked a mere $84,657 by May 12, 2022.

 

While market volatility looks set to continue, the selloff has brought valuations across stocks and bonds to more reasonable levels. As investors, we should recognize much bad news is already priced in, assess our previously developed long-term strategies to make sure they remain suitable, and look for opportunities to upgrade to quality investments. Further, the S&P 500 now trades below both its 5- and 10-year averages. Bond markets, particularly municipal bonds, look attractive for the first time in many years (taxable equivalent yields of 3%–5% depending on duration). It is hard to call a bottom, but it does look to be a good entry point for those invested for the long term. 

The important thing for investors to remember is that in prior crises, markets have found a bottom well before the coast was actually clear.

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All market and economic data as of May 2022 and sourced from Bloomberg and FactSet unless otherwise stated.

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