Reassessing the Evolving Market Landscape
- As outlined in our January 2022 Outlook – Navigating Moderation, we anticipated a challenging investment environment with heightened levels of volatility.
- The broad themes outlined at the beginning of the year – the evolving nature of the pandemic, central bankers’ balancing act and historically high inflation remain the prevailing themes. Along with the rising probability of recession, these themes will likely drive capital markets volatility throughout the second half of the year.
- As of June 13, 2022, the S&P 500 officially entered bear market territory, which is more than 20% below its all-time high set in January of 2022. In addition to a global stock market rout, the 10-Year U.S. Treasury yield is up about 2% year to date (through June 14), making the first half of 2022 one the worst periods for the bond markets on record.
The State of the Broader Economy
With the economic fallout including the exacerbation of inflationary forces from the war in Ukraine, inflation at 40-year highs, a flattening yield curve bordering on inversion and a bear market in the S&P 500 Index recession expectations have been steadily rising this year. Near-term economic and inflation data is likely to underwhelm if not disappoint, particularly on the heels of the strong economic advances in the aftermath of massive fiscal and monetary stimulus throughout the pandemic. Even in the face of slowing economic growth and forward-looking growth expectations, the Federal Reserve (Fed) has little wiggle room to focus on anything other than reining in inflation. Given the Fed’s failure to raise rates in 2021 in the face of what it called “transitory” inflation at the time, it has no choice now but to play catch up, even if it means causing a recession. As a result, global stock and bond markets have been grappling with increasing stagflation 1 concerns, which have necessitated the broad repricing of financial assets that we have seen.
Our 2022 Themes – Revisited
1) From Pandemic to Endemic
- Despite the general trend toward less virulent subsequent variants, we expect COVID-19 to continue to exacerbate supply chain bottlenecks, particularly in China, where a zero COVID-19 policy is still leading to unpredictable production stoppages and global economic growth headwinds. It is another factor leading to supply shortages and inflationary pressures.
- Portfolio Impact : The Fed can only impact demand with monetary policy, but the supply bottlenecks are likely to continue for some time, exacerbated by flare-ups in COVID-19 infections. Expect supply chain bottlenecks to continue to weigh on production, economic growth, and inflation forces.
2) Policy Maker Tightrope
- Central bankers across the globe continue to implement an array of policy responses, crafted to address their own unique economic circumstances. While many central banks are raising rates to dampen inflation, conditions in some regions have required more nuanced approaches. These range from the European Central Bank’s near-term emphasis on quantitative tightening via its bond-purchase program likely paired with rate increases, to the People’s Bank of China’s efforts that lean into more stimulus to stabilize an economy recently maligned by widespread lockdowns in response to a COVID-19 outbreak.
- Portfolio Impact: Exacerbated by disparate policy responses by central bankers across the globe, conditions remain unsettled with inflation and interest rates. We believe wise action remains to actively manage fixed income and mitigate overall portfolio duration through portfolio construction. Bolstered by a more favorable valuation profile, emerging market stocks may draw additional support from more stimulus in China and a marginally stabilizing global commodity complex. The Fed’s austerity campaign and a resilient U.S. Dollar could serve as headwinds; however, the case for emerging market stocks persists, as we mentioned in our January 2022 Outlook.
3) Inflation: Coming or Going?
- Inflation continues to run at 40-year highs, which is untenable to the Fed. As shown by the Fed’s nearly unanimous approval of its 75-basis-point hike on June 15, there will be a more accelerated and emphatic path to higher rates than expected as recently as last week or last month. Among Fed officials, the weighted-average expectation for the fed funds rate at year end currently stands at 3.6% according to the CME FedWatch Tool as of June 17, 2022. One week before on June 10, it stood at 3.3%; one month before on May 17, it stood at 2.9%. The current fed funds rate is 1.5%-1.75%1.
- Portfolio Impact: The path to a moderating inflation trend is likely to be choppy. Rising interest rates and a slowing economy could lead to waning inflationary pressures towards the end of 2022. However, as we outlined in our January 2022 Outlook, an allocation to real assets continues to be important to diversify and help protect the portfolio from further rising inflation.
4) Volatility Ahead: Be Comfortable with Your Risk Posture
- Equity markets no longer enjoy accommodative monetary policy and find their relative appeal more directly challenged by meaningfully higher bond yields. As investors find they can earn higher rates of return investing in bonds on a go-forward basis, stocks reprice (down) until a new equilibrium is achieved. Interest rate volatility remains higher than normal as investors labor to gauge the Fed’s further policy intentions, which will be driven primarily by inflation data. So far in 2022, the number of days where the 10-year U.S. Treasury has moved 10 basis points (0.10%) or more is well above the pace of previous years.
- Portfolio Impact: We remain vigilant to the evolving conditions in markets. All things considered, we reaffirm the investment orientations we shared with you earlier in the year – namely, our preference for a globally diversified equity profile, an inclination to diversify fixed income as to mitigate interest rate risk, and our commitment to real asset exposure. We believe this positioning should moderate the most stressful potential effects currently influencing markets.
Updated Market Forecasts and Portfolio Implications
Markets have been in a consolidating mode year to date as investors grapple with stubbornly high inflation, evolving Fed policy, and the conflict in Ukraine. From the beginning of the year through June 16, domestic equities (S&P 500 Index) have declined by 22.5%, while international equities (MSCI ACWI Ex USA Index) and U.S. bonds (Bloomberg US Aggregate Index) are down 18.34% and 11.5%, respectively 2. Only commodities and related real assets have offered any protection to investors in 2022.
Our capital markets research team regularly surveys the investing landscape. When we see meaningful changes, we revise our forward-looking assumptions. We completed this exercise in early June for the period ending May 31. Our forward-looking return expectations for many asset classes increased due to this year’s wide scale repricing of markets as mentioned above.
Markets retreated broadly across global fixed income and equity asset classes this year resulting in similar modifications in return expectations across broad and sub asset classes. Consequently, the forecast revisions that were made did not generate meaningful changes to representative portfolios.
In summary, our best ideas portfolios remain in place as of this mid-year update. While markets during the first half of 2022 have been challenging, it is important to remember that they move based on changing expectations about the future. While painful in the short-term, the selloff has repriced many assets across fixed income and equity classes to more compelling valuations on a forward-looking basis. While it is foolhardy to predict market bottoms, it is important to note they have usually come with peaks in both pain and pessimism. It is unlikely to be different during this bear market. In full recognition of the rapidly evolving markets, we encourage engagement with your advisor to discuss the circumstances unique to your portfolios.