Investors were taken on a roller coaster ride during the first quarter. After falling double-digits from January through mid-March, global equities staged a fierce 11%-plus rally to close out the month. All told, markets held up relatively well given the litany of concerns that made their way onto the ongoing carousel of concerns.
This included Russia’s invasion of Ukraine—which first and foremost is a humanitarian crisis—that served to exacerbate inflationary and supply chain pressure and placed a downward impulse on global growth, especially in Europe. Accordingly, our macro team also cut back our 2022 U.S. economic growth outlook from near 3% to closer to 2%.
Despite the aforementioned challenges and with a clear focus on combating inflation, the Federal Reserve (Fed) pressed on to raise short-term rates for the first time since 2018. The market quickly priced in an aggressive tightening pace over the course of this year alongside the tapering of their balance sheet. Consequently, the 10-year yield jumped to around 2.5%, a full percentage point higher than where it ended 2021.
Notably, stocks bottomed on February 24, the day of the invasion – which was arguably the day of maximum fear.
There wasn’t a singular reason for the subsequent snapback, but at the lows, the market was already discounting some of the known challenges. Stocks were pricing in more than a 40% probability of recession, which appeared too high. Additionally, investor sentiment reached one of the lowest levels of the past 30 years, and stocks found strong buying interest at a forward P/E of 18x, or the lower-end of our expected range.
Although the primary market uptrend remains intact, following the sharp rebound, the S&P 500 now trades closer to a 20x forward P/E. This is towards the upper end of our expected near-term range and suggests the short-term market risk/reward is mixed.
Moreover, the inversion of the yield curve, along with deteriorating relative price trends of other important economically-sensitive areas— such as financials, homebuilders, and semiconductors—suggests investors are concerned about the Fed’s ability to find the right balance of slowing inflation without unduly hurting the economic recovery. The debate about whether the Fed is moving too slow or too fast and the direction of inflation will continue to inject volatility into markets.
That said, a yield curve inversion has historically not been a timely sell indicator for stocks – the S&P 500 has risen in the 12-months following five out of the past seven inversions by an average of 11%.
Our House View remains that near-term recession risks remain relatively low, aided by the booming services side of the economy, solid consumer and business balance sheets, and a healthy job market. Corporate profits are also at an all-time high and earnings in aggregate tend to rise alongside higher inflation.
Netting out these crosscurrents, compared to the early part of the cycle, where our outlook and positioning was heavily skewed to the positive side, our current view is that investors should maintain only a modest equity tilt, upgrade the quality of portfolios, and reduce cyclicality.
More directly, we recommend investors maintain a U.S. equity overweight given its continued status as the big blue-chip country with higher-quality companies. However, we are downgrading U.S. small caps to neutral due to slower economic growth and mixed earnings and price trends. We downgraded the financials and technology sectors earlier in March and maintain sector overweights to defensive and commodity-linked sectors, including energy, REITs, and staples.
Although we remain underweight fixed income, a slightly increased allocation to higher-quality bonds makes sense for ballast given wider potential outcomes. Following the sharp rise in rates, bond yields have become more productive again, and we are still finding some relative opportunities in credit.
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