June 14, 2022
Market Volatility Update
The S&P 500 is off 22% from its peak, and 62% of constituents have fallen into “bear market” territory.
Friday’s deluge of data reiterated a belief among investors that the Federal Reserve has fallen behind the curve and must act more forcefully to combat broadening inflation even as consumer sentiment plummets. Market pricing of the yield curve signals that the challenge of engineering a “soft landing” has been ratcheted up. This follows a few weeks during which financial conditions eased and “risk-on” relief rallies helped boost equities.
Investors can expect tighter financial conditions and policy rates, which limit upside for equity valuations while exerting downward pressure on fundamentals including corporate earnings.
We continue to advocate defensive posturing as it relates to equities and last month moved to a tactically underweight position in our multi-asset framework. We maintain a preference for segments demonstrating higher quality, stable and/or high conviction cash flows, and yield.
In our previous pieces, we noted that markets don’t correct by moving sideways and that bear markets have three stages: 1) a sharp drop, 2) reflexive rebound and 3) longer fundamental bottoming. These musings seem especially prescient as recent “risk-on” relief rallies have been shaken off with a resumption of more defensive selling pressures. We’re not trying to frighten or come off as pessimists — rather we hope to assist clients in achieving their financial goals.
The S&P 500 is off 22% from its intra-day high on January 4, and the average stock has declined approximately 26% from its 52-week high. The same figures for the Nasdaq Composite Index stand at –31% and 49%, respectively. The bears are out in full force. The most recent lurch lower has come from a realization that monetary policy may need to tighten at a higher and faster pace to combat pervasive inflation. This stresses both the valuation and fundamental components underpinning equities.
We’ve noted that the Fed will use financial conditions as a primary transmission mechanism to affect policy. Generally, financial conditions are thought to include short-term policy rates (Fed Funds), intermediate bond yields (10-Year Treasury and credit spreads), the trade-weighted dollar and a slight weighting to some form of equity valuation. Mortgage rates could also be an ancillary consideration. Our view has been that the Federal Reserve (the Fed) will guide market-based financial conditions at a more agile pace than through policy rate setting at Federal Open Market Committee meetings. Therefore, a lower rerating of equity valuations was entirely congruent with the Fed’s goal while we awaited the more lagged effects of higher rates to ultimately filter through to fundamentals (read: earnings).
But financial conditions began to loosen up again in recent weeks, which seemed at odds with the Fed’s explicit goals. Former Fed President Bill Dudley opined on June 1, “Financial conditions have eased a bit, with stock prices rebounding and bond yields falling. If this earning of financial conditions were to continue, Fed officials would have to respond by pushing short-term rates higher than currently anticipated.” On the day that Dudley penned his missive, the OIS-implied Fed Funds rate for December was priced at 2.73%, while today it sits at 3.43%.
Friday’s data deluge shifted the narrative from “Peak Inflation” to “Peak Policy Lag” as investors repriced their outlook given increased belief that the Fed had again fallen too far behind the curve. The headline inflation data was eye opening, and the core, trimmed mean and sticky variations were arguably even more troubling. Meanwhile in Ann Arbor, the University of Michigan’s Consumer Sentiment Index registered its lowest level ever while the Expectations Index hit its lowest level since May 1980, when the Fed Funds rate was 11%. The mean and median expectation for inflation 5–10 years out surged to 4.3% and 3.3%, respectively. This gives the macro observer the impression that pricing pressures are high and broadening, that consumer expectations for those pressures are becoming untethered and that consumer confidence is already on very shaky ground even before monetary policy has become restrictive.
The bond market is sounding some alarms. In April, we noted that an inversion of the 2s/10s Treasury curve has more limited predictive power, whereas the Fed Funds-to-10-Year curve (“FFs-10s”) is a more reliable indicator for the economic cycle. A policy rate above intermediate yields implies that investors expect some mix of declining economic output and rate cuts to ultimately follow. The FFs-10s curve did not invert in April, nor is it inverted today; however, the market is implying an inversion within months. As mentioned above, traders are pricing in an implied policy rate of 3.43% in December while the 10-Year currently trades at 3.34%. This is concerning.
From an equities perspective, we’ve advised a more defensive approach in recent months and shifted to an equities underweight in multi-asset allocations. We expect equities to continue taking their cues from three main pillars powering the market:
- Geopolitical flash points
- Central banking policy
- Fundamental outlook for economic growth and earnings
The most recent market volatility is obviously attributable to an expected hawkish shift in central bank policy, but we believe the third component will shift into focus as a likely source for incremental pressure. We ask rhetorically: We know the “P” in the price to earnings ratio, but can you trust the “E”? As we move toward the heart of Q2 earnings season in July and Q3 in October, we’ll maintain a keen focus on the trajectory of management guidance and analyst estimates in forward periods. Margins, in particular, appear vulnerable as analysts have decreased revenue expectations corresponding with a slowdown in nominal growth, but they’ve preserved higher earnings growth rates by expanding margins.
Exhibit 1: Multiple compression has outstripped positive earnings to drive equities lower this year.
Source: FRIM Investment Research, Bloomberg. Data as of June 13, 2022.
First Republic Private Wealth Management encompasses First Republic Investment Management, Inc., an SEC-registered Investment Advisor, First Republic Securities Company, LLC, Member FINRA/SIPC, First Republic Trust Company (“FRTC”), First Republic Trust Company of Delaware LLC (“FRTC-DE”) and First Republic Trust Company of Wyoming LLC (“FRTC-WY”).
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