Market Update

May 19, 2022

Market Volatility Update

What’s Important

• Markets will remain under pressure with significant bouts of volatility persisting as investors digest a regime shift toward tighter policy intended to thwart inflation.

• The scenario tree of economic outcomes is much more equally weighted, given material risks of higher-for-longer inflation, stagflation or even recession.

• We advise equity investors to remain defensive and rebalance toward equity sectors we favor and toward high-quality equities within sectors.

• On the back of the equity volatility, we recommend investors consider the following for their asset allocation:

• Wait to deploy new cash, and use the anticipated volatility as the Fed tightens policy to average into high-quality companies over the next several months to capture the volatility.

• If you are overweight risk assets, reduce exposures, as we expect additional downside from global equities.

• If you are neutral or underweight risk assets, stay the course; we expect additional rebalancing opportunities over the coming months.

• Opportunistically review Alternatives for additions to portfolios, including option strategies, hedge funds and credit funds; select private equity exposures remain attractive.

Equities are churning through a channel of volatility in the midst of a drawdown threatening to metastasize into a more consequential bear market. The driving force behind the turbulence is the fear of a significant economic slowdown induced by a sharp Fed tightening cycle in response to inflation. This shift is in sharp contrast to the post-COVID backdrop in which policy reached historic levels of accommodation and growth surged well above trend. As a result, markets are adjusting to the new regime with many segments that thrived in an era of peak liquidity and are now buckling up for a much bumpier road forward. We expect U.S. equities to move higher into year-end, but there could be additional downside and volatility will persist, auguring more defensive investor positioning.

Yesterday, the first-quarter earnings results from a select group of consumer bellwethers were a microcosm of investor concerns. Companies are finding it increasingly difficult to manage inventory and costs that are hampering margins and impairing earnings. This threat to fundamentals coincides with an ongoing repricing of “risk assets” lower, consistent with tighter financial conditions that include higher rates, yields and spreads as the Fed looks to wring excesses out of the system. These pressures are especially acute in certain segments (“Concept Capital”) characterized by high valuation concentrated in some distant terminal figure. With the cost of capital rising and the economic backdrop murky, investors are prioritizing value, yield and stability.

We expect markets to stabilize when: 1) a resolution to the trifecta of current risks — higher inflation, stagflation or recession — comes clearer into focus; 2) credit markets stabilize; and 3) inflation and jobs data break lower, giving the Fed room to slow the current tightening policy. The Fed will continue to play a central role and has given no indication that they will let up in their ambition to stabilize price levels. Financial conditions have already tightened, acting as a transmission mechanism for Fed policy, but we caution that additional downside to equities of 15-20% is possible if additional tightening is signaled and/or economic momentum deteriorates more than expected. This is not our base case, as we believe that the U.S. economy is on solid footing, bolstered by strong consumer spending, and low financial stability risks. However, we expect several quarters of readjustment for the economy to normalize into a more sustainable trajectory, allowing for policy to settle.

In our view, investors should consider rebalancing back to target for risk assets that have drifted above prescribed weights. Neutral or underweighted positions should remain for the time being, and defensive positioning within equities is preferred. We suggest deploying new cash opportunistically and on a systematic basis (averaging) to capture peaks and ebbs in volatility. Private market valuations are likely to compress quickly, potentially creating attractive entry points in credit, real estate and select equities. Hedge funds, long/short strategies and option programs may be attractive methods for managing risk and capturing volatility.