Markets Struggle to Find Footing as Rates Rise
A number of risks have converged on financial markets in a short period of time and have clouded the outlook for the economy and asset prices. The historic rise in inflation, exacerbated by tight labor markets, China’s ongoing COVID-related lockdowns, and a sudden energy price spike resulting from Russia’s invasion of Ukraine, has started to put pressure on corporate profits and triggered a dramatic rise in interest rates.
The rapid transition of Fed policy from quantitative easing to quantitative tightening is one of the most significant developments for financial markets since the 2008/2009 global financial crisis. The sustained level of monetary stimulus on the heels of the GFC and the COVID pandemic resulted in an unprecedented environment of low to negative real interest rates and created an investment landscape where there was “no alternative” to equities (and seemingly no ceiling for stock prices). Now, as the Fed pivots to fight inflation and the 10-year bond yield has risen to nearly 3%, the already significant pressure on earnings multiples (the “P/E ratio”) may have only just begun. In this environment, value stocks have become more attractive than growth stocks because current earnings and cash flow are more valuable than unknown future earnings as rates go higher.
The US may still be able to avoid a recession if strong consumer and corporate spending exiting the pandemic stay on track. Corporate earnings are expected to grow around 10% in 2022 and 8% in 2023. While we wouldn’t be surprised if these estimates decline somewhat, the US economy has underlying strength.
However, the number of recent shocks to the system and the time it will take to digest them have prompted us to become more defensive. Under these conditions we would normally turn to the safety of the bond market, but the inflation outlook that caused the recent, sudden downward repricing of bonds has the potential to continue.
Therefore, in spite of rising risk levels since the beginning of the year, we continue to favor stocks over bonds, specifically U.S. large cap stocks with an emphasis on valuation and income. We have very little exposure to small cap stocks where prices are still elevated. We also maintain our underweight to international markets due to fundamental/structural factors that include the lingering impacts of COVID and the war in eastern Europe.
Our outlook for bonds also remains cautious as the Fed continues to push short term rates higher. While yields have become more attractive, we are especially concerned about price volatility in intermediate and longer term maturities. We remain underweight the entire asset class, but see value in floating rate private credit and certain shorter duration bonds. We also seek opportunities in alternative assets, including real estate and equity income strategies, as a way to diversify risk exposure, hedge against inflation, and increase current income.
We are likely headed for a period of below-trend growth, as sticky inflation takes a bite out of real economic activity and there is a reset in both fiscal and monetary policy. As the Fed normalizes interest rates, earnings multiples must come down. While we do expect solid earnings growth, we anticipate that the market multiple will continue to compress toward historical norms, thus limiting upside to stock prices.
In an environment of slowing earnings and economic growth, P/E multiple contraction, rising rates, and an uncertain geopolitical environment, it’s difficult to expect annual returns as robust as those we’ve seen over the past several years, which have been well above long term averages. We think it prudent to expect a period of below-trend returns as the long-term interest rate cycle normalizes. That being said, while our forecast is based on solid fundamental reason and logic, we recognize the market is not always as rational.
As always, please call or write with any questions or feedback.