Our Investment Strategy Group shares their observations on current volatility within the financial markets.
We have continued to see a push-and-pull dynamic between the Federal Reserve and the market for the better part of 2022. In the first half of 2022, it was the market bullying the Fed to take inflation seriously and to increase interest rates. The second half, thus far, has been marked by the Fed “throwing its weight around” and the market (re)learning the old adage of “don’t fight the Fed.” The inflation print last week led to a broad-based repricing of the Fed “terminal rate” expectations (i.e. the anticipated peak or top fed funds rate for this hiking cycle). During the summer rally, the market was expecting the terminal rate to be between 3.3% to 3.7%, but that number has continued to drift higher in recent weeks. With the August inflation data coming in above consensus expectations, the market is now pricing in a terminal rate above 4.25%. Higher interest rates typically negatively impact longer duration assets such as long-dated bonds and growth-oriented stocks. This is why, in our view, the market reacted to the news so negatively last Tuesday. For reference, the S&P 500 Index fell more than 4% that day, while interest rates across the yield curve rose significantly: The U.S. two-year Treasury yield rose 18 basis points (bps), the five-year yield rose 13 bps, and the 10-year yield rose 5 bps.
We maintain a defensive positioning view within portfolios by overweighting cash and underweighting risk assets. We were wary of the summer market rally that saw S&P 500 Index bounce over 17% from its lows in mid-June, only to give up most of these gains in recent weeks. Our summer rally skepticism was largely driven by the following concerns:
First, we need to see a deceleration of inflation over handful of months. While July’s inflation report was a positive sign, in our view, August’s report was clearly a step backward. Broadly speaking, inflation pressures are easing but the Fed wants to be certain before considering a pause in rate hikes. With the labor market (and wages) continuing to show resilience, we believe the Fed will likely maintain its aggressive stance to tighten financial conditions and continue to increase interest rates. We’ll need to see labor demand weaken and labor supply increase (i.e., unemployment rate to increase, jobless claims to increase, etc.). In other words, economic growth must slow for the Fed to think about pausing and see rates markets stabilize (i.e., the US 10-year Treasury has gone from the mid-2%s to mid-3%s and back in the last three months) in order for equity markets to stabilize.
Our second concern revolves around earnings. In the second quarter, corporate earnings were generally mixed but, in the aggregate at the index level, they were positive (+6 – 7% year-over-year). However, if investors dig deeper and strip out Energy sector earnings, earnings were actually at minus 4%. Following commentary and forward guidance from company earnings announcements, concerns remain about companies’ ability to maintain profit margins. In a typical recession (which has not yet been “called”) earnings have fallen about 17%, and we have not seen that yet. However, for calendar years 2022 and 2023, consensus earnings estimates are still expected to increase by nearly 8%, which is a bit optimistic in our view.
The third factor that gives us pause is the market’s expectation of what the Fed will do going forward. The market is looking for the Fed to start cutting interest rates next year—the “Fed pivot”—because economic growth is anticipated to slow. This may or may not happen. We believe the Fed is seeking to avoid the mistakes of the 1970s when it increased rates rapidly and then took its foot off the pedal, only to see inflation rise again. We believe the Fed will look to avoid that outcome at any cost. With the August inflation data print, the market is now pricing in a more “hawkish” (higher) interest rate backdrop for late 2022 and 2023.
As mentioned, our positioning view is more defensive with increased cash on hand, reduced or rebalanced the composition of our equity exposure, and, in general, sought more high-quality positioning throughout client portfolios. We will continue look for tactical opportunities to add to equity and fixed income exposures as the market continues to retest lows established in mid-June (S&P 500 level of 3,666 and 10-Year Treasury yield of 3.5%).
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