There is almost no more room left on the ongoing carousel of concerns. After a strong rally to end March, investors were met with April showers. Global equity markets fell about 8% during the month. Fixed income failed to provide a buffer as the 10-year U.S. Treasury yield shot up to near 3% for the first time in several years, which weighed on bond prices.
Topping the list of investor concerns is the potential of an aggressive Federal Reserve (Fed) policy shift to cause a sharp economic slowdown. At the same time, there’s still no resolution to the Russia-Ukraine war, and China’s COVID-related lockdowns are weighing on global growth, inflation, and supply chains.
Several of these challenges led us to downgrade equities to neutral in early April while also slightly raising our stance on fixed income given the sharp rise in yields. That said, stocks have had a decent pullback since our downgrade, but we are not becoming more negative as prices go lower. Challenges remain, but at least markets are now better discounting some of these uncertainties.
To start, a sense of perspective is helpful. While markets have had a tough road this year, the setback has come after one of the sharpest rebounds in modern history –stocks more than doubled in less than two years. Moreover, this year’s market pullback of 14%, so far, is right in line with the largest intra-year decline seen in a typical year.
Although our macro team has ratcheted down economic growth expectations, most indicators suggest a recession is unlikely this year, at least in the U.S. This is important insofar as stocks have historically risen 85% of the time on a one-year basis when the economy is in expansion.
And markets are already pricing in roughly a 50% chance of recession given stocks have averaged a drop of 29% (median of 24%) surrounding past economic contractions. Thus, if recession fears ebb, stocks would likely re-rate higher.
There has also been a healthy reset in valuations and sentiment. Indeed, the S&P 500 is now at a 17.5x forward price-to-earnings ratio (P/E), down from 21.5x late last year. The average stock, as proxied by the S&P 500 Equal Weight Index is trading at a very reasonable P/E of 15.3x.
At the same time, equity outflows have reached a short-term extreme, and the percentage of investors who consider themselves bullish has dwindled to less than 20%. From a contrarian standpoint, this is a positive and suggests the hurdle rate for positive surprises is low.
Although these factors are likely to cushion the downside, for equity markets to gain much traction to the upside on a sustained basis, investors will likely need to see the relentless repricing of short-term interest ratesabate and have greater confidence that the Fed’s actions will be able to tame inflation without unduly hurting the economy. This is a challenging balancing act that will take time and add to market volatility.
Given the crosscurrents, we still advise a neutral overall risk posture and upping the quality of one’s portfolio. Accordingly, we retain a bias to the U.S., given its stronger economy, and to large cap equity with its orientation to higher-quality companies.
We still view foreign markets as less attractive considering the global growth challenges and their more cyclical nature. It’s worth noting, though, that there have been tentative signs of relative price and earnings stability in several international markets, aided by weaker currencies. Likewise, the policy rhetoric from China has become somewhat more accommodative recently. Still, it’s premature to upgrade them given the many false dawns over recent years and heightened geopolitical risks.
Our fixed income team’s view of higher rates and higher volatility has been borne out, though the sharpness of the rate move higher has exceeded expectations. While it’s been a painful journey, the good news is yields are productive again. For investors seeking outlets for cash balances, the anticipation for Fed rate increases is creating compelling income opportunities in the 1-5-year range of the U.S. Treasury curve as well as an attractive entry point for investment grade municipals.
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