By Ellen Hazen, CFA, Chief Market Strategist
At any point in time, there are multiple competing narratives that attempt to explain what is happening in various markets. For the last two years, the COVID-19 pandemic – and actions taken to respond to it – have been the predominant driver of market prices. In March 2020, economic activity dramatically slowed as a result of shutdowns, and the government responded with massive fiscal and monetary stimulus in the form of lower interest rates, a larger Federal Reserve balance sheet, and direct transfers to US households and businesses. These responses worked so well that US economic growth re-accelerated, causing, among other things, inflation.
Let’s take a step back and remember where we were before COVID. Unemployment was running very low, at only 3.5%. Economic growth was solid, at +3.5%. The economic cycle had been strong for several years, and corporate profit margins were at all-time highs, as illustrated in the chart below.
Starting in March of 2021, inflation began to materially accelerate, increasing from well below the Fed’s long-term 2% target, to over 4%, and most recently to over 7%. As a result, last week the Fed raised interest rates by a quarter of a point and is set to raise rates at least seven more times by year’s end, according to both market-implied measures and the Fed’s own projections reflected in its “Dot Plot.”
What does this mean for markets? To understand this, we need to understand why raising the Federal Reserve rate is expected to lower inflation. Inflation results when there is greater demand for goods and services than supply of goods and services. Raising interest rates does not increase supply, but it is likely to reduce demand. Therefore, the Fed’s action is being taken primarily to reduce demand via increasing the cost of money.
This will likely have the effect of slowing the economy – indeed, estimates for US GDP have already declined from the beginning of the year, from 3.8% in January to 3.7% in February, and most recently down to 3.5%. The war in Europe will further crimp economic growth along multiple fronts: higher commodity prices in those commodities exported by Russia and Ukraine (wheat, coal, oil, gas); physical destruction of productive capital in Ukraine; massive displacement of productive workers and the economic costs to countries absorbing refugees; and continued supply chain disruption globally.
Since January, both equity and fixed income markets have been reflecting this expectation of slower growth. On the fixed income side, the yield curve has significantly flattened, with the spread between 2-year Treasury bonds and 10-year Treasury bonds declining from 1.20% in the fall of 2021 to only 0.06% now. (A flatter yield cure is historically a reflection of bond market participants’ expectations for slower growth, while an inverted yield curve – when the 2-year Treasury bond has a higher yield than the 10-year Treasury bond – has historically preceded economic recessions). On the equity side, some indicators such as volatility, have also suggested slowing growth. The Volatility Index (“VIX” see chart below) has remained volatile, recently rising to 35 before falling back to 19 currently. However, corporate profit estimates have not materially yet declined. (Often, Wall Street analysts are late to downgrade profit estimates, and may wait until late April / early May, when companies report Q1 2022 earnings). GDP growth in 2022 will certainly be lower than 2021’s torrid pace of 5.7%.
What does this all mean for markets? For fixed income investors, slower growth and rising inflation point us toward investing in higher-quality assets that are still insulated from inflation: investment grade bonds, better-quality high yield bonds, and floating rate bonds.
Looking at how equity markets perform in a slowing economy, historically the S&P500 is unlikely to repeat the high double-digit returns that we saw in 2019, 2020, and 2021. Quality will be rewarded here as well. In such an environment, we believe one should invest in companies with high cash generation, stable growth, and high margins.
The biggest risk in the current environment is that if the Fed raises rates too aggressively it could trigger a recession. Right now, markets are not reflecting that as a probable outcome. And, the Fed has repeatedly said that it will be data-dependent – in other words, it will keep a careful eye on a variety of economic indicators and stand ready to pause the interest rate increases if the economy shows signs of stress.
The current environment is not smooth sailing for investors. But it is also not a terrible environment for them. In fact, many elements are strong, including low unemployment, rising wages, and still-growing corporate profits. In environments like this – indeed, at most points in time – the indicators are mixed rather than uniformly positive or negative. But mixed indicators do not mean a likely recession or imminent market decline. Today’s investing environment still provides opportunity.
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